## pp060217-increasing-resilience-to-large-and-volatile-capital-flows

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### Context and high-level conclusions
- Capital flows offer financial-deepening benefits but can contribute to systemic financial risk buildup.
- The global financial crisis (GFC) illustrated how vulnerabilities, cross-border interconnectedness, and source-country policy spillovers can amplify adverse effects when markets seize up and flows reverse.
- Post-crisis reforms (Basel III) have increased transparency, capital, and liquidity in financial institutions; implementation of new standards is underway.

### Role and main features of macroprudential policies (MPMs)
- Definition: MPMs are primarily prudential tools to limit systemic risk.
- Three tasks (from the Fund’s Macroprudential Framework):
  - (i) increase resilience by building buffers;
  - (ii) mitigate pro-cyclical feedbacks and contain unsustainable leverage and volatile funding;
  - (iii) contain structural vulnerabilities from interlinkages and “too important to fail” institutions.
- Common tools:
  - Countercyclical capital buffers (CCyB) and provisions, sectoral capital requirements, measures to contain liquidity and FX mismatches, caps on loan-to-value (LTV) and debt-to-income (DTI) ratios.
  - Monetary and fiscal instruments can be used (e.g., reserve requirements; levies on wholesale funding).
- Conditions for effectiveness:
  - Focus on systemic vulnerabilities, build on strong microprudential supervision, guided by continuous risk assessment, and consider risks across the whole financial system beyond banks.

### Institutional View (IV) on capital flows and interplay with MPMs
- Core IV messages:
  - Handle capital flows primarily with macroeconomic policies: exchange rate flexibility, FX intervention, monetary and fiscal adjustment, supported by strong institutions and supervision.
  - CFMs should not substitute for warranted macroeconomic adjustment.
  - CFMs can be appropriate in certain circumstances (e.g., inflow surge raising financial stability risks) but should be targeted, transparent, and generally temporary.
- Classification:
  - Measures that limit flows and reduce systemic risk are both CFMs and MPMs (CFM/MPMs); ongoing evaluation of their longer-term usefulness versus costs is required.
  - CFMs for disruptive outflows: generally for crisis situations or imminent crises, as part of a broad policy package, and temporary.

### Operational challenges and areas for further work
- Real-time assessment of channels from capital flows to systemic risk is difficult and country-specific.
- Policy constraints can arise from large cross-border institutions, weak supervisory frameworks, and information gaps for tool calibration.
- Calls for further work: deeper examination of transmission channels and the role of MPMs in limiting systemic financial risk, accounting for countries’ financial and institutional development.

### Evidence base, country coverage, and study scope
- Country case studies: Cambodia, Colombia, Croatia, Iceland, Korea, Peru, Sweden, and Turkey.
- Quantitative database:
  - 141 countries: 37 advanced, 65 emerging, and 39 low-income economies.
  - Ratios and correlations computed for the 1990–2015 period, aggregated using simple (unweighted) averages unless noted.
- Key empirical finding:
  - Other investment inflows: a one percent of GDP increase in other investment flows leads to an increase of 0.6 percentage points in credit to GDP (Blanchard et al., 2016).

### Systemic risk as the anchor for assessing capital flow impacts
- Systemic risk is multi-dimensional:
  - Risks building over time (financial accelerator effects, volatile funding).
  - Cross-sectional vulnerabilities from financial system structure and interlinkages.
- Empirical links:
  - Capital inflow surges can drive exchange rate and asset price appreciation, raising collateral values and borrowing via financial accelerators.
  - Rising cross-border non-core liabilities enable credit expansion beyond retail deposits, creating maturity/currency mismatches.
  - Gross debt positions raise contagion risks through leverage chains.
  - Example evidence: around one-fifth of inflow surge episodes in emerging markets end in banking or currency crises (Ghosh, Ostry, and Qureshi, 2016).

### Five stylized transmission channels from inflows to systemic risk
- (i) credit booms;
- (ii) asset price booms;
- (iii) unhedged foreign currency exposures;
- (iv) non-core funding of the banking system;
- (v) interconnectedness.
- These channels reinforce each other, especially credit booms, asset-price booms, and non-core funding.

### Role of country circumstances and flow composition
- Determinants of systemic-risk build-up: capital market depth, dollarization, strength of microprudential supervision, monetary policy settings, structure of macroprudential policies.
- Gross inflows show stronger relationships with systemic risk; surges dominated by debt inflows are more crisis-prone; bank inflows have robust effects on credit growth.
- Country episodes:
  - Korea: pre-2008–09 GFC gross debt inflows to banks increased while running current account surpluses.
  - Turkey: 2002–07 and 2010 inflows intermediated by local banks led to rapid credit growth.
  - Colombia: high correlation of credit with capital flows in the 1990s/early 2000s, but not more recently.

### Asset prices, unhedged FX borrowing, and non-core funding (detailed effects)
- Asset prices:
  - Net capital inflows strongly positively related to real estate prices.
  - Asset price booms without rising borrower leverage pose limited systemic threat; combined with leverage they amplify risk.
- Unhedged FX borrowing:
  - Tends to rise when domestic rates exceed global rates and local currency expected to appreciate.
  - Reversals and depreciation cause defaults, higher nonperforming loans, and bank capital erosion (e.g., Colombia late 1990s).
- Non-core funding:
  - Capital inflows linked to increases in wholesale-funded credit; loan-to-deposit ratio is a useful proxy.
  - Examples: Turkey, Peru, Korea experienced vulnerabilities from external wholesale FX funding that created rollover and market-access risks.

### Financial cycles and indicators
- Financial cycle framework links credit and asset-price rises to systemic-risk build-up and subsequent sharp falls.
- Credit gap (deviation of credit from long-term trend) used to position financial cycle and calibrate tools like the CCyB.
- Methodological challenges: data requirements and conceptual debates (stock vs flow comparisons).

### Gross debt flows, cross-exposures, and interconnectedness
- Gross positions have risen rapidly since the 1990s with pro-cyclical cross-exposures.
- Gross debt flows can increase systemic risk even without large net flows (examples from pre-GFC European bank activity).
- G-SIIs and interconnectedness can increase resilience but also become systemic risk sources under large negative shocks.

