30057 International Economics

Jan David Bakker

Bocconi University

Part 4 - International Capital Flows and

International Financial Crises

May 2022

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Introduction
• Since the 1980s, financial globalization has been rising even more rapidly than trade.
For many people, it is now possible to invest in stocks, bonds and derivatives from all
around the world.

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Introduction

• However, financial flows are also very volatile, and have not yet regained their 2007
peak.

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Outline

1. Financial globalization in theory and in practice

2. History of global financial liberalization (with a focus on the 2008/2009 Financial

Crisis and the Eurozone crisis)

3. Financial regulation

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Causes of financial globalization

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Causes of financial globalization

• Advances in information and computer technology

• Globalization of national economies
- Increased multi-national activity
- Increased trade flows
• Liberalization of national financial and capital markets
- US removed restrictions of activities across states and separation of investment
banking/insurance from commercial banking
- India removed interest rate controls, cuts in reserve and liquidity requirements, an
overhaul of priority sector lending, deregulation of entry barriers, strengthening of
prudential regulations and supervision, and partial privatization of public sector banks

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The benefits of financial globalization

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The benefits of financial globalization
• “Free capital movements facilitate a more efficient global allocation of savings,
and help channel resources into their most productive uses, thus increasing
economic growth and welfare. [...] International capital flows have expanded the
opportunities for portfolio diversification, and thereby provided investors with a
potential to achieve higher risk-adjusted rates of returns. [...] These are not abstract
concepts, but benefits that every country represented in this room has enjoyed as a
result of its access to the international capital markets”. – Stanley Fisher (1997)

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The benefits of financial globalization

• Fischer’s speech lists the two main arguments in favour of financial globalization:
1. It should allocate the world’s savings to the most productive uses worldwide.
2. It should help investors to reduce risk through diversification.
• A line of other benefits have also been brought forward:
- Finance can enable goods trade (e.g., Fiat needs to pay its US suppliers in dollars
before selling its final product, so it needs a credit in dollars).
- Finance creates gains from intertemporal trade, allowing “impatient” or young countries
to borrow from “patient” or old ones.
- International competition could force domestic financial institutions to be more efficient.

• However, we will concentrate here on the two major arguments.

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Allocating the world’s savings (theory)

• In general, the role of the financial system is to channel resources from savers
(mainly private households) to borrowers (private households and firms) in the most
efficient way, that is, selecting the most profitable investment projects.

• In autarky, the financial system of a country is constrained by S = I. This can lead to

inefficient outcomes at the world level.

• Consider the following example with two countries, Italy and Ghana.
- Domestic savings in Italy are 10 bn $, domestic savings in Ghana 2 bn $.
- In each country, there are 10 firms. Each firm has an investment opportunity requiring 1
bn $.
- However, there is some heterogeneity in returns: Firm 1’s project gives a return of 10%,
Firm 2’s project a return of 9%,... and Firm 10’s project a return of 1%.

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Allocating the world’s savings (theory)
Autarky
• In Italy, all 10 projects are financed, in Ghana, only the two best ones.
• Clearly, world savings are not optimally invested: an Italian firm with a 1% return is
financed while a Ghanaian firm with a 8% return is not.

Financial Globalization
• Integrating financial markets improves the situation.
- In both Italy and Ghana, six projects are financed, bringing all a return of at least 5%.
→ Investment is allocated in the best possible way.
• Financial globalization helps economies to overcome the constraint I = S.
- Economies with profitable investment opportunities, but little savings (Ghana) can run
current account deficits to increase their investment.
- Economies with lots of savings, but little investment opportunities can run current
account surpluses to invest their savings elsewhere.

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Allocating the world’s saving (from theory to data)

Two key predictions

1. Under autarky S and I are perfectly correlated, while under perfect financial
globalization there should be no correlation between I and S

2. Financial globalisation should lead to a capital flow from capital-rich to capital-poor

countries.

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Assessment 1: the Feldstein-Horioka Paradox
• In 1980, Feldstein and Horioka proposed a famous test of financial globalization,
arguing that if it were perfect, there should be no relationship between domestic
savings and domestic investment.

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Assessment 1: the Feldstein-Horioka Paradox
• In 1980, Feldstein and Horioka proposed a famous test of financial globalization,
arguing that if it were perfect, there should be no relationship between domestic
savings and domestic investment.

