Global Banking, Financial Spillovers, and Macroprudential Policy Coordination

Revised version published on 5 May 2023.

Summary

Focus

There is growing evidence that international financial spillovers have become a two-way street. They occur not only from the major advanced economies to the rest of the world, but also, and increasingly, from a group of large middle-income countries to advanced economies. Because financial markets are prone to amplification effects, and because business and financial cycles remain imperfectly synchronised across countries, this new environment creates the potential for shocks in one jurisdiction to be magnified and transmitted to others through short-term capital flows. In turn, these flows may exacerbate financial instability in both originating and recipient countries, thereby creating a case for international macroprudential policy coordination. The paper's objective is to characterize the cross-border transmission mechanism of global financial shocks and measure the gains from such coordination.

Contribution

The paper develops a two-region, core-periphery model with imperfect financial integration and cross-border banking to study the transmission of financial shocks and the gains from international macroprudential policy coordination.  The model is calibrated for two groups of countries, the major advanced economies and a group of large (systemically important) middle-income countries, which have been identified in recent studies as generating significant reverse spillovers (or spillbacks) to advanced economies. Financial frictions occur at two levels: between firms and banks in each region, and between periphery banks and a global bank in the core.  

Findings

Numerical experiments show that the model replicates the stylized facts associated with global banking shocks, with respect to output, credit, house prices, and real exchange rate fluctuations in recipient countries, as documented in the empirical literature. Welfare gains from macroprudential policy coordination are positive---and significant, provided that the cost of instrument manipulation is not too large---if the degree of international financial integration, which raises the scope for spillback effects from the periphery to the core, is sufficiently high. 

Abstract

The transmission of financial shocks and the gains from international macroprudential policy coordination are studied in a two-region, core-periphery model with a global bank, a two-level financial structure, and imperfect financial integration. The model replicates the stylized facts associated with global banking shocks, with respect to output, credit, house prices, and real exchange rate fluctuations in recipient countries, as documented empirically. Numerical experiments, based on a parameterized version of the model, show that the gains from coordination increase with the degree of financial integration, which raises the scope for spillback effects from the periphery to the core, through trade and private capital flows. However, even when coordination is Pareto-improving, the resulting gains may be highly asymmetric across regions.

JEL classification: E58, F42, F62

Keywords: global banking, financial spillovers, macroprudential policy coordination