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

Financial Integration and Financial Instability Dmitriy Sergeyevy

Discussion by Ashoka Mody June 13, 2014, Amsterdam

The Framework

• “Entrepreneurs” issue “safe” debt

– Valued for liquidity purposes

• “Banks” use the proceeds to lend for “risky

projects”

• Failure of risky projects cause fire sales
• …which create negative externalities, which

are not internalized

Capital flows can help…but

• Periphery benefits from capital inflows—

cheaper finance for projects with relatively high marginal products

• But some projects will fail, causing negative

externalities, which are not accounted for

• Periphery regulator can help by taxing bankers

who undertake the risky lending

• And that is the best outcome
• But…

Regulator in the center responds

• Periphery tax on bankers: “world” returns on

safe debt go down

• The Center is “hurt”: lower returns to

“entrepreneurs” and more domestic lending with the negative externalities

• Center regulator responds by reducing taxes
• n its bankers to raise “world” returns
• In equilibrium, aggregate welfare is lower

Policy Options

• Coordination
• Capital Controls in the periphery
• Reduced reliance on “safe” debt

Policy coordination

• Monetary policy analogy
• Federal Reserve eases policy to stimulate
• Search for yield, capital inflows to emerging

economies

• Negative externalities: appreciating real

exchange rate, higher domestic leverage

• Potentially disruptive end—fire sales
• “Excess flows”

Coordination in practice

• Raghuram Rajan: “[T]he current environment is one of

extreme monetary easing through unconventional

• policies. To ensure stable and sustainable growth, the

international rules of the game need to be revisited.”

• Bernanke’s response: “You say that the rules of the

game should prevent policies with 'large adverse spillovers ….' If you have a different empirical assessment than I do, that in fact, emerging markets would be better off if they hadn't been used, then you would have a different view."

Capital Controls

• Helen Rey, August 2013

– US monetary policy determines global financial cycle – Imposes binding constraint on domestic monetary policy – Independence possible only through capital controls

• Klein and Shambaugh, September 2013

– Capital (especially temporary) controls do not work – Even modest exchange rate flexibility helps

• Forbes, Fratzscher, Straub, December 2013

– Capital controls do not work on macro targets – But can help reduce financial vulnerability: credit growth, currency mismatches.

“Safe Debt”

• The problem is that banks are borrowing “safe

short-term” to lend to risky projects

• More reliance on equity

– Role of exchange rate flexibility

• Admati and Hellwig argue for more equity

holding by banks

• If banks—in the center and the periphery—

were required to hold more equity, then would the spillover effects not be mitigated?