## _102111 ## Source details **Canonical URL:** [_102111](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_102111.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_102111.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_102111.pdf.json) --- ### Overview - Case studies document the regulatory and supervisory dimension of episodes during the recent crisis involving capital flows that generated systemic stress, with primary focus on source country regulation and supervision; recipient country policies covered where important. - Three case studies: systemic stress from flows between advanced economies driven by foreign investor demand for U.S. financial products transforming risky assets into highly-rated securities. - Three additional case studies: flows from advanced-economy source countries to EMEs (Sweden and the Baltic countries; Austria and selected central and eastern European countries) and flows designed to circumvent bank regulations. - Case studies and policy recommendations are based almost entirely on official Fund documents and are not comprehensive episode accounts. ### A. European Banks and United States Money Market Mutual Funds (MMMFs) — Findings and linkages - U.S. MMMFs were a key provider of short-term funding to global financial firms; prime funds invested in ABCP, CDs, repo, commercial paper (CP), short-term corporate notes, and other money funds and accounted for about 45 percent share of the market in late 2008. - Government and tax-free money funds invested mainly in treasuries, agency debt, and municipal bonds. - SEC Rule 2a-7 regulated credit quality, issuer concentration and maturity of assets; MMMFs not permitted to hold more than 5 percent of investments in second tier paper, or more than a 5 percent exposure to any single issuer (other than government and agencies). - European MMMFs were equivalent to only about 8 percent of bank deposits. - Before the crisis, about half of prime U.S. MMMF exposure was to Europe, and around one third to the euro area. - Pre-crisis U.S. MMMF funding financed European bank SIVs purchasing ABS/MBS, creating largely unregulated maturity transformation and foreign exchange liquidity risk for European banks. - Mid-September 2008 run: Reserve Primary Fund “broke the buck”; redemptions totaled more than $40 billion (approximately 67 percent of the Reserve Primary Fund‘s net assets) in the following days. - Total MMMF assets declined from a peak of $3.9 trillion in 2009 to about $2.7 trillion in the first half of 2011. - Run on MMMFs threatened runs on the U.S. CP and CD markets and thereby on non-U.S. (mainly European) banks, destabilizing global bank funding markets. ### A. Policy implications and actions for MMMFs - Official stabilizing actions: - Temporary guarantee program. - Fed liquidity facilities including Money Market Investor Funding Facility (MMIFF) where New York Fed provided senior secured funding to SIVs. - Proposed and implemented policy changes: - Require MMMFs to maintain portion of portfolios in instruments readily convertible into cash; reduce exposure to long-term debt; limit investments to highest quality securities. - Permit funds that have “broke the buck” to suspend redemptions to allow orderly liquidation. - SEC changes tightening 2a-7 liquidity requirements and credit and interest rate exposure. - President‘s Working Group (2010) options for industry comment including: convert to a floating NAV structure; establish private emergency liquidity facilities; require in-kind redemptions; require insurance; differential treatment for stable- and floating-NAV funds; regulate MMMFs as special purpose banks; impose constraints on unregulated MMMF substitutes. - IMF recommendation: require money market funds to make real-time disclosures of actual (as opposed to “stabilized”) net values. ### B. The American International Group (AIG) — Findings and exposures - AIG in 2007: largest and most diversified insurance company in the world; revenues from domestic/foreign life insurance, diversified property/casualty insurance, aircraft leasing, consumer finance. - Regulatory fragmentation: more than 70 U.S. insurance subsidiaries regulated by state supervisors; over 175 non-insurance or foreign entities overseen by various national supervisors; AIG Financial Products (AIGFP) operated as London branch of a French incorporated subsidiary and was not effectively regulated. - AIGFP sold mortgage default protection via CDSs on largely subprime mortgage CDOs to G-SIFIs; CDSs guaranteed by AIG exposed it to mortgage risk. - Main G-SIFI counterparties: Société Générale, Deutsche Bank, Goldman Sachs, Merrill Lynch, Calyon, Barclays, UBS. - Ratings downgrades triggered collateral posting obligations by AIGFP that AIG could not meet; funding markets refused to roll over AIG‘s debts. - AIG suffered $121 billion of losses on holdings of derivatives and securities; $85 billion covered by earnings, leaving a capital loss of about $36 billion. - AIG received about $198 billion in loans and equity from the Federal Reserve; about $92 billion of the support funds went to major institutions (examples): $11 billion to Société Générale; $8.5 billion to Barclays; $11.8 to Deutsche Bank; $7.3 billion to Goldman Sachs. Most bailout monies have been repaid. - Contagion channels: losses to counterparties of derivatives or securities lending; forced liquidation of collateral depressing credit market prices; potential large