### Mapping macroprudential instruments to risks
- Broad-based tools (resilience across credit exposures):
  - CCyB, dynamic loan loss provisioning (DPR), leverage ratios, repeated macroprudential stress tests.
  - Country examples: Sweden and Norway activated positive buffers in 2015; Hong Kong in 2016; Czech Republic, Iceland, and Slovakia in 2017.
- Sectoral and asset-side tools (target specific credit categories):
  - Sectoral capital requirements, LTV/DSTI caps, underwriting guidance, higher risk weights on FX exposures.
  - Examples: higher risk weights on FX mortgage loans in Serbia (2008) and Poland (2008); DSTI/LTV caps on FX mortgages in Poland (2011), Hungary (2010), Romania.
- Liquidity tools (contain volatile funding vulnerabilities):
  - Basel III LCR and NSFR; country-specific core funding ratios and liquidity charges; differentiated reserve requirements by currency.
  - Examples: Sweden applies LCR separately to EUR and USD; Iceland imposed LCR and NSFR differentiated by currency.
- Basel III timing:
  - LCR phased-in beginning in 2015 to reach 100 percent by January 2019.
  - NSFR to become a minimum standard by January 2018.

### Twin benefits, mechanisms, and limitations of MPMs
- Twin benefits:
  - Increase resilience.
  - Contain procyclical dynamics among asset prices, credit, and wholesale funding during inflow surges and reversals.
- Specific mechanisms:
  - Capital buffers protect against FX losses on depreciation.
  - Liquidity requirements reduce susceptibility to funding stress.
  - Caps on interbank exposures and G-SII surcharges reduce contagion risk.
- Evidence on effectiveness:
  - Capital tools improve resilience when buffers are usable (e.g., Jiménez et al., 2012).
  - Liquidity tools change funding profiles and enhance resilience (e.g., Banerjee and Mio, 2014; Bonner, 2012).
  - Loan restrictions and borrower-based tools (LTV, DTI) tend to have stronger effects on credit than capital or liquidity tools.
  - Variation of CCyB within typical ranges between 0 and 2.5 per cent has limited effect on credit growth during buoyant times (e.g., Basten and Koch, 2015; Jiménez et al., 2012).
  - DTI limits more powerful than LTV limits in containing credit increases (Kuttner and Shim, 2016).
- Key limitation — leakage and circumvention:
  - Leakage can be domestic (shift to non-bank lenders) or cross-border (credit provision from abroad or foreign affiliates).
  - Loan restrictions (LTV, DTI) may have smaller leakage if applied to all lenders.
  - Strategy: expand scope of application of MPMs to contain leakage (IMF-FSB-BIS, 2016).

### Source-country policies, reciprocity, and global spillovers
- Source-country policies can reduce global systemic risk (FSB, 2017):
  - Aligning investment fund redemption with asset liquidity to reduce fire-sale risk.
  - Reciprocity agreements for macroprudential tools (BCBS for CCyB; ESRB in EU).
  - Home-authority capital surcharges on G-SIIs to bolster affiliate resilience in host countries.

### Costs, timing, calibration, and adjustment costs of MPMs
- Types of costs:
  - Adjustment costs for financial firms from balance-sheet affecting tools.
  - Efficiency costs for borrowers: curtailed access or higher cost of credit.
  - Potential short-run output costs from tightening.
- Mitigation:
  - Provide sufficient notice for banks to meet CCyB requirements (BCBS recommends up to 12 months).
  - Announce liquidity or loan-to-deposit rules ahead of enforcement.
- Output and calibration:
  - Capital/liquidity tools: short-run output costs generally small versus longer-run benefits; larger costs if tightening is aggressive or ill-timed.
  - Sectoral tools (LTV, DTI): larger short-run output effects; tighten gradually during robust growth.
- Risk assessment guidance:
  - Use multiple indicators to guide tool choice:
    - Broad vulnerabilities → tighten broad-based tools (capital, liquidity).
    - Sectoral vulnerabilities → use narrowly targeted tools (e.g., tight LTV/DSTI for household FX borrowing).
  - MPMs should be commensurate with risk profiles.

### Distinguishing MPMs, CFMs, and CFM/MPMs — assessment criteria
- An MPM classification requires:
  - (i) identification of a potential systemic-risk source; and
  - (ii) a plausible transmission path showing how the measure reduces systemic risk.
- Determination of CFM status considers:
  - Context (e.g., adopted during inflow surge), calibration, and country circumstances.
- Conceptual assessment steps:
  - Step 1: Does the measure discriminate on residency? If yes, it is a CFM by design.
  - Step 2: If not residency-based, does it differentiate by currency?
    - Measures neither residency- nor currency-based are more likely MPMs (example: CCyB).
    - Currency-based MPMs may be asset-side (usually not CFMs), asset-liability, or liability-side measures; liability-side measures can be CFMs if calibrated to limit flows.
- Practical guidance:
  - A reserve requirement on FX deposits raised in response to increased systemic risk would likely be an MPM if well-calibrated to risk; if raised beyond what is needed or with no material systemic-risk change, it is more likely a CFM/MPM.

### Timing, duration, and sequencing: MPMs vs CFMs
- MPMs:
  - Can be implemented pre-emptively and maintained until systemic risk dissipates or materializes.
- CFMs:
  - Should not be pre-emptively implemented; when used during surges they should be temporary and scaled back as pressures abate.
- CFM/MPMs:
  - May be maintained longer after inflow pressures abate if they continue to manage systemic risks, but require continual re-evaluation of costs and alternatives that do not limit flows.

### Managing outflows and MPM relaxation
- General view: outflows are normal and facilitate investor recoupment/diversification; policies should generally facilitate orderly outflows with warranted macroeconomic adjustment.
- Temporary CFMs on outflows are possible in crises but should not substitute for adjustment and must be lifted when conditions abate.
- Conditions for MPM relaxation (must satisfy all three):
  - (i) buffers are in place;
  - (ii) capital outflows are generating financial stress;
  - (iii) relaxation is expected to relieve stress and contain adverse procyclical dynamics.
- Operational considerations:
  - Establish minimum macroprudential settings (based on international minima) to preserve confidence through downturns.
  - If outflows do not generate financial stress, relaxation generally has no benefit.
  - Choose which tool to relax based on stress source: solvency vs liquidity.
- Experience:
  - Croatia: relaxation of FX liquidity buffers and reserve requirements released over EUR6 billion, or more than 14 percent of GDP, to the banking system during 2008–2012, helping preserve stability and defend the exchange rate.
  - United Kingdom: CCyB released from 0.5 to 0 percent on July 1, 2016, after the Brexit referendum to prevent excessive credit tightening; supervisors engaged banks on contingency planning for short-term liquid assets.