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Assessment 1: the Feldstein-Horioka Paradox
• In 1980, Feldstein and Horioka proposed a famous test of financial globalization,
arguing that if it were perfect, there should be no relationship between domestic
savings and domestic investment.

• But in reality, there is a strong relationship between these two variables.

- This has been confirmed many times (the data on the graph are for 1990-2011).
• Their results have been interpreted as suggesting that financial globalization has not
fulfilled its promise.
- However, alternative interpretations are possible: perhaps differences in returns across
countries are just not very large, governments are intervening to prevent capital flows, or
it is very hard to identify good investments from abroad...

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Assessment 2: Why doesn’t capital flow to poor countries?
According to conventional wisdom:
1. Developing countries have low savings (as they have low incomes), but offer many
investment opportunities (as they have a high marginal product of capital).
2. Advanced countries have high savings, but relatively little investment opportunities.
⇒ Financial globalization should lead to large capital flows from advanced to
developed economies.

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Assessment 2: Why doesn’t capital flow to poor countries?
According to conventional wisdom:
1. Developing countries have low savings (as they have low incomes), but offer many
investment opportunities (as they have a high marginal product of capital).
2. Advanced countries have high savings, but relatively little investment opportunities.
⇒ Financial globalization should lead to large capital flows from advanced to
developed economies.

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Assessment 2: Why doesn’t capital flow to poor countries?

1. Perhaps developing countries do not have high returns to investment?

• The classical argument for why they should have higher returns is based on
diminishing returns to scale.
  1− α
L
When Y = AK α L1−α and P = 1, then MPK = αA .
K
• As poor countries have a low level of K , their MPK should be high.
• But perhaps poor countries have also low productivity A and a less educated
workforce L, and therefore their marginal product of capital is actually low?

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Assessment 2: Why doesn’t capital flow to poor countries?
2. Perhaps developing countries have high returns to investment, but their financial
markets (or other institutions) do not work well.
• Caballero, Farhi and Gourinchas (2008) have argued that financial market
imperfections in developing countries are key.
- For instance, if the judiciary system is imperfect, banks may get away with stealing
investors’ money.
- If there is a lot of corruption, banks may lend to well-connected people rather than the
best entrepreneurs.

• These problems prevent investors to take advantage of the best investment

opportunities, and prompt them to send their money abroad once they get the
opportunity to do so.
• Thus, financial globalization can actually lower investment in poor countries: in
autarky, all savings had to be invested nationally, but with open markets, they can
now be sent abroad to better-working financial markets.
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Assessment 2: Why doesn’t capital flow to poor countries?
2. Perhaps developing countries have high returns to investment, but their financial
markets (or other institutions) do not work well.
• Others have argued that developing countries have exceptionally high savings,
because they do not have a welfare state (unemployment and health insurance,
pensions...) so that their citizens are exposed to higher risk.
• Furthermore, after the Asian crisis in the 1990s, many Asian governments started
building up huge savings in order not to depend on the IMF any more.
• In a famous speech in 2005, Fed chairman Ben Bernanke spoke of a “global savings
glut” flowing to the United States.

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Assessment 2: Why doesn’t capital flow to poor countries?
• China is a prime example: its banking system is often critizised for its inefficiency
(loans inefficient state-owned firms, etc.), savings rates are extremely high (ageing
population saving for retirement).

• However, Chinese investment was still enormous (to compare, the US investment
rate is 20% of GDP, Italy’s 17%). For poorer countries, capital outflows have been
more of a problem.
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Capital flowing to tax havens

• Many firms use tax havens for financing. This creates a bias in official statistics.
- Petrobras, one of the largest companies in the world, sells bonds and stocks to
foreigners through the Petrobras International Finance Company (PIFCO), based in the
Cayman islands.
- When an Italian invests in these securities, this is registered as Italian investment in the
Cayman islands, not Italian investment in Brazil.
• This is very important for some countries.
- Official statistics show that US citizens hold $547 billion of equity in the Cayman Islands
(more than in Germany or France!).
- Almost all of this is actually investment in China, with large Chinese firms (Alibaba,
Tencent) using the Cayman islands to avoid Chinese laws that limit foreign ownership.