losses for policy holders and pension beneficiaries. ### B. Shortfalls in supervision and regulation identified - Group supervision: parent holding company was a thrift holding company under OTS since 2005; OTS deferred to functional regulators and lacked authority to resolve a failure. - Insurance supervision: state-based system lacked systemic focus and group-wide oversight capacity; federal regulators had limited responsibility; multiplicity of state regulations imposed inefficiencies. - Regulatory perimeter: securitization, growth in certain OTC derivative markets, and “shadow banking” created gaps; significant gaps in regulation of OTC derivative products and markets and in prudential regulation and market conduct rules; lack of collateral requirements for certain bilaterally-settled OTC derivatives contributed to undetected leverage build-up. - Cross-border regulation and coordination: foreign regulators had narrowly defined jurisdiction and deferred to home country regulators; absence of a consolidated regulator with good information about mortgage risk was key. - Macroprudential perspective: a single financial authority with systemic view would likely have better understood systemic implications of AIG’s business model. ### B. Policy implications and reforms following AIG - Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 provisions relevant to AIG case: - Registration requirements for OTC derivative dealers and “major swap participants”. - Central clearing of standardized derivatives contracts; CFTC and SEC powers to determine which instruments subject to clearing and trading on exchange or swap execution facility. - Reporting requirements for all derivative transactions and trading positions of major market participants. - Enhanced prudential requirements for risk exposures from OTC derivative trading for transactions not centrally cleared and collateral requirements for OTC derivatives. - Authority for regulators to safeguard market stability; capital and collateral requirements; market conduct provisions for OTC derivatives markets. ### 20. Insurance regulatory reforms that would help address the issues raised by AIG - Develop supervision of groups through consolidated financial condition reporting and analysis of the group as a whole (including unregulated affiliates) and further development of colleges of supervisors. - Improve regulation of bond insurance and securities lending, including reserving and capital treatment of market risks associated with guarantees and treatment of liquidity risks. - Modernize solvency requirements using more forward-looking approaches (e.g., stress and scenario testing and other forms of dynamic financial analysis). ### German banks and United States mortgage-backed securities — key links and findings - Several German banks expanded rapidly into U.S. ABSs and other structured products via conduits or SIVs in a "search for yield." - Over one-fifth of U.S. ABSs estimated held abroad pre-crisis; German banks (and banks in UK, Switzerland, France, Netherlands, Belgium) had significant exposure. - U.S. private-label securitization market grew to almost $5 trillion in 2006. - 2003: GSEs source of 76 percent of MBS/ABS issuances; by mid-2006 private label issues had risen to 57 percent share. - Private-label growth driven by subprime and "Alt-A" mortgages with senior tranches rated AAA/Aaa. - Arbitrage of Basel I capital requirements: securitized products held off-balance-sheet had zero capital adequacy risk weights. - Regulatory differences incentivized large purchases of U.S. MBSs by German banks: U.S. simple leverage ratio; European banks held ABSs in trading books with low risk weights; sponsorship of SIVs had no capital charge; MBSs served as collateral for dollar wholesale funding; SIVs were unregulated maturity transformers. ### Impact on German banks and public interventions - Germany experienced first shocks in July 2007; German bank SIVs faced funding difficulties and contractual obligations to finance SIVs. - Selected exposures (over equity / over assets) for banks (examples): - Sachsen-Finanzgruppe — Over equity: 1,126 — Over assets: 30.3 - West LB — Over equity: 542 — Over assets: 12.7 - IKB (until July 29, 2007, before bailout) — Over equity: 494 — Over assets: 20.5 - Deutsche Bank — Over equity: 114 — Over assets: 3.3 - Commerzbank — Over equity: 85 — Over assets: 2.2 - KfW — Over equity: 58 — Over assets: 2.6 (mitigated by unlimited sovereign guarantee) - Interventions and costs: - IKB and Sachsen Landesbank rescues in summer 2007. - West LB rescue package in early 2008. - Hypo Real Estate nationalized in 2009 after liquidity support package worth €35 billion later increased to €50 billion. - October 2008 new framework: - Special Fund for Financial Market Stabilization (SoFFin) administered by Federal Agency for Financial Market Stabilization (FMSA). - Measures: guarantees, recapitalizations, asset purchases, winding-up institutions. - Strengthened mandate of BaFin. ### Policy implications — U.S. mortgage crisis and recommended reforms - Crisis drivers: unsustainable lending boom fueled by low interest rates and capital inflows; housing bubble; shadow banking growth; decline in underwriting standards; weaknesses in risk management, governance, compensation; complex derivatives with poorly understood risk properties. - Staff recommended reforms: - Address supervisory gaps and shadow banking to close regulatory