### Capital account liberalization and building macroprudential capacity
- Benefits: efficient allocation of savings, risk diversification, lower financing costs, competition, technology transfer, and financial development.
- Risks: poor liberalization sequencing can lead to systemic-risk buildup; historical crises followed liberalization in many cases.
- Integrated approach:
  - Liberalize flows that are less systemic-risk-inducing first (e.g., FDI); manage portfolio bond and short-term banking flows carefully with macroprudential strengthening.
  - Strengthen institutional arrangements, toolkits, data (national credit registers, surveys), and supervision before liberalizing further.
  - Where capacity is lacking, adopt caution, develop supervisory capacity, consider rules-based macroprudential approaches, and use permanent capital buffers to be relaxed only in large external shocks.

### Policy implications, Fund role, and future work
- Macroprudential policies can increase financial-system resilience and contain systemic vulnerabilities amid large and volatile capital flows.
- Establishing frameworks and preemptive measures supports financial systems during outflows so they continue to provide services.
- Relaxation of MPMs can assist countering outflow-related financial stress if buffers exist, but macroeconomic policies remain primary.
- IMF support: surveillance of macroprudential policy in Article IV consultations, promotion of institutional arrangements in FSAPs and Technical Assistance.
- The Fund will continue to build evidence (including a comprehensive database of macroprudential measures) and integrate findings into surveillance and TA to improve guidance on benefits, costs, effectiveness, and calibration of MPMs.

*International Monetary Fund — CONCLUSIONS (pp060217-increasing-resilience-to-large-and-volatile-capital-flows)*

### CONCLUSIONS __________________________________________________________________________________ 36

### CONCLUSIONS

### Context
- Capital flows can deliver substantial benefits, including via financial deepening, but also have the potential to contribute to a build-up of systemic financial risk.
- The global financial crisis (GFC) highlighted how vulnerabilities in financial systems, built up alongside increasing cross-border interconnectedness and spillovers from source countries’ policies, can lead to large adverse effects when markets seize up, capital flows reverse, and balance sheets unwind.
- Post-crisis regulatory reforms have focused on increasing the resilience of financial systems so they are more transparent and less complex, with institutions that are better capitalized, less leveraged, and hold more liquid assets—helping absorb losses and manage liquidity risks, including those arising from cross-border flows. Significant progress has been made through the Basel III process, and implementation of the new standards is underway.

### Role and Main Features of Macroprudential Policies (MPMs)
- Macroprudential policy is the use of primarily prudential tools to limit systemic risk.
- MPMs can:
  - increase the resilience of financial systems to aggregate shocks;
  - mitigate the pro-cyclical build-up of risks over the financial cycle;
  - help countries harness benefits of capital flows while managing associated risks.
- Many Fund members have established macroprudential frameworks or are in the process of doing so.
- From the Fund’s Macroprudential Framework (IMF, 2013a; and IMF, 2014a):
  - Macroprudential policies are primarily prudential measures designed to limit systemic risk.
  - They pursue three “tasks”: (i) increase resilience by building buffers; (ii) mitigate pro-cyclical feedbacks and contain unsustainable leverage and volatile funding; and (iii) contain structural vulnerabilities from interlinkages and “too important to fail” institutions.
  - Tools include countercyclical capital buffers and provisions, sectoral capital requirements, measures to contain liquidity and foreign exchange (FX) mismatches, and caps on loan-to-value (LTV) and debt-to-income (DTI) ratios. They can also include tools traditionally associated with other policy fields, such as monetary (e.g., reserve requirements) and fiscal policy (e.g., levies imposed on wholesale funding).
  - Conditions for effectiveness: focus on systemic vulnerabilities (not broader objectives), build on strong microprudential supervision, guided by continuous assessment of evolving risks, and consider systemic risks across the whole financial system beyond banks.

### Institutional View on Capital Flows and Interplay with MPMs
- The Fund’s Institutional View (IV) on capital flows (IMF, 2012a; and IMF, 2015) emphasizes:
  - Capital flows should be handled primarily with macroeconomic policies, including exchange rate flexibility, FX intervention, and monetary and fiscal policy adjustment, supported by robust institutions and sound financial supervision and regulation as well as appropriate structural policies.
  - CFMs should not be used to substitute for warranted macroeconomic adjustment.
  - In certain circumstances, introducing capital flow management measures (CFMs) can be appropriate, including when a capital inflow surge raises risks of financial instability, but CFMs should be targeted, transparent, and generally temporary—being lifted once the surge abates, in light of their costs.
  - Policy tools designed to limit capital flows and to reduce systemic financial risks stemming from such flows are considered both CFMs and MPMs (CFM/MPMs). The economic usefulness of maintaining such measures over the longer term needs to be evaluated against their costs on an ongoing basis, considering alternatives that directly address systemic risks but are not designed to limit capital flows.
  - When responding to disruptive outflows, CFMs should generally be used only in crisis situations or when a crisis may be imminent; they should be implemented as part of a broad policy package and be temporary.
  - Capital flow liberalization should be well planned, timed, and sequenced; countries are better placed to benefit if they have achieved certain thresholds of financial and institutional development.

### Operational Challenges and Need for Further Work
- The channels from capital flows to systemic risk are difficult to disentangle and assess in real time; impacts depend on country-specific circumstances including financial system structure, private-sector balance sheets, and institutional and policy frameworks.
- Constraints on policy responses can arise from:
  - presence of large cross-border financial institutions;
  - weaknesses in supervisory frameworks that limit scope to establish robust macroprudential frameworks;
  - information gaps complicating design and calibration of effective macroprudential instruments.
- The IMFC and the IMF Executive Board have called for further work on the interaction between macroprudential policies and policies related to capital flows, including deeper examination of transmission channels and the role of MPMs in limiting systemic financial risk—taking into account countries’ financial and institutional development.