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Capital flowing from the US via tax havens to emerging economies

Source: Coppola, Maggiori, Neiman, and Schreger (2021)

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Capital flowing to tax havens

Source: Coppola, Maggiori, Neiman, and Schreger (2021)

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Capital flowing to tax havens

Source: Coppola, Maggiori, Neiman, and Schreger (2021)

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Implications

• Chinese capital inflows are larger (and so its current account surplus is smaller) than
the official data would suggest.
- “While much attention has been paid to the $1.1 trillion of U.S. Treasuries held by China,
almost no attention has been paid to the $700 billion of U.S. holdings in Chinese
equities” (Coppola et al., 2021).

• This is a relatively recent trend.

- So, in the last 5-10 years, the large imbalances between the US and China have been
closing more than previously thought.

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The benefits of financial globalization

Fischer’s speech lists the two main arguments in favour of financial globalization:
1. It should allocate the world’s savings to the most productive uses worldwide.
2. It should help investors to reduce risk through diversification.

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Diversifying risk
• Which of the following investment strategies would you choose?
A. Certain return of 10% over ten years.
B. 50% probability of a 20% return, 50% probability of a 0% return.

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Diversifying risk
• Which of the following investment strategies would you choose?
A. Certain return of 10% over ten years.
B. 50% probability of a 20% return, 50% probability of a 0% return.

• Both investments have the same expected return.

• However, a large majority of people prefer option A, because it is less risky.
- That is, most people are risk-averse, assessing an investment both on its average return
(the higher, the better) and its variance (the lower, the better).
• One way to lower the variance of investment is diversification. For instance, when
investing in two stocks, when one does bad, there is the chance that the other may
do well.
• By increasing the number of assets people can invest in, financial globalization
increases the possibilities for diversification.

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Diversifying risk

• Consider a simple example. There are two countries in the world, Italy and New
Zealand, and both have one asset, a field of Kiwis.
• The Kiwi harvest is random, and there are two possible states of the world:

Italy New Zealand

State 1 100 50
State 2 50 100

• Italy’s and New Zealand’s kiwi harvests are negatively correlated (when one is low,
the other is high).
• World kiwi production is constant at 150.

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Diversifying risk
Autarky
• Both countries consume on expectation (or on average, if you think of this situation as
ongoing) 75 kiwis.
• However, there is risk and therefore time variation in consumption: sometimes people
consume 100 kiwis, sometimes they only get 50.
Financial Globalization
• Assume the two kiwi fields are owned by listed firms.
- Then, Italians can buy 50% of the shares in New Zealand’s kiwi fields (giving it the right,
as a dividend, to 50% of New Zealand’s harvest).
- Italians pays New Zealand by giving it 50% of the shares in its own kiwi fields.

• This leaves average consumption unchanged, but completely eliminates risk for both
countries, which now always consume exactly 75 kiwis.

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Diversifying risk

• This example is obviously overly simple.

- There was no aggregate risk (world production was the same in all states of the world).
In practice, world output does fluctuate, and that risk cannot be diversified away.
- Assets in both countries were perfectly negatively correlated. In reality, such assets are
hard to find.
• However, the general principle is valid even with aggregate risk and in the absence of
perfect negative correlation.
- As long as assets are not perfectly positively correlated, diversification decreases risk
and makes people better off.

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Diversification in practice
• The amount of foreign assets held in the portfolio of many investors has steeply
increased over the last 40 years.
- In the 1970s, just 6% of capital owned by US citizens were foreign assets. In 2008, this
had increased to 47%.
• This may seem a large fraction, but is it?
- The United States represent around 20% of the world’s capital stock.
- So, if investments were perfectly diversified internationally, US residents would hold 80%
of foreign assets!
- This “home bias”, which is present in many other countries, too, is another major puzzle
in international finance.
• Note also that these statistics are sometimes difficult to interpret.
- Sometimes, assets are held abroad for regulatory reasons, not diversification.

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Bottom line

• Economists’ opinions on financial liberalization are more diverse than their opinions
on trade.
- “In contrast to the growing consensus among academic economists that trade
liberalization is, by and large, beneficial for both industrial and developing economies,
debate rages among academics and practitioners about the costs and benefits of
financial globalization.”
Kose, Prasad, Rogoff and Wei (2007).