arbitrage; level playing field; improve risk management in repo and funding markets; ensure systemic institutions and markets inside regulatory perimeter. - Increase transparency in off-balance-sheet vehicles and rating agencies; improve CRA procedures, transparency, governance, conflict-of-interest mitigation for "issuer pays" model. ### Policy implications — Germany-specific regulatory lessons and reforms - Reduce reliance on external auditors; attract and retain skilled supervisors. - Require more frequent financial statements and encourage wider use of IFRS reporting to capture off-balance-sheet activity. - Establish bank resolution framework recognizing banks' payment system role and allowing quick resolutions and dilution of shareholders' equity claims. - New bank restructuring law (in force since 2011) grants broad powers to facilitate timely resolution of systemically relevant problem banks, including transfer to another institution (including a bridge bank) with emphasis on protecting deposits and systemically significant business parts. - European Commission to publish legislative proposals for harmonized EU resolution tools, likely including debt write-down or debt conversion tools. ### Austrian banks and CESE countries — key findings - At end-2007, 19 percent of banking flows to CESE region originated from Austrian banking groups. - Total claims of Austrian banks to CESE countries amounted to 70 percent of Austrian GDP; corresponding figures: Germany 5 percent, Italy 18 percent. - Six major Austrian groups active in CESE: UniCredit Bank Austria, Erste Bank, Raiffeisen Zentralbank Österreich, Volksbank, Bank für Arbeit und Wirtschaft und Österreichische Postsparkasse, Hypo Group Alpe Adria. - Almost 50 percent of lending by foreign subsidiaries of these groups was denominated in foreign currency. - Four main recipients: Czech Republic, Romania, Hungary, Croatia — accounting for 60 percent of Austrian claims on CESE region. - During 2003–2008, double digit credit growth occurred in all main recipients; foreign currency lending small in Czech Republic but more than half of private credit in Romania and Hungary. - Net capital inflows during 2003–2008: Czech Republic cumulative 50 percent of GDP (mostly FDIs) versus Romania 170 percent of GDP. - Intra-group liquidity transfers key in financing subsidiaries; funding patterns varied by country. ### Crisis impact on recipient and source countries - Currencies of Eastern European countries faced strong pressures to depreciate in first half of 2009 but between 2007 and end-2010 depreciated only between 3 percent and 15 percent in selected recipient countries. - During 2008–2009, net capital flows dropped by more than 10 per cent of GDP in Hungary, Romania and Croatia; net capital inflows remained roughly stable in Czech Republic. - Deterioration in Austrian-bank loan quality fed back into Austria: two medium-sized Austrian banks—Kommunalkredit and Hypo Group Alpe Adria—were nationalized in 2008–2009. - Austrian government approved €100 billion rescue package (36 percent of GDP) composed of capital support measures and guarantees. - Lehman bankruptcy accelerated downturn in Baltic countries; cumulated output decline in 2008–2009 ranged from 14 percent in Lithuania to almost 25 percent in Latvia. ### The “Vienna initiative” and collective-action problems - “Vienna initiative”: national regulators, international financial institutions, largest international private banks coordinated to prevent sudden stops to Eastern European countries. - Foreign banks agreed not to reduce exposures to Romania, Serbia, Bosnia Herzegovina, Hungary, Latvia and pledged to maintain adequate capitalization in foreign subsidiaries. - IMF provided emergency loans to governments agreeing to policies to avert crises. - National central banks committed to perform IMF-standard stress tests and continuous information exchange. - Austrian authorities used moral suasion to stop Swiss franc loans by Austrian banks in Eastern Europe and called for higher capital requirements for Austrian groups with large exposures. - Collective-action challenge: international banks had incentives to withdraw lending while recipient authorities had incentives to prevent repatriations; small number of players and long-term investment views reduced coordination problems. ### Policy implications — source and recipient countries; cross-border coordination - Source-country recommendations: - Risk monitoring and analysis should include special regional focus on exposures to main recipient regions. - After domestic measures, source-country authorities could assist consumer financial education campaigns in recipient countries. - Strengthen joint supervision and risk assessment, allow source regulators to take part in on-site inspections in recipient countries. - Allow supervisory authority in source country to object to creation of financial groups combining banks and nonbanks. - Recipient-country recommendations: - Supervisory authority should monitor liquidity position of foreign parent banks. - Address real estate sector risks; foreign funds often directed to real estate causing boom-bust cycles. - Be aware regulations can be circumvented, e.g., corporate entities borrowing directly from parent banks abroad after domestic credit ceilings tightened. - Cross-border coordination: - Minimize regulatory arbitrage and conflicting national regulator interests. - New European bodies