### Evidence Base and Scope for Analysis
- The paper draws on country experiences, including eight background case studies covering Cambodia, Colombia, Croatia, Iceland, Korea, Peru, Sweden, and Turkey—countries diverse in income group and financial system structure that faced large and volatile capital flows and actively used MPMs as part of strategies to address associated risks.
- The paper’s structure:
  - analysis of the relationship between capital flows and systemic risk, presenting five distinct aspects of systemic risk that can arise from capital flows;
  - discussion of the potential for macroprudential tools to help limit the various dimensions of systemic risk during capital inflow surges, and factors influencing tool effectiveness;
  - exploration of the complementarity between the Fund’s macroprudential framework and the Institutional View, and identification of principles for classifying MPMs that may also be CFMs to ensure appropriate and consistent Fund advice;
  - considerations for macroprudential policy settings in the event of capital outflows, and discussion of the role of macroprudential policies in building resilience during capital flow liberalization.

*International Monetary Fund — CONCLUSIONS (pp060217-increasing-resilience-to-large-and-volatile-capital-flows)*

### 8.      Systemic risk is the anchoring concept for assessing the impact of capital flows on the

### 8.      Systemic risk is the anchoring concept for assessing the impact of capital flows on the

### Systemic risk: definition and relevance
- Systemic risk is described as a multi-dimensional concept encompassing:
  - risks building up over time (e.g., financial accelerator effects, volatile funding),
  - cross-sectional vulnerabilities from the structure of the financial system, including linkages within and across classes of financial intermediaries.
- Numerous proxy approaches exist for different dimensions of systemic risk, including financial cycles and regulatory ratios such as the loan-to-deposit ratio.

### Empirical links between capital flows and systemic risk
- The literature finds that large and volatile capital flows can give rise to systemic risk via multiple channels:
  - Capital inflow surges can exert upward pressure on exchange rates and other asset prices, raising collateral values and net worth and increasing borrowing capacity via financial accelerator effects.
  - Rising cross-border non-core liabilities allow banks to extend credit beyond domestic retail deposits, contributing to credit booms and maturity/currency mismatches.
  - Buildup of gross debt positions raises contagion risks through leverage chains as counterparty obligations proliferate.
- Recent empirical research generally finds a close association between capital inflow surges and financial crises; for example:
  - Ghosh, Ostry, and Qureshi (2016) find that around one-fifth of inflow surge episodes in emerging markets end in banking or currency crises.
  - The combination of sharp appreciation and rising leverage is a robust predictor of financial crises (Gourinchas and Obstfeld, 2012).

### Five stylized transmission channels of inflows to systemic risk
- The paper distinguishes five stylized transmission channels:
  - (i) credit booms;
  - (ii) asset price booms;
  - (iii) unhedged foreign currency exposures;
  - (iv) non-core funding of the banking system;
  - (v) interconnectedness.
- These channels often reinforce each other through feedback effects—especially credit booms, asset price booms and non-core funding.

### Role of country circumstances and composition of flows
- Key determinants of whether inflows build systemic risk include:
  - depth of capital markets,
  - presence of dollarization,
  - strength of microprudential supervision,
  - settings of monetary policy,
  - structure of macro-prudential policies.
- The relationship between capital inflows and systemic risk appears stronger for gross inflows, although net inflows matter as well.
- Surges dominated by debt inflows are more likely to end in crises; bank inflows have a robust effect on credit growth.

### Evidence on inflows and credit booms
- Both gross and net inflows are correlated with credit growth.
- Capital inflow surges are good predictors of credit booms (Reinhart and Reinhart, 2009; Mendoza and Terrones, 2008), though not all inflow surges result in credit booms.
- Example country episodes:
  - Korea: prior to the 2008–09 GFC, gross debt inflows to Korean banks increased considerably while the country ran current account surpluses.
  - Turkey: episodes of ample capital inflows including 2002–07 and 2010 intermediated by local banks led to rapid credit growth.
  - Colombia: credit was highly and positively correlated with capital flows in the 1990s and early 2000s, but not more recently.

### Quantitative coverage and findings
- Database coverage and aggregation:
  - 141 countries: 37 advanced, 65 emerging, and 39 low-income economies.
  - Ratios and correlations calculated for the 1990–2015 period, aggregated using simple (unweighted) averages unless otherwise noted.
- Specific empirical findings:
  - Other investment inflows: a one percent of GDP increase in other investment flows leads to an increase of 0.6 percentage points in credit to GDP (Blanchard et al., 2016).
  - Correlations between flow types and credit growth are strongest for non-FDI flows, particularly gross debt flows.
  - Correlations tend to be stronger during 2003–09 (run-up to the GFC and during the crisis).

### A. Effects through asset prices
- Capital inflow surges often push up asset prices, magnifying credit booms via financial accelerator effects.
- Net capital inflows have a strong positive relationship with real estate prices.
- Direct foreign purchases of real estate can build systemic risk if they fuel generalized price increases and domestic buyers increase leverage.
- Asset price booms not associated with rapid increases in borrowers’ leverage do not seem to pose significant threats to financial stability.
- Reversals in inflows and tighter global financing conditions can reduce asset prices, erode net worth, reduce borrowing capacity, and trigger asset sales and further valuation declines.

### B. Unhedged foreign borrowing
- Unhedged foreign currency borrowing often rises during inflow episodes when domestic rates exceed global rates and local currency is expected to appreciate.
- There is a strong statistical correlation between capital flows and the share of foreign-currency lending.
- Risks materialize when flows reverse and the exchange rate depreciates, potentially causing defaults, higher nonperforming loans, and erosion of bank capital.
- Historical example: Colombia in the late 1990s—peso depreciation hit corporates with large unhedged FX exposures, deteriorating banks’ loan portfolios.

### C. Effects through banks’ non-core funding
- Under favorable external conditions, banks may increase “non-core” liabilities (including FX funding) to support credit growth.
- The loan-to-deposit ratio is a useful proxy for the extent to which credit outpaces deposit accumulation.
- Capital inflows are associated with increases in wholesale-funded credit; impacts on vulnerabilities are amplified when supervision and regulation are weak.
- Examples:
  - Turkish banks’ external wholesale FX funding supported loan growth and created rollover risk.
  - Peruvian banks’ rapid increase in non-core liabilities in the late 1990s left them exposed to sudden stops.
  - Korea relied on cross-border wholesale funding in the run-up to the GFC and was vulnerable to loss of foreign funding once global liquidity conditions turned.
- Severe shocks can trigger wholesale runs and loss of access to bond markets; reliance on non-core funding was a key vulnerability in banking crises of the 1990s and 2000s.