• As we have just seen, the empirical evidence on the gains from financial globalization
is mixed.
• Also, financial globalization made many countries (especially developing ones) more
vulnerable to financial crises.

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Outline

1. Financial globalization in theory and in practice

2. History of global financial liberalization (with a focus on the 2008/2009 Financial
Crisis and the Eurozone crisis)
A. Some basics on financial institutions
B. The 2007/2009 Financial Crisis

3. Financial regulation

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Financial Fragility
• Banks and other financial firms (mutual funds, hedge funds...) are fragile, because
their balance sheet has a “liquidity mismatch” (Brunnermeier, 2014).
- Deposits are liquid: you can go to the bank and withdraw all yourmoney at any time
- Loans are in general not that liquid: E.g., loan of 5 mn. $ to a small company is hard to
sell to someone else (who does not know that company so well, or does not know the
bank’s criteria for giving loans...).

Assets Liabilities
Loans Shareholder Equity
Other Assets Deposits
Other Debts

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Financial Fragility
• Banks and other financial firms (mutual funds, hedge funds...) are fragile, because
their balance sheet has a “liquidity mismatch” (Brunnermeier, 2014).
- Deposits are liquid: you can go to the bank and withdraw all yourmoney at any time
- Loans are in general not that liquid: E.g., loan of 5 mn. $ to a small company is hard to
sell to someone else (who does not know that company so well, or does not know the
bank’s criteria for giving loans...).

Assets Liabilities
Loans Shareholder Equity
Other Assets Deposits
Other Debts

• This makes financial institutions vulnerable to runs: when depositors/investors

suddently want their money back, they cannot sell off loans and other assets quick
enough and go bankrupt (even though their loans may actually be of good quality).

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Banks and Financial Fragility
• Banks failures impose high costs on the real economy.
- They disrupt investment, as firms are denied credit.
- They force failing banks to “fire-sell” their assets at low prices, and these lower prices
may again adversly affect other banks or firms.

• Many economists (including the former Fed chairman Ben Bernanke) have argued
that bank failures made the Great Depression a lot worse.
• As a result, banks have been strongly regulated after the Depression:
- Deposit insurance: a common fund (or the state) guarantees that deposits are safe (up
to a certain maximum amount), even when the bank fails.
- Capital requirements: for each loan, the bank must set aside a certain percentage of
the value as reserves. The riskier the loan, the higher the percentage.
- Separation between investment and retail activities of banks (the so-called
Glass-Steagall Act in the US, passed in 1933 and repealed in 1999).

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Financial Deregulation

• Since the 1970s, rules and regulations for the financial sector have been loosened in
most developed economies, both for national and international operations.
- International deregulation generated a boom in offshore banking, and the growth of
international financial centres like London, New York, Luxembourg or Singapore.
• Offshore banking denotes the operations of a bank outside of its home country.
- Banks use offshore operations to take advantage of regulatory differences: for instance,
in London, there are less rules for transactions carried out in dollars than for transactions
carried out in pounds (and less rules than for dollar transactions in New York).
- This gave rise in the 1970s to the so-called eurodollars: deposits in dollars held outside
of the US, mainly in London and Luxembourg (the “euro” in eurodollars has nothing to do
with the currency, but just stands for dollars held outside the US).

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Shadow Banking

• In order to avoid banking regulations, a lot of financial activity also moved to

non-bank entities, such as mutual funds.
- These funds sometimes performed activities that were very similar to banks (and were
often owned by banks), but did not fall under the same regulations.
- Many of them were also held offshore (In particular, Ireland was able to attract a large
number of funds owned by European and US banks).

• This “shadow banking system” was difficult to monitor by regulators, but the
2007-2009 crisis showed that it had the same fragilities as the regular banking
system.

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Financial fragility

• Deregulation has boosted financial globalization, but there is also evidence that it
made the international financial system less stable.

Source: Reinhart(2014).