created: European Systemic Risk Board (ESRB); European Securities and Markets Authority; European Banking Authority; European Insurance and Occupational Pensions Authority. - Colleges of supervisors being set up for more effective cross-border supervision. ### Sweden and the Baltic countries — boom, bust, and bank exposure - Baltic foreign currency loans around 2008: Estonia and Latvia ~80 percent of GDP; Lithuania ~40 percent of GDP in 2008 — 2–4 times 2003 levels. - Foreign capital inflows into Baltic countries (Total Capital Inflows, percent of GDP): 2004 11.4; 2005 12.2; 2006 21.2; 2007 18.7; 2008 10.4; 2009 -7.8. - Two Swedish parent banks (Swedbank and SEB) funded large part of credit expansion; Swedish banks relied substantially on external wholesale financing: 40 percent of total funding at end-March 2008. - Swedish policy responses: - Riksbank provided ample liquidity to Swedish banks at longer maturities and against broader collateral; provided foreign currency liquidity support to Estonia and Latvia via swap arrangements in February 2009. - Latvia secured external funding through IMF-supported programs. - Supervisory cooperation: 2010 Nordic-Baltic MOU facilitated information sharing, joint risk assessments, on-site examinations. - Pre-crisis shortcomings: Baltic authorities underestimated risks; Swedish supervisor lacked resources and knowledge of Baltic asset quality; in-depth studies carried out only in second half of 2007. - Fund recommendations for Swedish authorities: monitor credit concentration to a small group of foreign countries; monitor Swedish banks’ business models; restrict foreign currency lending to unhedged borrowers if necessary; increase supervisory capacity and resources. - Regulatory update: In March 2011, Swedish supervisor announced higher capital requirements including conservation capital buffer and countercyclical capital buffer for Swedish banks and urged faster implementation than Basel Committee proposals. ### Capital flows bypassing regulated financial institutions — channels and systemic risks - Channels of circumvention: - Host-country borrowers switch borrowing from local affiliate to home-country parent bank (example: Bulgaria 2005–06 bank-by-bank credit ceilings; Croatia corporate entities borrowing directly from parent banks abroad). - Lending shifts from foreign banks to less regulated local nonbanks (example: leasing institutions in Serbia). - Nonbank lenders less influenced by domestic monetary policy measures. - Systemic risks: - Unregulated providers of capital flows do not internalize systemic risks. - Borrower risks: excessive external liability structures exposing borrowers to exchange rate and foreign exchange liquidity risk. - Lender risks: indirect exchange rate risk, foreign exchange liquidity risk, credit concentration risk. ### Policy implications and recommended measures for bypassing flows - Widen regulatory perimeter: all systemically important financial markets and institutions (banks and nonbanks) should be properly regulated. - Micro- and macro-prudential measures designed to address systemic risks: - Examples of effective restrictions: Belarus, Moldova, Turkey restricted household foreign currency borrowing through long-standing prudential regulations. - Currency-specific limits on loan-to-value ratios and payment-to-income ratios could slow credit growth and prevent large currency mismatches. - Strengthen home–host supervisor cooperation: effective communication, information sharing, joint analysis, and coordinated responses. - Residency-based CFMs more likely an option when prudential measures have no traction; use only when appropriate macroeconomic conditions are in place; non-prudential CFMs that do not discriminate by residency may be preferable. ### Empirical findings on surge episodes and sudden reversals - About one-quarter of surge episodes were followed by sudden reversals. - One-third of surge episodes that ended in abrupt reversals were in Latin America; Asia has ~50 percent of regional surge episodes ending in sudden outflows. - Crashes defined using a three-year window with a negative net flow larger than 1 percent of GDP occurring in first, second, or third year after surge episode. - Qualitative determinants of sudden reversals: - Global policy shifts: sharp increase in real U.S. interest rates raises probability of abrupt reversal. - Domestic macro fundamentals: deterioration in current account balance (to GDP) and rapid expansion of domestic credit (to GDP) over the surge episode increase likelihood of crash. - Mitigating factors: greater real currency appreciation during episode and higher FDI to GDP ratio associated with lower likelihood of hard landing. - Selected quantitative estimates (specification examples, robust s.e. in parentheses): - Real US interest rate: 0.111* (0.063) in column (1). - Current account balance/GDP: -0.082*** (0.027) in column (1). - Total domestic credit/GDP: 0.031*** (0.012) in column (1). - FDI/GDP: -0.116*** (0.043) in one specification. - Sample/fit: Observations: 100; reported pseudo R2 across specifications include 0.127, 0.133, 0.203, 0.166, 0.184, 0.194, 0.341. - Significance: ***, **, * indicate significance at 1, 5 and 10 percent levels respectively. ### International regulatory and supervisory architecture; current reforms and timelines - Institutional roles: - G-20: forum of 19 countries and EU. - FSB: high-level officials from central