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Symposium 2014

Proposal - Sand in the wheels of harmful capital flows

The Challenge

The 2008/09 economic and financial crisis taught the world an important lesson: while the nature of the financial industry has become truly global, with an increasing number of actors and institutions ...

The 2008/09 economic and financial crisis taught the world an important lesson: while the nature of the financial industry has become truly global, with an increasing number of actors and institutions on the credit market, regulation is still highly fragmented among different national supervisory authorities. To maintain systemic stability and prevent contagion, more is required than merely ensuring the orderly operation of individual financial institutions. Different regulators—including monetary authorities—must cooperate in order to achieve better, but not necessarily more, regulation. Better regulation should aim at identifying overleveraging and emerging vulnerabilities, ensuring the adequate pricing of risk, and promoting better incentives for prudent behavior. In pursuing these targets, regulation will require changes to institutional structures, the content of rules, and especially the structures of supervisory agencies.

Banks which operate across borders on a significant scale should be required to run local operations as subsidiaries.

In principle international capital flows could increase global economic efficiency, and foster development, directing capital to its most productive use. In practice capital flows come in different forms with different economic value. Long-term foreign direct investment flows, particularly if accompanied by skill or technology transfer, can be strongly beneficial. Short term financial flows can be volatile and harmful, flooding emerging markets with bonanzas of hot money in boom periods, followed by sudden stops.

The most unstable category of capital flows is cross- border bank lending intermediated by banks operating as branches rather than subsidiaries. If all banks with significant lending operations in a country were required to subsidiaries and if this were accompanied with other appropriate prudential policies, a mild counter to volatile capital flows would be introduced. Global banking groups could still transfer long term equity, long-term debt and skills. But central banks and regulators could require that cross-border funding of the subsidiary , whether from the group or from outside it, was long-term and stable in nature.

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