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A long series of financial crises
• Financial liberalization first triggered a series of emerging-market crises:
- The Latin American debt crises of the 1980s, leading to a “lost decade” for these
countries.
- The Mexican crisis (1994).
- The (East) Asian crisis (1997), in Thailand, South Korea, Malaysia, Indonesia,
Singapore and the Philippines.
- The Russian crisis (1998).
• These episodes were not all the same: in some cases, it was a government debt
crisis, in others, a crisis in the private sector.
• However, they shared some common elements.
- A rapid inflow of international investment, triggering an economic boom.
- A rapid reversal of capital flows, when international investors panicked and pulled their
money out, creating an economic crisis.
- A rapid fall of the exchange rate, hurting local banks and firms with a lot of their debt in
foreign currency (the “original sin”).
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A long series of financial crises

• Reinhart and Rogoff describe these episodes in their book “This Time is Different”.
- Every time, investors convince themselves that the current boom will last.
- Also, investors were sure that the United States could not have an emerging-market type
crisis.
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Outline

1. Financial globalization in theory and in practice

2. History of global financial liberalization (with a focus on the 2008/2009 Financial
Crisis and the Eurozone crisis)
A. Some basics on financial institutions
B. The 2007/2009 Financial Crisis

3. Financial regulation

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The roots of the crisis are both domestic and international
• Financial deregulation and the rise of the subprime mortgage market were important
domestic developments for the crisis to emerge
• At the same time there is a important role for international capital flows and global
current account imbalances as well:
- “The deep causes of the [2008-2009] financial crisis lie in global imbalances—mainly,
America’s huge current-account deficit and China’s huge surplus.” The Economist,
January 2009.

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The roots of the crisis

• As we have seen already several times, the 2000s were marked by large capital flows
from China (but also other emerging economies) to the United States.
• This money needed to be invested somewhere...
- In particular, foreign investors wanted safe assets (ranked AAA by rating agencies and
therefore supposed to have very little variation in payoffs).
- This pushed the US financial system to more “creativity” in designing assets with these
properties, expanding subprime credit and packaging together these credits in
mortgage-backed securities to create AAA securities.
• While this narrative emphazises the demand side, other economists have
emphasized much more the supply side (arguing that subprime and MBS would have
happened irrespective of foreign capital inflows).
- This debate is not settled yet.

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The crisis unfolding
• In 2006/2007, housing prices in the US started to fall.
- This reduced the value of banks’ mortgages and MBS.
- Banks and other financial institutions experienced runs (e.g. Northern Rock in the UK).
• The crisis escalated in September 2008, when the US government decided to let the
large investment bank Lehman Brothers fail.
- World-wide financial meltdown, as it was clear that Lehman would not repay its debts
and everyone was uncertain how much his business partners were exposed to Lehman.
- Both in the United States and in Europe, governments intervened with bailouts.
• All these disruptions in the financial system were quickly transmitted to the real
economy, through a contraction of credit supply.
- At the same time, consumption was also depressed because the fall in house prices
forced many houseowners to deleverage and stop consuming.
- Relative importance of these channels is still debated (Mian/Sufi, “House of Debt”, 2014)

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International aspects

• In some aspects, the US financial crisis looks like an emerging market crisis: large
capital inflows before the crash, sudden runs on banks and financial institutions...
• In other aspects, it was different:
- it did not lead to a massive capital flight from the US.
- the dollar did not depreciate, but actually appreciated as there was a worldwide “flight to
safety” in the form of US government bonds.

• The crisis had also a much larger impact, with banks and financial institutions around
the whole world (but especially in Europe) being hit.
• In Italy (and in Southern Europe in general), the initial impact of the US financial crisis
was muted, because local banks had not invested a lot in the US.
- However, the Euro crisis was just around the corner.

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Misplaced confidence
• In September 2008, two weeks after the Lehman crash, the Spanish prime minister
José Luis Rodriguez Zapatero visited the United States.

• In a speech in front of the Spanish chamber of commerce in New York, he argued

that “Spain will soon recover its potential growth path. [..] This is due to, among other
things, the good state of its public finances, and the fact that Spain "has perhaps the
most solid financial system in the whole world”.

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Misplaced confidence

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What happened?
• “Importantly, the EZ Crisis should not be thought of as a government debt crisis in its
origin – even though it evolved into one. Apart from Greece, the nations that ended
up with bailouts were not those with the highest debt-to-GDP ratios. [..] The real
culprits were the large intra-EZ capital flows that emerged in the decade before the
Crisis.” (Baldwin et. al, 2015).

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Why was capital flowing to the periphery?
• 1. Lower risk. Investors believed that the Euro eliminated devaluation, inflation and
government default risk forever.