### Box: Financial cycles and systemic risk (summary)
- The financial cycle is a conceptual framework linking rising credit and asset prices to the build-up of systemic risk and subsequent sharp falls in credit and/or asset prices.
- Source country policies influence global capital flows and can affect financial cycles in open economies.
- Financial cycles have become more synchronized with capital flow surges/troughs and have increased in amplitude.
- A credit gap (deviation of credit from long-term trend) is a commonly used indicator for the position in the financial cycle and for calibrating tools like the countercyclical capital buffer (CCyB).
- Methodological challenges: significant data requirements and conceptual debates (e.g., comparing a stock variable like credit to flow variable GDP).

*International Monetary Fund — Capital Flows and the Role of Macroprudential Policies (excerpt).*

### 21.      Gross debt flows can increase systemic risk, even in the absence of significant net flow

### 21.      Gross debt flows can increase systemic risk, even in the absence of significant net flow

### Gross positions, cross-exposures, and systemic risk
- Gross positions have increased very rapidly since the 1990s (Gourinchas and Rey, 2014), with cross-exposures between residents and non-residents being pro-cyclical (Broner et al., 2013).
- Under inadequate regulation and supervision frameworks, gross debt flows can be associated with a significant build-up of risk (Borio and Disyatat, 2011).
- Example: European global banks’ pre-GFC activity funded purchases of US mortgage-backed securities by selling short-term paper in U.S. money markets—raising gross assets and liabilities in both the US and Europe, with no net flow—which is cited as an explanation for larger impacts of the subprime crisis on European financial systems despite Europe having a current account surplus (e.g., Bayoumi and Bui, 2011; Shin, 2012; McGuire and von Peter, 2012).

### Global systemically important institutions (G-SIIs) and interconnectedness
- Increased interconnectedness can contribute to resilience under certain conditions, but can become a source of systemic risk under large negative shocks (Acemoglu et al., 2015).
- Distress or disorderly liquidation of large and highly connected financial institutions can potentially lead to wider instability.

### Mapping macroprudential instruments to risks
- Post-crisis reforms, including Basel III microprudential reforms, have strengthened capital quality and levels and introduced higher standards for liquidity risk management and supervision.
- Macroprudential frameworks complement microprudential measures and can improve capacity to intermediate cross-border flows safely.
- Macroprudential policy can:
  - Increase resilience to aggregate shocks, including reversals of capital flows, by building buffers so the financial system can continue to provide credit.
  - Contain the build-up of systemic vulnerabilities by reducing procyclical feedbacks between asset prices or exchange rates and credit, and by containing unsustainable increases in leverage and volatile funding.
- While macroprudential measures can limit the transmission of capital flows to systemic risks, their objective is not to restrict capital flows or to control asset prices, interest rates, or exchange rates.

### Types of macroprudential tools and examples
- Broad-based tools (increase resilience; affect all credit exposures):
  - Countercyclical capital buffers (CCyB)
  - Dynamic loan loss provisioning requirements (DPR)
  - Static or dynamic leverage ratio
  - Repeated macroprudential stress tests (e.g., CCAR in the US)
  - Country examples: Sweden and Norway activated positive buffers in 2015; Hong Kong in 2016; Czech Republic, Iceland, and Slovakia in 2017. DPR first introduced by Spain in 2000 and adopted in Latin America (e.g., Colombia, Peru). Croatia used caps on credit growth in the 2000s.
- Sectoral and asset-side tools (target specific credit categories):
  - Sectoral capital requirements (risk weights), e.g., higher risk weights on FX mortgage loans in Serbia (2008) and Poland (2008).
  - Limits on loan-to-value (LTV) ratios and debt-service-to-income (DSTI) ratios.
  - Loan restrictions and underwriting guidance; constraints can be tighter for lending in FX.
  - Examples: DSTI/LTV caps on FX mortgages in Poland (2011), Hungary (2010), Romania; higher risk weights on FX or FX-linked corporate loans in Croatia during the 2000s; Russia imposed higher risk weights on certain FX exposures in 2016.
  - Targeted fiscal measures can complement prudential measures when asset prices are driven up by capital inflows, preferably non-discriminatory.
- Liquidity tools (contain vulnerabilities from volatile funding):
  - Basel III liquidity standards: Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR).
  - LCR effects: increase holdings of liquid assets; reduce illiquid assets; lengthen funding maturities.
  - NSFR and country-specific core funding ratios (e.g., New Zealand), loan-to-deposit ratio (e.g., Korea), liquidity charges.
  - Examples of currency-differentiated liquidity measures: Sweden applies LCR separately to EUR and USD as well as to all currencies; Iceland imposed both LCR and NSFR ratios differentiated by currency.
  - Price-based measures: Korea’s liquidity charges on non-core foreign currency liabilities.
  - Differentiated reserve requirements on FX liabilities in Peru and Turkey.
  - Direct measures: constraints on banks’ gross open foreign exchange positions (spot or forward), caps on foreign currency borrowings.
- Basel III implementation timing and standards:
  - LCR minimum standard phased-in beginning in 2015 and steadily increasing to 100 percent by January 2019.
  - NSFR to become a minimum standard by January 2018.
  - Basel III includes LCR by significant currency as a monitoring tool.

### Twin benefits and transmission channels
- Macroprudential tools generally:
  - Induce greater resilience.
  - Help contain procyclical dynamics among asset prices, credit, and wholesale funding during inflow surges and subsequent reversals.
- Specific mechanisms:
  - Capital buffers built in good times protect against losses from FX borrowing when local currency depreciates.
  - Liquidity requirements mitigate susceptibility to funding pressure during capital outflows.
  - Caps on interbank exposures and capital surcharges on global or regionally systemically important institutions can reduce contagion risks from cross-border exposures.
  - Strengthening payment, settlement, and clearing arrangements increases transparency and reduces build-up of credit exposures.

