Financial Integration and Financial Instability Dmitriy Sergeyev - - PowerPoint PPT Presentation

Financial Integration and Financial Instability

Dmitriy Sergeyev Bocconi University International Banking: Microfoundations and Macroeconomic Implications Amsterdam June 12-13, 2014

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Safe securities and financial integration

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Safe securities and financial integration

Safe securities:

◮ Examples: bank deposits, short-term collateralized debt ◮ Useful medium of exchange: prevents adverse selection

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Safe securities and financial integration

Safe securities:

◮ Examples: bank deposits, short-term collateralized debt ◮ Useful medium of exchange: prevents adverse selection

Cross-border flows:

◮ Massive increase in cross-border capital flows in Europe

since introduction of Euro

Plots

◮ Partly associated with banks selling safe claims abroad ◮ Why? Removal of capital controls and exchange rate risk

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Safe securities and financial integration

Safe securities:

◮ Examples: bank deposits, short-term collateralized debt ◮ Useful medium of exchange: prevents adverse selection

Cross-border flows:

◮ Massive increase in cross-border capital flows in Europe

since introduction of Euro

Plots

◮ Partly associated with banks selling safe claims abroad ◮ Why? Removal of capital controls and exchange rate risk

This paper asks:

◮ Can safe debt markets integration make crises worse? ◮ Can this integration reduce welfare? ◮ How should financial sectors be regulated in the integrated

world?

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Safe securities and financial integration

Safe securities:

◮ Examples: bank deposits, short-term collateralized debt ◮ Useful medium of exchange: prevents adverse selection

Cross-border flows:

◮ Massive increase in cross-border capital flows in Europe

since introduction of Euro

Plots

◮ Partly associated with banks selling safe claims abroad ◮ Why? Removal of capital controls and exchange rate risk

This paper asks:

◮ Can safe debt markets integration make crises worse? Yes ◮ Can this integration reduce welfare? Yes ◮ How should financial sectors be regulated in the integrated

world? Depends: local vs. global regulator

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Related Literature

Imbalances due to difference in financial development

◮ Caballero, Farhi, Gourinchas (2008), Mendoza, Quadrini, Rios-Rull

(2009)

◮ This paper: Different productivities of marginal projects

Welfare effects of financial integration

◮ Mendoza, Quadrini, Rios-Rull (2009), Eden (2012) ◮ This paper: Endogenous creation of safe and liquid assets

Banking integration may increase volatility of prices

◮ Castiglionesi, Feriozzi, Lorenzoni (2009) ◮ This paper: Financial frictions

Macroprudential regulation of capital inflows

◮ Jeanne and Korinek (2010), Bianchi (2011) ◮ This paper: Capital controls = prudential regulation

Terms of trade manipulation

◮ Obstfeld, Rogoff (1996), Costinot, Lorenzoni, Werning (’12), Bengui

(2012)

◮ This paper: Banking regulation affects world interest rate

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Model Economy

◮ Households value holding safe debt

FP

◮ Banks have incentives to create safe assets

FP

◮ More safe debt can be created when it is short-term

Shocks

◮ Short-term debt creates fire-sales when households doubt

quality of assets

FP

◮ Limit on safe debt issuance is determined by the demand

for banks assets in crisis

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Equilibrium

Binding Collateral Constraints

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Equilibrium

Binding Collateral Constraints

Fire-sale price, Banks Assets, 5 / 15

Equilibrium

Binding Collateral Constraints

Fire-sale price, Banks Assets, 5 / 15

Equilibrium

Binding Collateral Constraints

Fire-sale price, Banks Assets, Safe Assets, Return on Safe Assets, 5 / 15

Equilibrium

Binding Collateral Constraints

Fire-sale price, Banks Assets, Return on Safe Assets, Safe Assets, 5 / 15

Inefficiencies and Externality

Frictions

◮ Nonpecuniary demand for safe claims ◮ Bankers inability to raise new funds in crisis

Externality

◮ Pecuniary externality when collateral constrains bind ◮ Overinvestment and overissuance of safe securities

Policies

◮ Limit safe short-term debt issuance ◮ Tax safe debt

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Cross-Country Assumptions

Countries

◮ Center (C), Periphery (P)

Markets

◮ Banks funding markets are global ◮ Fire-sale markets are local ◮ Banks invest locally

Why does capital flows from center to periphery?

◮ higher returns on new investments in periphery

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Effects of Integration

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Effects of Integration

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Effects of Integration

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Effects of Integration

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Welfare Effects of Integration

Result

• 1. The center always benefits from integration.
• 2. When asymmetry between countries is not large enough

then the periphery losses from integration. Intuition

◮ Gains are second order in the size of capital flows ◮ Losses are proportional to the size of capital flows

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Regulation: Safe Debt Taxation

(Periphery) Regulator

◮ Maximizes her country economic welfare

max

τ P

U P

◮ Faces all equilibrium conditions as constraints ◮ Chooses proportional taxes τ P on safe debt issuance

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Effects of Regulation

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Effects of Regulation

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Effects of Regulation

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Effects of Regulation

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Effects of Regulation

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Welfare Effects of Regulation

Periphery regulator’s decision has three effects on periphery:

◮ Reduction of overissuance of safe debt (positive) ◮ Reduction of supply of valuable safe securities (negative) ◮ Interest rate manipulation (positive)

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Welfare Effects of Regulation

Periphery regulator’s decision has three effects on periphery:

◮ Reduction of overissuance of safe debt (positive) ◮ Reduction of supply of valuable safe securities (negative) ◮ Interest rate manipulation (positive)

and two effects on the center

◮ Increase in overissuance of safe debt (negative) ◮ Interest rate manipulation (negative)

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Uncoordinated Safe Debt Taxation

Result A Nash equilibrium can be locally Pareto-improved if the periphery regulator decreases and the center regulator increases their taxes. Implications

◮ Scope for coordination of financial regulation policies ◮ Global regulator finds it optimal to set country-specific

state-dependent taxes

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Can capital controls help?

