Greater international financial integration in recent decades has increased the scope for cross-border financial spillovers from one group of countries to another. Do these spillovers, and the resulting financial risks that they create for the world economy, provide greater scope for international policy coordination in the area of prudential policy? In an ongoing joint research programme with the Bank for International Settlements, Professor Pierre-Richard Agénor has focused on this and a range of related issues. In this blog he discusses the key insights and main policy lessons that have been drawn so far.
- Increased global financial interconnectedness, despite significant potential benefits, has led to new policy challenges.
- National policymakers around the world have relied increasingly on macroprudential policy.
- Maintaining a macroprudential policy coordination agreement is likely to be challenging in practice – even when mutual gains from such coordination are potentially large. To address this challenge requires ensuring that appropriate and credible sanctions are in place to mitigate the temptation to renege.
International financial integration and global financial shocks
Over the past three decades, and despite a slowdown coinciding with the Global Financial Crisis of 2007-09, the degree of integration of international financial markets has increased significantly. One aspect of this process, as documented for instance by the World Bank, is related to the dramatic increase in cross-border bank capital flows. Studies have also established that large, global banks play a significant role in the international transmission of financial shocks – both as a direct conduit for the propagation of financial shocks from one group of countries to another, and as an amplifying mechanism for these shocks.
Increased global financial interconnectedness, despite significant potential benefits, has led to new policy challenges. International capital flows have helped fuel domestic credit booms and asset price pressures that have often ended in financial crises. In addition, international financial spillovers have become a two-way street. Financial market volatility in some large middle-income countries (especially China) is increasingly transmitted back to asset prices in advanced economies – with the potential to create financial instability in both directions.
Policy responses and regulatory leakages
To insulate themselves from global financial shocks and mitigate the systemic financial risks that international capital flows may create, national policymakers around the world have relied increasingly on macroprudential policy. As usually defined, macroprudential policy consists of actions taken by a regulatory authority in its own jurisdiction, with the goal of promoting financial stability and mitigating systemic risks to its financial system. These actions use a set of instruments that reduce the vulnerabilities of the financial system by imposing specific rules on banks and their borrowers.
These policies appear to have been effective to some degree. However, the evidence suggests also that they themselves can be a source of cross-border capital flows, as financial institutions shift their lending operations across countries in response to regulatory changes in a particularly country. This phenomenon has been referred to as regulatory leakages. The issue therefore is whether greater coordination among national regulators is desirable to prevent leakages and respond more effectively to global financial spillovers (that is, the impact that seemingly unrelated events affecting the financial sector in advanced economies can have on economies in other parts of the world, especially the larger ones) and spillbacks (the effects that similar events occurring in the rest of the world can have on advanced economies).
In a joint research programme with the Bank for International Settlements (an institution who plays a central role in international banking regulation), I have focused on that issue. The programme has also considered how to measure the magnitude of potential gains from international coordination, and the role international financial organisations may, or should, play in monitoring system-wide financial risks and promoting coordination in the area of macroprudential regulation.
The rationale for international policy coordination
Even though cross-border spillovers and spillbacks may be significant, and may indeed have increased in magnitude in recent years, it does not necessarily follow that that cooperation is prima facie desirable. If the global economy is experiencing a recession for instance, the coordinated adoption of an expansionary fiscal policy by some large countries may, through trade and financial spillovers, benefit all countries. The magnitude of this gain may actually increase with the degree to which countries are interconnected.
But if maintaining financial stability is also a policy objective, the propagation of financial risks must also be a source of concern. To the extent that these risks (in the form of excessive credit growth for instance) tend to increase with the magnitude of spillovers and spillbacks, there is a case for macroprudential policy coordination. Such coordination may involve setting joint rules for the equity capital that banks are required to hold, either permanently, or temporarily, depending on how well the economy is doing.
The gains from international coordination
Given a rationale for international macroprudential regulation, how large are the gains, in terms of achieving standard objectives for policymakers, such as price stability and GDP stability for central banks, and financial stability (measured in terms of a steady credit-to-GDP ratio) for regulators? Estimates have been based on comparing outcomes when countries act independently, with a situation where they act cooperatively. Under uncoordinated policymaking, each country’s regulator sets its own policy instrument, taking the choice of instrument of all other regulators as given. The resulting outcomes typically fail to fully factor cross-border spillovers into national policy decisions. In contrast, if regulators coordinate their choices by jointly determining instrument settings, the spillovers each of them is confronted with would be taken into account. Thus, coordination may enable all policymakers to attain better outcomes. Indeed, some studies have found that the gains from coordination can be potentially significant.
Can coordination be sustained in practice?
However, even if gains do exist in principle, achieving and maintaining coordinated policies across countries may prove difficult in practice. Indeed, assuming that a cooperative outcome can be achieved, and that regulators have agreed to coordinate, each of them almost invariably has an incentive to renege. Once one regulator has set its instrument at the agreed level, the others can set their own instrument at a different value and attain an even better outcome in terms of their own policy objectives. This incentive is stronger the smaller the perceived ex post cost of reneging on the agreement.
Maintaining a macroprudential policy coordination agreement is thus likely to be challenging in practice – even when mutual gains from such coordination are potentially large. To address this challenge requires ensuring that appropriate and credible sanctions are in place to mitigate the temptation to renege. A possible response may also be for countries to entrust an assessment of the need for coordination to reputable multilateral financial institutions – in effect, a group of “honest brokers”. How best and how much should national responsibilities be delegated to these institutions remains a matter of debate.