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Why was capital flowing to the periphery?
• 2. Investment opportunities. Periphery countries appeared to offer attractive
investment opportunities to high-savings core countries.
- But the reasons for which the marginal product of capital appeared to be high were
perhaps not sustainable.
- Periphery countries, especially Spain and Portugal, had very low, sometimes negative,
productivity growth.

Source: Garcia-Santana et al. (2016)

• Instead, several periphery countries had housing bubbles (Spain and Ireland).
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Exploding bank debt
• Most of the capital inflows went through the national banking sector, which became
more and more indebted.

• This left the periphery economies vulnerable for a sudden stop.

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The crisis
• Sudden stop triggered by the bust of the housing bubble in Spain and Ireland, and by
the revelation that the Greek government concealed its true debt.
• Just as in an emerging market crisis, foreign investors suddently pulled their money
out and/or demanded much higher risk premiums.
- This created runs and spirals in the banking system and for the Greek government.
- In Spain and Ireland, governments bailed out some banks and which increased their
deficits. This created a second, public debt crisis which became most acute in 2011/12
• The crisis was made worse by the institutional features of the Eurozone.
- Countries do not have their own currency: they cannot print money to bail out banks or
devaluate their currency
- “Taken together, these two features meant [that] euro-denominated borrowing was akin
to foreign currency debt in a traditional, developing nation ‘sudden stop’ crisis.” (Baldwin
et al., 2015).

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Crisis management

• Eurozone leaders reacted with a series of bailouts for Greece, Ireland and Portugal in
2010 and 2011.
- These bailouts were conditional on strict austerity policies, which made the crisis even
worse.
• Furthermore, as the crisis had become a sovereign debt crisis, there were runs on
government bonds.
- In particular, investors did not believe any more that no government could fail.
- The doubts and reluctances of core countries to bail out the periphery seemed to
indicate that bailouts would not happen at all costs...
- ... and the costs of austerity suggested that some countries might prefer to leave.

• In June 2012, Spain applied for a (bank) bailout as well, and tensions were at a
maximum.

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Conflicting Worldviews

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Conflicting Worldviews
Germany
1. Focus on rules
- Rules are necessary to create discipline in a union of heterogeneous countries.
- If they are broken, confidence gets lost.

2. The most important economic problem is moral hazard.

- By rescuing a country/a bank, one encourages irresponsible behaviour.

France
1. Focus on discretion
- In crisis times, policy makers should have the possibility to disregard rules.
- This gives them greater flexibility.

2. The most important economic problem are self-fulfilling liquidity problems.

- Expectations can be self-fulfilling: letting one country/bank fail will trigger a run bringing
down even a priori healthy banks/countries.
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The magic words

• “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro.
And believe me, it will be enough.”
Mario Draghi, July 26, 2012.
• With large bond purchases, the ECB managed to stop the worst of the run, and a
(slow) recovery could begin.
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Next in line
• Imbalances in Europe and the US became smaller after the crises, but did not
disappear.
• To fight the crisis, central banks in the US and in Europe kept interest rates low and
increased money supply.
• This money needs to go somewhere, and after 2009, it started going again
increasingly to emerging markets.
- And as a result, there were more emerging market sudden stop crisis, e.g. in Brazil
(2014-2016) or Turkey (2018).

Source: The Economist (November 2015). 52 / 62

Outline

1. Financial globalization in theory and in practice

2. History of global financial liberalization (with a focus on the 2008/2009 Financial

Crisis and the Eurozone crisis)

3. Financial regulation

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Government options for regulating the financial sector

1. Deposit insurance

2. Reserve requirements

3. Capital requirements and asset restrictions

4. Bank examination

5. Lender of last resort facilities

6. Government-organized restructuring and bailouts

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Government options for regulating the financial sector

1. Deposit insurance
- Insures depositors against losses up to a certain amount when banks fail

2. Reserve requirements
- Banks required to maintain some deposits on reserve at the central bank in case they
need cash

3. Capital requirements and asset restrictions

- Higher bank capital (net worth) means banks have more funds available to cover the
cost of failed assets
- Asset restrictions reduce risky investments by preventing a bank from holding too many
risky assets and encourage diversification by preventing a bank from holding too much
of one asset