banks, regulators, treasuries from 24 jurisdictions, ECB and EU, six international standard-setting bodies, four international financial institutions (including IMF); coordinates international work; membership does not impose legal obligations. - BIS: membership of 58 central banks; hosts central bank meetings; permanent staff 589. - IMF: legal oversight over members' exchange rate, reserve and related policies; bilateral surveillance and FSAP assessments. - World Bank: assesses certain financial standards and helps conduct FSAPs. - Standard setters: BCBS (27 member countries), IOSCO, IAIS (~190 jurisdictions), other bodies (CPSS, IASB, IADI, IOPS, IAASB); FSB coordinates work of standard setters. - Information-sharing fora: CGFS (BIS), Senior Supervisors Group (SSG), supervisory colleges. - Basel III and related timeline: - Tighter trading book assets and contingent liabilities requirements introduced July 2009. - Basel III approved July 2010; calibration approved September 2010. - Implementation planned to start January 1, 2013, completion by January 1, 2019. - Liquidity Coverage Ratio (LCR): implementation in January 2015 after observation period beginning 2011 extended until mid-2013; BCBS to issue final technical details in June 2012. - Net Stable Funding Ratio (NSFR): minimum standard by January 2018 after observation period starting 2012. - G-SIBs additional loss absorbency: - Surcharge (CET1) ranging from 1 percent to 2.5 percent depending on systemic importance; surcharges could reach up to 3.5 percent. - Implementation begins January 2016, fully effective January 1, 2019. - Methodology for identifying G-SIBs subject to changes and additional testing by March 2012. - OTC derivatives market infrastructure: - G-20 agreement (Pittsburgh, September 2009): standardized OTC derivatives to be traded on exchanges/electronic platforms and cleared through CCPs by end of 2012; contracts reported to trade repositories. - FSB, IOSCO, CPSS working groups formed; BCBS (September 2011) concluded most agreement would be met by end-2012 but urged national jurisdictions to accelerate progress. - Regulatory perimeter and shadow banking: - FSB approved initial recommendations (July 2011 plenary in Paris) from Shadow Banking Task Force. - Five areas for further work: regulation of banks' interactions with shadow banking entities; regulatory reform of MMMFs; regulation of other shadow banking entities; regulation of securitization; regulation of activities related to securities lending and repos. - FSB set up dedicated workstreams with progress reports to be submitted by July (as stated in source). ### Supervisory intensiveness, colleges, adherence to standards, and coordination literature - FSB recommendations (November 2010) for enhanced supervision address supervisory mandates, independence, resources, supervisory powers, techniques, consolidated supervision, supervisory colleges, and macroprudential surveillance; implementation ongoing. - Effectiveness of supervisory colleges: - Core colleges with small number of key jurisdictions perform well. - Broader colleges with more jurisdictions work less effectively. - BCBS suggestion (September 2010): allow host jurisdictions to participate in supervisory colleges of G-SIBs whose affiliates are systemically important in the host country. - Adherence to standards: - BCBS and FSB monitoring via FSAPs, peer reviews, thematic reviews; BCBS to publish members’ adoption status and review consistency of members’ legislation/regulations with international minimum standards. - IMF, BCBS, FSB coordinate assessments to avoid duplication. - Literature on international coordination: mixed outcomes; coordination reduces regulatory arbitrage but can reduce national flexibility; models (Dell’Ariccia and Marquez 2005; Morrison and White 2009) show results hinge on assumptions and financial integration. ### Empirical analysis of multilateral effects of Capital Flow Management measures (CFMs) - Objective: test impact of CFM announcements in one country on equity returns and equity fund flows of other countries in same region using event studies. - Data and specification: - Daily data January 2003 to September 2011 for five Latin American countries (Brazil, Chile, Colombia, Mexico, Peru) and five Asian countries (Indonesia, Korea, Malaysia, Philippines, Thailand). - Main dependent variable: changes in equity prices in USD terms. - One-day response window used; robustness checks with 2, 5, 10 day windows similar. - Only CFM events with domestic market move ≥ one standard deviation selected. - Selected CFM events (examples): - Brazil: IOF taxes on various dates (19-Oct-09 effective 20-Oct-09; 4-Oct-10 effective 5-Oct-10; 18-Oct-10 effective 19-Oct-10), reserve requirements and other measures (6-Jan-11; 28-Mar-11; 6-Apr-11; 27-Jul-11). - Colombia: 6-May-07 (7-May-07) imposed 40 percent URR on foreign borrowing; 23-May-07 (24-May-07) extended URR to nonresidents' portfolio investments. - Korea and Thailand: multiple measures across 2009–2011 as listed in source. - Results — equity returns (selected examples): - Brazil's measures: neighboring-equity-returns relationship coefficients: Chile 0.282***; Colombia 0.196***; Mexico 0.432***; Peru 0.231***. - Impact of Brazil’s CFM events on neighbors (examples): Mexico -0.507*** (0.1490); Peru 0.146* (0.0804). - Colombia's May 2007 URR impacts: Chile -0.176*** (0.0561); Brazil 0.479*** (0.0713); Mexico 0.219*** (0.0487); Peru 