◮ Currently popular among some policy makers ◮ Recent literature in international finance provide rational

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Can capital controls help?

◮ Currently popular among some policy makers ◮ Recent literature in international finance provide rational

No: for global regulator

◮ Capital controls will only introduce inefficiency

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Can capital controls help?

◮ Currently popular among some policy makers ◮ Recent literature in international finance provide rational

No: for global regulator

◮ Capital controls will only introduce inefficiency

Yes: for local regulator

◮ It is optimal to address two objectives (reduction of

externality and interest rate manipulation) with two tools

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Conclusion

◮ Financial integration leads to larger crises in recipient

country

◮ Integration may lead to welfare losses in recipient country ◮ Regulators choose inefficient levels of safe debt taxation ◮ Regulators want to use both debt and capital flows taxation

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Thank You

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Additional Slides

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• 10
• 8
• 6
• 4
• 2

2 4 6 8 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013

CA/GDP %

Germany Spain

Source: Eurostat Back 18 / 15

0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Financial sector liabilities (trilliongofg€)

Domestic LTRO Foreign Source: Shin (2012) and Bank of Spain Back 19 / 15

Spanish Covered Bonds

50 100 150 200 250 300 350 400

2003 2004 2005 2006 2007 2008 2009 2010 2011

BillionvEuros

Spain:vstockvof mortgage coveredvbonds (endvyear) Spain:vnew issuancevof mortgage coveredvbonds

85% are owned by foreigners in 2011

Source: Shin (2012) and Barclays Capital Back 20 / 15

Household

max

C0,C2(s2),D,B(s2) C0 + βEC2 + v(D)

s.t. C0 + 1 RD D +

• s2

B(s2)PB(s2) ≤ Y C2(s2) ≤ D + B(s2) + πBanker(s2) + πOI(s2)

FP

Interior solution for B(s2) and D implies RB = 1 β > RD = 1 β + v′(D)

Back 21 / 15

Household

Objective C0 + v0(D0) + pβ max

D1∈[0,D0]

• D1 + B(G) + πBanker(G) + πOI(G) + D0 − D1 + v1(D1 + D0 − D1)
• + (1 − p)β

max

D1∈[0,D0]

• q {D1 + B(Bnc) + πBanker(Bnc) + πOI(Bnc) + D0 − D1 + v1(D0 − D1)}

+ (1 − q) {B(Bc) + πBanker(Bc) + πOI(Bc) + D0 − D1 + v1(D0 − D1)}

• where D1 is roll-over choice.

In optimum D1(G) = D0 and D1(B) = 0. ⇓ C0 + βEC2 + v(D0) where v(D0) = v0(D0) + βv1(D0). Back 22 / 15

Banker

max

B,D,I,K

πBanker = p

• AF(I) − D − B
• + (1 − p)
• QcK − D + q
• AF(I) − K − min{B, AF(I) − K}
• + (1 − q) · 0
• Budget at t = 0

I ≤ D RD + PB(G)B + PB(Bnc) min{B, AF(I) − K}

• value of risky debt

Safe debt must be safe D ≤ QcK K ≤ AF(I)

Back 23 / 15

Uncertainty

Good news Bad news

Back 24 / 15

Outside Investor

◮ Endowment W in t = 1 ◮ Storage technology: DOI

1 → 1

◮ Late technology: W − DOI

x → δg(x) + (1 − δ) · 0 increasing, concave, δg′(W) > 1

◮ Buys K risky projects at Qc from banks:

QcK ≤ DOI Problem max

K,DOI πOI =

q · K

Risky projects

+ δ · g(W − DOI)

• Late technology

+ [DOI − QcK]

• Storage technology

Solution q = Qcδg′(W − QcK)

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Full Integration

Main results

◮ Local lending markets ◮ Local fire-sale markets

Full integration? Assumptions

◮ Ex ante symmetric countries ◮ Correlation µ between arrival of good/bad news

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Full Integration

Fire-sale market integration

◮ Larger pool of outside investor funds when only economy is

in crisis

◮ Incentives to issue more safe debt

Lending market integration

◮ Effective diversification of collateral ◮ Incentives to issue more safe debt

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Example

0.2 0.4 0.6 0.8 1 6.4 6.6 6.8 7 7.2 I 0.2 0.4 0.6 0.8 1 4.3 4.35 4.4 D 0.2 0.4 0.6 0.8 1 0.3 0.31 0.32 0.33 Qc µ 0.2 0.4 0.6 0.8 1 8.625 8.63 8.635 8.64 8.645 Welfare µ 28 / 15

• 6.0
• 4.0
• 2.0

0.0 2.0 4.0 6.0 1995 1997 1999 2001 2003 2005 2007 2009 2011

Real GDP growth %

Germany Spain Source: IMF 29 / 15