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Government options for regulating the financial sector

4. Bank examination
- Regular examination prevents banks from engaging in risky activities

5. Lender of last resort facilities

- Acts as insurance for depositors and banks, in addition to deposit insurance.
- Prevents bank panics.
- Creates a moral hazard for banks to take excessive risk because they are not fully
responsible for the risk

6. Government-organized restructuring and bailouts

- Failing all else, the central bank or fiscal authorities may organize the purchase of a
failing bank by healthier institutions
- In this case, bankruptcy is avoided thanks to the government’s intervention as a crisis
manager, but might come at public expense

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Problems in regulating (international) finance
• The 2008/2009 financial crisis exposed weaknesses in national and international
financial regulation.
- Looser rules may have increased risk-taking
- and the authorities did not notice this build-up of risks.
• Once the crisis came, many countries strongly intervened, in most cases bailing out
their banks.
- There is a broad consensus that this was necessary at the time to prevent an even
larger crisis.
• However, there are also problems associated with these interventions: they create
moral hazard.
- That is, if a bank is sure it will be rescued, it has an incentive to gamble, as it is insured
against failure.
- The bigger the bank, the more this is true: certain banks are “too big to fail”.
• This makes policy in a crisis tricky. So, what can be done to avoid such crises from
occuring?
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Problems in regulating (international) finance

• Unfortunately, the international financial system is much harder to regulate than a

national one.
- Offshore finace is not very regulated, which limit the effectiveness of national
regulations: if one type of activity is forbidden in Italy, the bank can just do it elsewhere.
- There are little incentives to change this. If London were to regulate offshore finance
more, it would lose business to its competitors, and gain little (in all likelihood, if the
Italian bank has problems because of its London trading, it’s the Italian government that
will have to deal with it).
- In general, differences in regulations and the great interconnectedness make life difficult
for regulators. Whose rules should apply? And who is responsible to enforce them?

• There is no global regulator that defines and enforces rules on an international level
(such as the WTO for world trade)

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Problems in regulating (international) finance

• Therefore, some people speak of the “Trilemma of International Finance”. This

means that of the following three objectives, only two can be achieved:
1. Financial stability
2. National control over financial regulation
3. Free international capital movements

• A country which wants 1. and 2. needs to cut itself off from the international financial
markets, otherwise its banks can escape regulation through offshore finance.
• A country which wants 1. and 3. needs to accept to give up some sovereignty, as its
financial institutions can only be supervised internationally.

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International regulatory changes
• Basel III regulations. Basel regulations are a set of common rules and standards for
financial supervision agreed upon by the main central banks of the world.
- Basel III increased banks’ capital requirements (taking into account off-balance sheet
assets, to account for the shadow banking sector)
- It also forces banks to hold a greater amount of liquidity to respond to runs.
• Financial Stability Board.
- This advisory committee was created in 2009 (first president: Mario Draghi). It should
monitor the international financial situation and give recommendations on what to do.
• National Reforms
- In the USA, the Dodd-Frank Act (2010).

• Many further reforms keep being debated, and many questions remain open: should
capital requirements be countercyclical? How does one avoid banks becoming too
big to fail?
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Changes in the Eurozone

• The Eurozone created new institutions to cope better with future crises.
- The European Stability Mechanism (ESM), which is supposed to bail out economies
in crisis.
- The Banking Union, which means that large banks are now directly supervised by the
ECB. However, moving to a common deposit insurance mechanism has proved to be
impossible for the moment.
- Increased Monitoring by the European Commission, which should detect current
account imbalanced early on and alert countries.

• But most experts agree that these measures have been to weak, and that the
Eurozone needs further (fiscal) integration in order to be successful in the future.

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Limits to capital flows
• The succession of financial crises has somewhat shifted the dominant opinion among
economists and policy makers.
• Institutions like the IMF traditionally promoted financial globalization (remember
Fischer’s speech), but are a lot more cautious now.
- The dominant opinion is that capital flows are good, but that they need to be controlled.
In particular, many people advocate (temporary) controls on short-term capital flows, to
avoid sudden withdrawals of international capital from a country (as happened in all
emerging market crises).
• In December 2012, under the influence of its chief economist Olivier Blanchard,
endorsed capital controls, a highly symbolic step.

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