0.179** (0.0852). - Sample statistics examples: Brazil 2009-11 measures Observations 7,468; R-squared 0.453. Colombia May 2007 URR Observations 7,430; R-squared 0.504. - Results — Asian examples (selected): - Thailand's measures: equity-returns relationship coefficients: Indonesia 0.348***; Malaysia 0.167***; Philippines 0.224***; Thailand 0.276***. - Korea's 2010 measures: Indonesia 0.453***; Korea 0.454***; Malaysia 0.221***; Philippines 0.223***. - Impact examples: Korea's 2010 measures: Indonesia -0.253***; Korea -0.400***; Malaysia -0.0703***; Philippines -0.162***. - Results — flows to Brazil equity funds (selected): - Flows-to-Brazil coefficients as regressors: Chile 0.0283 (0.0023); Colombia 0.101** (0.0009); Mexico 0.0156 (0.0299); Peru 0.00472 (0.0041). - Interaction (Flows to Brazil * Brazil's CFM events): Chile 0.0542** (0.0396); Colombia -0.0191 (0.0069); Mexico -0.0372* (0.1840); Peru -0.106*** (0.0368). - Sample statistics examples: Observations: Chile 878; Colombia 603; Mexico 883; Peru 528. R-squared: Chile 0.077; Colombia 0.155; Mexico 0.102; Peru 0.142. - Interpretation: daily flows to Brazil equity funds largely driven by persistence; correlations between flows to Brazil and neighbors mostly not significant; Chile and Peru exhibit significant responses on Brazil’s CFM dates, often differing from equity return estimates. - Variable definitions and data sources listed (equity returns in USD, VIX, oil/non-oil commodity prices, US yield, CDS, policy rates, LIBOR, EPFR flows). ### Trade policy literature summary (multilateral implications of capital flow policies) - Theoretical foundation: free trade optimal under comparative advantage (Ricardo); free trade allows countries to specialize and be better off. - Interventionist trade policies prevalent; justifications often rest on market imperfections (e.g., strategic trade policy, infant-industry arguments). - Political economy: Stolper-Samuelson implies trade creates asymmetric income effects; lobbying can produce interventionist policies. - Skepticism about active strategic trade policy: effectiveness sensitive to market structure details and high informational requirements (Krugman quote referenced). - Negative spillovers: active trade policies can unilaterally increase domestic welfare at expense of trading partners; risk of policy wars and prisoner’s dilemma outcomes (historical 1930s example and Smoot-Hawley Act cited). - Role of international agreements/institutions: WTO and trade agreements help avoid trade policy wars by enabling punishment strategies and verification; international organizations assess deviations and coordinate responses. *Source: _102111 (IMF staff chapter/section excerpt).* ### 1. The case studies document the regulatory and supervisory dimension of episodes ### 1. The case studies document the regulatory and supervisory dimension of episodes ### Overview - The case studies document the regulatory and supervisory dimension of episodes during the recent crisis involving capital flows that generated systemic stress, with primary focus on source country regulation and supervision; recipient country policies are covered where important. - Three case studies focus on systemic stress from flows between advanced economies driven by strong demand by foreign investors for U.S. financial products that induced the U.S. financial sector to develop products transforming risky assets into highly-rated securities. - Three additional case studies cover flows from advanced economy source countries to EMEs, including expansion by banks from smaller advanced economies (Sweden and the Baltic countries; Austria and selected central and eastern European countries) and capital flows designed to circumvent bank regulations. - Case studies and policy recommendations are based almost entirely on official Fund documents and are not comprehensive episode accounts. ### A. European Banks and United States Money Market Mutual Funds (MMMFs) — Findings and linkages - U.S. MMMFs were a key provider of short-term funding to global financial firms; prime funds invested in ABCP, CDs, repo, commercial paper (CP), short-term corporate notes, and other money funds and accounted for about 45 percent share of the market in late 2008. - Government and tax-free money funds invested mainly in treasuries, agency debt, and municipal bonds. - The Securities and Exchange Commission (SEC) regulated credit quality, issuer concentration and maturity of assets that U.S. MMMFs can hold under Rule 2a-7, including that MMMFs are not permitted to hold more than 5 percent of investments in second tier paper, or to hold more than a 5 percent exposure to any single issuer (other than the government and agencies). - European MMMFs were equivalent to only about 8 percent of bank deposits, reflecting bank-dominated European financial systems and different deposit interest practices. - Before the crisis, about half of prime U.S. MMMF exposure was to Europe, and around one third to the euro area (Table 1). - Much pre-crisis U.S. MMMF funding financed structured investment vehicles (SIVs) set up by European banks to purchase asset-back securities (ABS), mainly mortgage-backed securities (MBS), creating maturity transformation that was largely unregulated and exposed European banks to foreign exchange liquidity risk. - In mid-September 2008, expected losses on Lehman holdings led to a run on U.S. MMMFs beginning with the Reserve Primary