### Effectiveness evidence and key limitations
- Literature supports potential effectiveness of macroprudential policies in achieving resilience and containing procyclical dynamics, but evidence is still accumulating and subject to caveats (Claessens, 2014).
- Findings on tool effectiveness:
  - Capital tools (e.g., CCyB) increase resilience and reduce probability and impact of crises when buffers are usable to absorb losses (e.g., Jiménez et al., 2012).
  - Liquidity tools tend to achieve desired changes in funding profiles, contributing to resilience (e.g., Banerjee and Mio, 2014 for the UK; Bonner, 2012 for the Netherlands).
  - Sectoral tools (LTV and DTI constraints) increase borrower resilience to asset price and income shocks and reduce likelihood of default and loss given default (e.g., Hallissey et al., 2014).
  - Loan restrictions and borrower-based tools (LTV, DTI) generally have stronger effects on credit than capital or liquidity tools, based on historical calibration.
  - Evidence suggests that variation of the countercyclical capital across typical ranges of between 0 and 2.5 per cent will have limited effect on credit growth when imposed in buoyant times, such as during a capital flow surge, because intermediaries can generate extra capital through retained earnings or issuing capital (e.g., Basten and Koch, 2015; Jiménez et al., 2012).
  - DTI limits are more powerful in containing increases in credit than LTV limits, because LTV constraints tend to ease when asset prices rise (Kuttner and Shim, 2016).
- Key limitation — leakage and circumvention:
  - Macroprudential tools can be circumvented, resulting in domestic or cross-border "leakage" (IMF-FSB-BIS, 2016).
  - Leakage preserves resilience effects on domestic intermediaries but can undermine containment of excessive credit and leverage in household and corporate sectors.
  - Domestic leakage: credit provision shifts from banks to non-bank lenders.
  - Cross-border leakage: increased provision of credit from abroad or through local affiliates of multinational intermediaries.
  - Some studies find smaller leakage effects for loan restrictions (LTV, DTI) which can be imposed on all lenders, including domestic non-banks and branches of foreign banks (e.g., Reinhardt and Sowerbutts, 2015).
  - Leakages are more likely where corporate funding shifts from bank-based to market-based and corporates borrow directly from abroad (e.g., Cizel et al., 2016; Buch and Goldberg, 2017).
  - Strategy to contain leakages: expand the scope of application of macroprudential tools (see IMF-FSB-BIS, 2016).

*International Monetary Fund — Capital Flows and the Role of Macroprudential Policies (excerpt).*

### 38.      Source country policies can also play an important role in increasing global

### pp060217-increasing-resilience-to-large-and-volatile-capital-flows - 38.      Source country policies can also play an important role in increasing global

### Source-country policies and cross-border resilience
- Source-country policies can increase global effectiveness of macroprudential policies in containing systemic risks from capital flows (FSB, 2017).
- Example policies:
  - Policies to reduce redemption risk of investment funds by aligning redemption policies with the liquidity profile of assets; these can reduce disruptive fire sales and contribute to reduced risk of disruptive capital outflows in emerging markets (FSB, 2017).
  - Reciprocity agreements for macroprudential tools agreed by the Basel Committee on Banking Supervision (BCBS) for the CCyB, and in the EU by the European Systemic Risk Board (ESRB) for a wide range of instruments.
  - Capital surcharges imposed by home authorities on global or regionally systemically important banks to contribute indirectly to the resilience of their affiliates in host countries and reduce host-country risks from failure of these entities.

### Costs, adjustment, and timing of macroprudential policies
- Types of costs to consider (IMF, 2014a; IMF-FSB-BIS, 2016):
  - Adjustment costs to financial firms from balance-sheet affecting tools (e.g., capital and liquidity tools).
  - Efficiency costs for borrowers, including curtailed access to credit and higher cost of credit.
  - Potential short-run costs to output from tightening macroprudential tools.
- Mitigation of adjustment costs:
  - Allow sufficient time for new constraints to be met; BCBS recommends a notice period of up to 12 months to provide banks time to meet a CCyB requirement.
  - New liquidity or loan-to-deposit ratio requirements are typically announced well ahead of enforcement to avoid procyclical adjustments (IMF, 2014a; IMF-FSB-BIS, 2016).
- Efficiency costs and targeted design:
  - Sectoral tools (LTV, DTI, higher capital on FX exposures) can curtail access or raise cost of credit; some costs may be intended as part of transmission.
  - Careful design can avoid excessive costs: caps on shares of loans at high LTV ratios (New Zealand) or high LTI multiples (UK) constrain rather than prohibit provision of credit.
  - Constraints on FX exposures can be applied only to unhedged borrowers rather than all FX borrowing (IMF, 2014a; IMF-FSB-BIS, 2016).

### Output effects and calibration
- Output costs differ by tool, timing, and calibration (IMF-FSB-BIS, 2016):
  - Capital and liquidity tools: short-run costs to output generally assessed as small and outweighed by longer-run benefits from reduced output volatility and lower probability/cost of financial crises (BIS, 2010). Costs are larger if tightening is aggressive or ill-timed.
  - Sectoral tools (LTV, DTI): evidence shows larger short-run effects on output via reduced consumption and investment (IMF, 2013b); hence should be tightened gradually and ideally during robust economic growth.

### Risk assessment and policy commensurateness
- Macroprudential policy should be commensurate with the profile of risks (IMF, 2014a; IMF-FSB-BIS, 2016):
  - Evaluate indicators of risk build-up across dimensions:
    - (i) vulnerabilities from a broad-based credit boom affecting lending to all sectors;
    - (ii) vulnerabilities from lending to specific sectors (household or corporate), including in FX;
    - (iii) increased funding vulnerabilities for the financial system, including from wholesale funding in FX (CGFS, 2012; IMF, 2013a; IMF, 2014a).
- Use multiple indicators to guide policy response:
  - Broad-based vulnerabilities → activate/tighten broad-based tools (capital and liquidity).
  - Specific sectoral vulnerabilities without broad boom → use narrowly targeted tools (e.g., tight LTV and DSTI caps for household FX borrowing, as in Poland).

### Complementarities between the MPP framework and the Institutional View
- Roles:
  - MPP framework: operational advice on use of macroprudential measures (MPMs) to increase resilience and contain procyclical systemic risk build-up.
  - Institutional View: recommends broad policy packages, including that CFMs can support macroeconomic adjustment and financial stability in certain circumstances (e.g., inflow surges) when: (i) room for macroeconomic policy adjustment is limited; (ii) needed policy steps require time; (iii) surge raises financial stability risks.
- Common principles for CFM/MPMs (IMF, 2012a):
  - (i) Avoid using CFMs/MPMs as a substitute for necessary macroeconomic adjustment.
  - (ii) Use instruments that are most effective, efficient, direct, and least distortive, subject to (i).
  - (iii) Seek to treat residents and nonresidents in an evenhanded manner.

