Financial Integration and Financial Instability Dmitriy Sergeyev Bocconi University International Banking: Microfoundations and Macroeconomic Implications Amsterdam June 12-13, 2014 1 / 15
Safe securities and financial integration 2 / 15
Safe securities and financial integration Safe securities: ◮ Examples: bank deposits, short-term collateralized debt ◮ Useful medium of exchange: prevents adverse selection 2 / 15
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 2 / 15
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? 2 / 15
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 2 / 15
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 3 / 15
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 4 / 15
Equilibrium Binding Collateral Constraints 5 / 15
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 Return on Safe Assets, Safe Assets, Fire-sale price, Banks Assets, 5 / 15
Equilibrium Binding Collateral Constraints Return on Safe Assets, Safe Assets, Fire-sale price, Banks 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 6 / 15
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 7 / 15
Effects of Integration 8 / 15
Effects of Integration 8 / 15
Effects of Integration 8 / 15
Effects of Integration 8 / 15
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 9 / 15
Regulation: Safe Debt Taxation (Periphery) Regulator ◮ Maximizes her country economic welfare U P max τ P ◮ Faces all equilibrium conditions as constraints ◮ Chooses proportional taxes τ P on safe debt issuance 10 / 15
Effects of Regulation 11 / 15
Effects of Regulation 11 / 15
Effects of Regulation 11 / 15
Effects of Regulation 11 / 15
Effects of Regulation 11 / 15
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) 12 / 15
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) 12 / 15
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 13 / 15
Can capital controls help? ◮ Currently popular among some policy makers ◮ Recent literature in international finance provide rational 14 / 15
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 14 / 15
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 14 / 15
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 15 / 15
Thank You 16 / 15
Additional Slides 17 / 15
CA/GDP Germany Spain % 8 6 4 2 0 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 -2 -4 -6 -8 -10 Back Source: Eurostat 18 / 15
Financial sector liabilities Domestic LTRO Foreign (trilliongofg € ) 2.0 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Back Source: Shin (2012) and Bank of Spain 19 / 15
Spanish Covered Bonds 400 BillionvEuros 350 300 Spain:vstockvof 250 mortgage coveredvbonds (endvyear) 200 150 Spain:vnew 100 issuancevof mortgage coveredvbonds 50 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 85% are owned by foreigners in 2011 Back Source: Shin (2012) and Barclays Capital 20 / 15
Household C 0 ,C 2 ( s 2 ) ,D,B ( s 2 ) C 0 + β E C 2 + v ( D ) max 1 � s.t. C 0 + D + B ( s 2 ) P B ( s 2 ) ≤ Y R D s 2 C 2 ( s 2 ) ≤ D + B ( s 2 ) + π Banker ( s 2 ) + π OI ( s 2 ) FP Interior solution for B ( s 2 ) and D implies R B = 1 1 β > R D = β + v ′ ( D ) Back 21 / 15
Household Objective C 0 + v 0 ( D 0 ) � � + pβ max D 1 + B ( G ) + π Banker ( G ) + π OI ( G ) + D 0 − D 1 + v 1 ( D 1 + D 0 − D 1 ) D 1 ∈ [0 ,D 0] � + (1 − p ) β max q { D 1 + B ( Bnc ) + π Banker ( Bnc ) + π OI ( Bnc ) + D 0 − D 1 + v 1 ( D 0 − D 1 ) } D 1 ∈ [0 ,D 0] � + (1 − q ) { B ( Bc ) + π Banker ( Bc ) + π OI ( Bc ) + D 0 − D 1 + v 1 ( D 0 − D 1 ) } where D 1 is roll-over choice. In optimum D 1 ( G ) = D 0 and D 1 ( B ) = 0. ⇓ C 0 + β E C 2 + v ( D 0 ) where v ( D 0 ) = v 0 ( D 0 ) + βv 1 ( D 0 ). Back 22 / 15
Banker � � max π Banker = p AF ( I ) − D − B B,D,I,K � � � + (1 − p ) Q c K − D + q AF ( I ) − K − min { B, AF ( I ) − K } � + (1 − q ) · 0 Budget at t = 0 I ≤ D + P B ( G ) B + P B ( Bnc ) min { B, AF ( I ) − K } R D � �� � value of risky debt Safe debt must be safe D ≤ Q c K K ≤ AF ( I ) Back 23 / 15
Uncertainty Good news Bad news Back 24 / 15
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