Fund which “broke the buck”; redemptions totaled more than $40 billion (approximately 67 percent of the Reserve Primary Fund‘s net assets) in the following days. - MMMFs retreated from purchasing and rolling over commercial paper, ABCP, repos, and CDs issued by financial firms and significantly shortened tenors of lending agreements, squeezing SIVs of European bank counterparties. - Total MMMF assets declined from a peak of $3.9 trillion in 2009 to about $2.7 trillion in the first half of 2011. - The run on MMMFs threatened runs on the U.S. CP market and then on the CD market and thereby on non-U.S., mainly European, banks, destabilizing global bank funding markets. ### A. Policy implications and actions for MMMFs - Official actions to stabilize MMMFs included a temporary guarantee program and creation of Fed liquidity facilities, including the Money Market Investor Funding Facility (MMIFF) under which the New York Fed provided senior secured funding to a series of SIVs to facilitate an industry-supported private-sector initiative. - Proposed and implemented policy changes to enhance resiliency and protect investors: - Require MMMFs to maintain a portion of portfolios in instruments readily convertible into cash, reduce exposure to long-term debt, and limit investments to the highest quality securities. - Permit funds that have “broke the buck” to suspend redemptions to allow for orderly liquidation of fund assets. - SEC regulations have been changed to tighten the 2a-7 liquidity requirements and credit and interest rate exposure. - The President‘s Working Group (2010) proposed options for industry comment including: - convert to a floating NAV structure; - establish private emergency liquidity facilities; - require in-kind redemptions; - require insurance; - provide differential treatment for stable- and floating-NAV funds; - regulate MMMFs as special purpose banks; - impose constraints on unregulated MMMF substitutes. - The Fund recommended that money market funds be required to make real-time disclosures of their actual (as opposed to “stabilized”) net values. ### B. The American International Group (AIG) — Findings and exposures - AIG in 2007 was the largest and most diversified insurance company in the world; bulk of revenues came from domestic and foreign life insurance, diversified property/casualty insurance, and other financial services including aircraft leasing and consumer finance. - AIG group lacked a single regulator; more than 70 U.S. insurance subsidiaries were regulated by state insurance supervisors, and over 175 non-insurance or foreign entities were overseen by various national supervisors. AIG Financial Products (AIGFP) operated as a London branch of a French incorporated subsidiary and was not effectively regulated. - AIGFP sold mortgage default protection via credit default swaps (CDSs) on largely subprime mortgage collateralized debt obligations (CDOs) to G-SIFIs; these CDSs were guaranteed by AIG, exposing it to mortgage risk. - Main G-SIFI counterparties included Société Générale, Deutsche Bank, Goldman Sachs, Merrill Lynch, Calyon, Barclays, and UBS. - As the crisis unfolded, ratings downgrades of AIG triggered collateral posting obligations by AIGFP that it could not meet; funding markets refused to roll over AIG‘s debts. - AIG suffered $121 billion of losses on holdings of derivatives and securities; $85 billion were covered by earnings, leaving a capital loss of about $36 billion. - AIG received about $198 billion in loans and equity from the Federal Reserve; about $92 billion of the support funds went to major institutions, including $11 billion to Société Générale; $8.5 billion to Barclays; $11.8 to Deutsche Bank; and $7.3 billion to Goldman Sachs. Most of the bailout monies have been repaid. - AIGFP accounted for a large share of the group’s losses; potential contagion channels included losses to counterparties of derivatives or securities lending transactions and forced liquidation of securities lending collateral depressing credit market prices; potential losses for policy holders and pension beneficiaries were large. ### B. Shortfalls in supervision and regulation identified - Group supervision: Parent holding company was a thrift holding company under Office of Thrift Supervision (OTS) general supervision since 2005 but OTS deferred to functional regulators for regulated subsidiaries and lacked authority to resolve a failure. - Insurance supervision: State-based system lacked systemic focus and capacity for group-wide oversight; federal regulators had limited responsibility over insurance companies except those affiliated with commercial banks or thrifts; multiplicity of state regulations imposed inefficiencies. - Regulatory perimeter: Securities regulation lagged behind innovation; securitization, growth in certain OTC derivative markets, and “shadow banking” contributed to the crisis; significant gaps existed in regulation of OTC derivative products and markets and in prudential regulation and market conduct rules; lack of collateral requirements for certain bilaterally-settled OTC derivatives contributed to undetected leverage build-up. - Cross-border regulation and coordination: Foreign regulators had narrowly defined jurisdiction and deferred to home country regulators; absence of a consolidated regulator with good information about mortgage risk was key; EU supplementary consolidated supervision implemented in 2005 could have