Committee on International Economic Policy and Reform

Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses

This report was written by the Committee on International Economic Policy and Reform, a non-partisan, independent group of experts, comprised of academics and former government and central bank officials. Its objective is to analyze global monetary and financial problems, offer systematic analysis, and advance reform ideas. The committee attempts to identify areas in which the global economic architecture should be strengthened and recommend solutions intended to reconcile national interests with broader global interests. Through its reports, it seeks to foster public understanding of key issues in global economic management and economic governance. Each committee report will focus on a specific topic and will emphasize longer-term rather than conjunctural policy issues. In this September 2012 report, the committee lays out a framework for cross-border banking flows and for improved regulatory coordination.

Committee Members

Markus Brunnermeier, Princeton University
José De Gregorio, University of Chile
Barry Eichengreen, University of California, Berkeley
Mohamed El-Erian, PIMCO
Arminio Fraga, Gavea Investimentos
Takatoshi Ito, University of Tokyo
Philip R. Lane, Trinity College Dublin
Jean Pisani-Ferry, Bruegel
Eswar Prasad, Cornell University and Brookings Institution
Raghuram Rajan, University of Chicago
Maria Ramos, Absa Group Ltd.
Hélène Rey, London Business School
Dani Rodrik, Harvard University
Kenneth Rogoff, Harvard University
Hyun Song Shin, Princeton University
Andrés Velasco, Columbia University
Beatrice Weder di Mauro, University of Mainz
Yongding Yu, Chinese Academy of Social Sciences

REPORT INTRODUCTION

The world has become more integrated, not just through trade but through financial flows. Financial integration offers many benefits but also poses risks. This observation in turn points to the question of how best to benefit from greater financial integration while limiting adverse effects. A complicating factor in improving the benefit- cost tradeoff from financial integration is that banks often play a central role in intermediating these flows. Banks behave in ways that differ from those predicted by textbooks of atomistic participants in financial markets. In addition, they are subject to uncoordinated regulatory and political forces that are and hard to predict.

In this report, we draw on the growing body of evidence on cross-border capital flows in an effort to better understand their effects in practice. Building on this analysis, we suggest ways in which policy should be adapted to reap the benefits of the flows while minimizing their costs. While bank flows cannot be studied in isolation, our analysis and policy recommendations focus on banks, as they intermediate a substantial fraction of cross-border capital flows, are highly volatile, and pose specific regulatory and policy challenges.

The textbook case for financial integration is well known. It allows capital to flow from capital-rich to capital-poor economies, where returns should be higher. These flows complement limited domestic saving in capital-poor countries and reduce their cost of capital, thus boosting investment and growth. Financial integration can also help cushion the impact of adverse shocks, since consumption can be smoothed by external borrowing even if incomes are volatile, while capital flows can help to sustain investment. Financial integration can provide risk diversification by allowing residents to transfer domestic risks to foreign investors while gaining exposure to foreign investment opportunities.

In addition, financial flows may have “collateral” or indirect benefits. Foreign direct investment (FDI) can bring new technologies, along with managerial and organizational expertise, to the receiving country. International investors tend to demand more transparency and better governance of local firms. By providing risk-bearing capital, financial integration can help domestic firms specialize, fostering faster productivity growth. Monitoring by international investors can discipline macroeconomic policies, encouraging governments to pursue sustainable fiscal policies and enlightened prudential strategies. These indirect benefits of financial openness thus promise faster economic growth.

Even diehard proponents of liberalized, open financial markets make some allowance for a slower pace of financial integration for developing or emerging economies, citing their weaker institutions and more limited capacity to absorb and benefit fully from the inflows of capital. In their view, however, the ideal of full capital account convertibility should still serve as the North Star that emerging-economy to which policy makers should navigate, even if they must steer close to land initially so as to avoid the perils of the open ocean that only advanced economies can navigate safely.

At the same time, recent events, from the subprime crisis in the United States to capital flow reversals and the banking crisis in Europe, have shaken faith that even advanced economies can harness the benefits of greater financial flows and deepen financial integration without incurring costs. The advanced countries that have been swept up first by the subprime crisis and now by the eurozone crisis are not the stereotypical emerging economies with weak institutions. Spain, for example, ranks high on traditional yardsticks of financial development such as the ratio of commercial bank assets to GDP, or of markers of financial integration such as cross-border liabilities as a proportion of GDP. And yet, those same measures of financial integration and development that were held up as yardsticks of progress have turned out instead to be the engines of financial distress as capital flow reversals have gathered pace in Europe. In contrast, it has been the emerging economies with what were presumed to be “weak” institutions and underdeveloped financial markets that have best weathered the storm.

These topsy-turvy outcomes have been disorienting for those who believed in the desirability of moving toward the ideal of liberalized, open financial markets in incremental steps. In this report, we will take stock of the traditional case for financial liberalization and offer our perspective on which principles have withstood the test of recent events and which ones now need rethinking.

Additional Resources