### Distinguishing MPMs, CFMs, and CFM/MPMs; assessment criteria
- Key principle: an MPM is assessed as such if it is geared towards containing systemic risk, which requires:
  - (i) identification of a potential source of systemic risk that needs addressing; and
  - (ii) identification of a plausible transmission path by which the measure reduces systemic risk.
- Determination whether an MPM is also a CFM requires consideration of:
  - Context (e.g., adopted during an inflow surge),
  - Calibration (scope and intensity),
  - Country-specific circumstances (financial system structure, market development) (paragraph 50).
- Flow-chart assessment steps (conceptual):
  - Step 1: Does the measure discriminate on residency? If yes, it is a CFM by design (e.g., limit on banks’ liabilities to nonresidents).
  - Step 2: If not residency-based, does it differentiate by currency?
    - Measures neither residency- nor currency-based more likely classified as MPMs (example: countercyclical capital buffer).
    - Currency-based MPMs typically fall into three categories:
      - (i) Asset-side measures (e.g., higher risk weights on foreign-currency loans to unhedged borrowers) — usually not CFMs.
      - (ii) Asset-liability ratio measures (e.g., currency-differentiated LCRs and NSFRs).
      - (iii) Liability-side measures (e.g., higher reserve requirements on FX deposits).
    - Asset-liability or liability-side measures could be CFMs if calibration indicates they are designed to limit capital flows, but determination is not automatic; staff assessment must consider context and calibration (paragraph 51).
  - Practical guidance: a reserve requirement on FX deposits raised in response to increased systemic risk (regardless of inflow surge) would likely be an MPM if well-calibrated to the risk; if increased with no material change in systemic risk or beyond what is needed, more likely a CFM/MPM.

### Timing, duration, and sequencing of MPMs vs CFMs
- MPMs:
  - Can be implemented pre-emptively and maintained to contain systemic risk build-up.
  - Should be maintained until systemic risk dissipates or risks materialize and financial conditions tighten.
- CFMs:
  - Should not be implemented pre-emptively before surges (Institutional View).
  - When used in a surge, CFMs should be temporary and scaled back when capital flow pressures abate to minimize distortions.
- CFM/MPMs:
  - May be maintained longer after inflow pressures abate if they continue to manage systemic financial risks, but their costs and effectiveness must be re-evaluated continually.
  - Alternatives that do not limit capital flows should be considered (e.g., replace residency-discriminating measures with even-handed instruments or replace with MPMs that achieve the same objective without limiting capital flows).

### MPMs and management of outflows
- General view:
  - Outflows are normal and allow investors to recoup investments and diversify; policies should generally facilitate orderly outflows with warranted macroeconomic adjustment.
- Risks of disruptive outflows:
  - Large, sustained, or sudden outflows can be disruptive and may cause crises (examples: reserve depletion, currency collapses, impaired balance sheets, jeopardized financial stability).
  - Disruptive outflows often reflect failure to correct macroeconomic and financial imbalances, in part fueled by prior inflows.

*Source: pp060217-increasing-resilience-to-large-and-volatile-capital-flows - 38.*

### 56.      Building economic and financial resilience is important for mitigating the risks

### pp060217-increasing-resilience-to-large-and-volatile-capital-flows - 56.      Building economic and financial resilience is important for mitigating the risks

### Resilience and policy framework
- Building economic and financial resilience mitigates risks associated with capital outflows by safely absorbing inflows and limiting systemic risk buildup.
- Key elements: strong institutional setup; sound macroeconomic, structural, and financial policies (including MPP).
- Primary responsibility for handling capital outflows: macroeconomic, structural, and financial sector policies (IMF, 2012a; and  IMF, 2015).
- Policy toolkit and roles:
  - Exchange rate flexibility: a key shock absorber.
  - Foreign exchange intervention: to prevent disorderly market conditions, provided reserves are adequate.
  - Monetary policy: adjust as necessary and feasible to maintain price stability.
  - Fiscal policy: depends on public debt sustainability and cyclical considerations.
  - Liquidity provision: may be required to support orderly financial conditions.
  - Relaxing CFMs on inflows: may be useful when surges subside.
  - Temporary CFMs on outflows: possible in crisis situations but should not substitute for macroeconomic adjustment and should be lifted once crisis conditions abate.

### Macroprudential policy (MPM) relaxation: conditions and rationale
- Relaxation of macroprudential measures (MPMs) can be an additional tool to respond to outflow-related risks but is inherently difficult during outflow episodes.
- Three conditions (IMF, 2014a; and IMF-FSB-BIS, 2016) that should be satisfied before relaxation:
  - (i) buffers are in place;
  - (ii) capital outflows are generating financial stress; and
  - (iii) relaxation is expected to relieve stress and thereby contribute to containing adverse procyclical dynamics.
- Rationale for relaxation:
  - To counter financial stresses from outflows and maintain provision of financial services to the real economy.
  - Not automatic: relaxation should be judged case-by-case and rely on the three conditions above.

### Operational considerations for relaxing MPMs
- Buffer requirement:
  - Relaxation relies on sufficiently large buffers so settings remain consistent with regulatory minima and confidence is maintained.
  - Macroprudential authorities should establish minimum levels for macroprudential settings, based where relevant on international minimum standards, that are generally considered safe through downturn conditions.
  - Building larger buffers ex ante creates policy space; where buffers are unavailable, responses must rely more on other policies.
- Triggering financial stress:
  - If outflows are observed but not generating financial stress, relaxation generally has no benefit; building buffers may be advisable instead.
  - Financial stress indicators: strains in funding markets, falling asset prices, increases in default rates.
  - Judgment is required in deciding to relax buffers in outflow episodes (IMF, 2014a).
- Expected efficacy:
  - Relaxation should be expected to relieve financial stress, particularly when macroprudential constraints themselves become binding.
  - Example: drying up of wholesale funding → liquidity constraints binding → making macroprudential liquidity buffers available can maintain interbank market functioning and credit provision.
- Tool-specific decisions:
  - Choose which tool to relax based on the source of stress (IMF, 2014a).
  - Weakened solvency (corporate/household) without liquidity stress → relax capital- or housing-related tools.
  - Liquidity stress before solvency signs → relax liquidity tools.
  - Global investor-confidence shocks → relax liquidity tools while possibly maintaining/increasing capital buffers or tightening other MPMs to restore confidence.