helped but third country exemptions and equivalence to the OTS limited its application. - Macroprudential perspective: A single financial authority with a systemic view would likely have better understood systemic implications of AIG’s business model. ### B. Policy implications and reforms following AIG - The Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 aims to strengthen OTC derivative market regulation and system resiliency. Key provisions relevant for the AIG case include: - Registration requirements for OTC derivative dealers and “major swap participants”; - Central clearing of standardized derivatives contracts and powers for the CFTC and SEC to determine which instruments should be subject to clearing and trading on an exchange or swap execution facility; - Reporting requirements for all derivative transactions and the trading positions of major market participants; - Enhanced prudential requirements for risk exposures arising from OTC derivative trading for transactions that are not centrally cleared and collateral requirements for OTC derivatives; - Authority for regulators to safeguard market stability; - Capital and collateral requirements; - Market conduct provisions for OTC derivatives markets. *Source: _102111 - 1. The case studies document the regulatory and supervisory dimension of episodes* ### 20. Insurance regulatory reforms that would help address the issues raised by AIG ### 20. Insurance regulatory reforms that would help address the issues raised by AIG ### Insurance regulatory reforms (summary) - Developing the approach to supervision of groups through consolidated financial condition reporting and analysis of the group as a whole (including unregulated affiliates) and further development of colleges of supervisors. - Improving the regulation of bond insurance and securities lending, including the reserving and capital treatment of market risks associated with guarantees (as in variable annuities) and the treatment of liquidity risks. - Modernizing solvency requirements, including through more forward-looking approaches to solvency regulation (e.g., utilizing stress and scenario testing and other forms of dynamic financial analysis). *Ibid.* ### German banks and United States mortgage-backed securities — key links and findings - Prior to the crisis, several German banks expanded rapidly into less familiar financial markets in a "search for yield," using conduits or SIVs to invest in U.S. ABSs and other structured investment products backed by residential mortgages. - Over one-fifth of U.S. ABSs were estimated to have been held abroad in the lead up to the crisis, with German banks (alongside banks in the United Kingdom, Switzerland, France, the Netherlands, and Belgium) having significant exposure. - The U.S. private-label securitization market grew from almost nothing in the early 1990s to peak at almost $5 trillion in 2006. - In 2003, the GSEs were the source of 76 percent of the mortgage-backed and asset-backed issuances; by mid-2006 private label issues had risen to a 57 percent share. - Private label issues grew largely through origination and securitization of high-risk subprime mortgages and "Alt-A" mortgages, supported by credit rating agencies giving AAA or Aaa to senior tranches. - Arbitraging of Basel I regulatory capital requirements contributed, since securitized products held in off-balance-sheet entities had zero capital adequacy risk weights. - Regulatory differences drove large purchases of U.S. MBSs by German banks: - U.S. banks faced a simple leverage ratio (as well as a risk-weighted one) and often increased leverage by placing assets in securitized pools and selling them. - European banks (and U.S. investment banks) held large amounts of U.S. ABSs in trading books where risk weights were low. - German and other European banks had incentives to sponsor SIVs since they did not face any capital charge on contingent exposures to such vehicles. - MBSs served as collateral for dollar wholesale funding in repo markets; SIVs invested in longer-dated securities financed by short-dated commercial paper and collateralized repos, making them unregulated maturity transformers. ### Impact on German banks and public interventions - Germany felt the force of the first shocks from the subprime mortgage markets in July 2007; increasing default rates raised doubts about asset quality and German bank SIVs faced funding difficulties, triggering contractual obligations by banks to provide financing to their SIVs. - Several banks—some of systemic importance—suffered large losses and funding problems; those perceived to have lower capitalization or lower quality capital were most at risk. - Selected exposure of German banks to conduit/SIV-financed assets (as presented): - Sachsen-Finanzgruppe — Ownership: Public — Over equity: 1,126 — Over assets: 30.3 - West LB — Ownership: Public — Over equity: 542 — Over assets: 12.7 - IKB (until July 29, 2007, i.e., before bailout) — Ownership: Private — Over equity: 494 — Over assets: 20.5 - Dresdner Bank (mitigated by integration into Allianz group) — Ownership: Private — Over equity: 364 — Over assets: 9.9 - Landesbank Berlin (mitigated by integration into S-Verbund Bayern) — Ownership: Public — Over equity: 179 — Over assets: 2.2 - BayernLB (mitigated by integration into S-Verbund Bayern) — Ownership: Public — Over equity: 170 — Over assets: 5.1 - HSH Nordbank — Ownership: Public — Over equity: 126 — