Cross-border regulatory spillovers and macroprudential policy coordination

Summary

Focus

Financial institutions and markets are highly interconnected. Accordingly, differences in national macroprudential policies can be an important source of international spillovers. Through cross-border regulatory arbitrage, these differences may lead to large swings in capital flows. In turn, the transmission of financial shocks across regions may be magnified – and financial risks exacerbated.  When global financial institutions can evade policy actions taken by regulators in their jurisdiction, financial cycles are not well synchronised across economies. Moreover, reverse spillovers are potentially significant.  However, prior coordination may improve global welfare. This is one of the rationales underlying Basel III's principle of reciprocity.

Contribution

We develop a two-region, core-periphery model with financial frictions. First, we characterise the cross-border leakages that occur when regulators in the core region tighten their macroprudential stance. Second, we evaluate the potential benefits of macroprudential policy agreements in the presence of regulatory arbitrage. Welfare gains associated with countercyclical capital buffers are calculated for three policy regimes: (i) independent national policies (Nash); (ii) international coordination; and (iii) reciprocity – The model is calibrated for two groups of countries: major advanced economies, and large middle-income countries which generate significant spillovers to advanced economies.

Findings

Numerical experiments show that our model replicates the stylised facts associated with monetary policy shocks. These relate to output, credit, house prices and real exchange rate fluctuations in recipient countries. We find that the magnitude of resulting cross-border capital flows depends on the degree of economies of scope in lending. Further, if regulators set policies on the basis of a narrow financial stability mandate – and these policies are evaluated in terms of household welfare – reciprocity may perform better than Nash and as well as international coordination. This is when regulatory leakages are strong.

Abstract

We develop a core-periphery model with financial frictions and cross-border banking to assess the magnitude of regulatory spillovers and the gains from macroprudential policy coordination. A core global bank lends to its affiliates in the periphery and banks in both regions are subject to risk-sensitive capital regulation. Following an expansionary monetary policy in the core, a countercyclical response in capital requirements in that region induces the global bank to increase cross-border lending. We calculate welfare gains associated with countercyclical capital buffers under a range of policy regimes, including independent policymaking, full coordination, and reciprocity---a regime in which capital ratios set in the core are imposed on the global bank's affiliates abroad. One of our key results is that, even when regulatory spillovers are strong, reciprocity can make all parties better off if regulators attach a sufficient weight to financial stability considerations. With a standard, utility-based welfare criterion, reciprocity may also perform better than independent policymaking when regulatory spillovers are weak.

JEL classification: E58, F42, F62.

Keywords: global banking, financial spillovers, regulatory leakages, macroprudential policy coordination.