### Experience and evidence
- Experience with relaxing MPMs remains scarce; staff advice is still evolving.
- Examples cited:
  - Croatia:
    - Implemented several MPMs pre-GFC and relaxed them when large inflows tapered and financial stress emerged.
    - HNB lowered required FX liquidity buffers, removed marginal and special reserve requirements, lowered the general reserve requirement, and allowed a larger share of the requirement to be fulfilled in domestic currency.
    - Relaxation released over EUR6 billion, or more than 14 percent of GDP, to the banking system over the course of 2008–2012 (Bokan et al., 2009; Rohatinski, 2009; and Vujcic and Dumicic, 2016).
    - Outcome: preserved financial stability and defended the exchange rate in a highly euroized economy; a systemic banking crisis was averted amid deep recession.
  - United Kingdom (Bank of England):
    - CCyB was released from 0.5 to 0 percent on July 1, 2016, a week after the Brexit referendum.
    - Relaxation aimed to prevent excessive tightening of credit conditions and associated negative economic impact; was not in response to a specific outflow distress.
    - Supervisors engaged with banks on contingency planning for short-term liquid assets in each material currency in case of severe wholesale stress (Bank of England, 2016).

### Capital account liberalization and macroprudential capacity
- Benefits of capital flow liberalization: efficient global allocation of savings and investments, risk diversification, reduction in financing costs, promotion of competition and technology transfer, facilitation of financial development (IMF, 2012a).
- Risks: poorly managed liberalization can lead to systemic risk buildup; historical crises followed liberalization in many cases (IMF, 2012a); but there are also many successful cases (IMF, 2012b).
- Integrated approach to liberalization:
  - Remove CFMs in a properly paced and sequenced manner; consider financial and institutional development levels (IMF, 2012a).
  - Liberalize first flows less likely to induce systemic risk (e.g., FDI); manage portfolio bond flows and short-term banking flows carefully and support with macroprudential strengthening.
- Strengthening capacity to deploy macroprudential tools:
  - Requires institutional arrangements, toolkits, and information (data and analysis capacity).
  - Reforms: deepen and strengthen financial markets; bolster ability to absorb flows and manage exchange rate risks; improve prudential regulation and supervision.
  - Data investments: expand supervisory data, establish data sharing mechanisms (e.g., national credit register), initiate surveys on asset prices and household/corporate debt.
- Where capacity is lacking:
  - Caution advised in further liberalization.
  - Develop supervisory capacity and data collection first.
  - Consider more rules-based macroprudential approaches (e.g., dynamic provisioning regimes, conservatively calibrated LTV and DSTI ratios).
  - Complement with permanent capital buffers that would be relaxed only in event of a large external shock (IMF, 2014a).

### Conclusions and policy implications
- Macroprudential policies can help countries facing large and volatile capital flows by increasing financial-system resilience and containing systemic vulnerabilities.
- Establishing macroprudential frameworks and introducing measures preemptively can support financial systems to remain stable and continue to provide services during capital outflows.
- While capital outflow risks should be handled primarily by macroeconomic policies, relaxation of macroprudential measures may assist countering financial stresses if buffers are in place.
- Capital flow liberalization should be supported by strengthening prudential regulation and supervision; macroprudential frameworks should be developed alongside liberalization.
- IMF support: surveillance of macroprudential policy in Article IV consultations, promotion of institutional arrangements in FSAPs and Technical Assistance (TA).

*Source: pp060217-increasing-resilience-to-large-and-volatile-capital-flows - 56–74 (excerpts).*

### 75.      While experience in the usage of macroprudential policies is growing, country

### CAPITAL FLOWS AND THE ROLE OF MACROPRUDENTIAL POLICIES

### Macroprudential policy calibration and guided discretion
- While experience in the usage of macroprudential policies is growing, country authorities are still learning how best to calibrate measures so as to reap their benefits while avoiding unnecessary costs.
- Large and volatile capital flows can contribute to systemic vulnerabilities, and their impact should be taken into account in determining the settings of macroprudential policies.
- Gauging the benefits of macroprudential measures, notably in terms of the reduced risk and severity of crises, relative to their costs for countries exposed to large and volatile capital flows is challenging; further work will be useful in this area.
- The Fund’s longstanding advice is that decisions on macroprudential policy be taken through “guided discretion,” where key indicators can help signal when adjustments might be appropriate, but the ultimate decision is a judgment drawing on all available information and expertise (IMF, 2014a).

### Consistency with existing Fund frameworks and staff guidance
- In providing advice, staff will continue to be guided by the macroprudential framework and the Institutional View.
- Although developed separately, both frameworks are consistent in fundamental principles, including that measures should not substitute for warranted macroeconomic adjustment.
- The conceptual framework laid out in this paper is seen as a helpful basis for assessing measures, especially when macroprudential policy measures (MPMs) and capital flow management measures (CFMs) potentially overlap.
- This framework aims to aid staff in providing consistent policy advice that helps economies better harness the benefits of capital flows by building resilience to large and volatile capital flows.

### Fund role, evidence building, and future work
- The Fund can play a role in continuing to develop and share expertise to support the growing understanding of these issues, and integrating these findings into Fund surveillance and technical assistance.
- Work is underway to compile a comprehensive database of macroprudential measures, which can inform further research on the usage and effectiveness of macroprudential policies, including in the presence of capital flows.
- The Fund’s engagement with the membership will continue to yield a rich evidence base of the experiences of a diverse range of countries in assessing systemic risks and using MPMs to limit systemic risk.

### Issues for discussion
- Do Directors agree that establishing sound macroprudential policy frameworks can help countries build resilience—without necessarily restricting capital flows—thereby helping them safely harness the benefits of capital flows?
- Do Directors find the conceptual framework for staff assessment of country measures laid out in the section of the paper on the complementarities of the IMF’s two existing frameworks (for macroprudential policies and the Institutional View) a helpful basis to guide sound policy advice?
- Do Directors agree that the Fund should continue to draw on country experiences to increase the understanding of the benefits, costs, effectiveness, and calibration of macroprudential measures in Fund surveillance?

*Source: CAPITAL FLOWS AND THE ROLE OF MACROPRUDENTIAL POLICIES (excerpt).*

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_Source: https://www.imf.org/-/media/files/publications/pp/2017/pp060217-increasing-resilience-to-large-and-volatile-capital-flows.pdf_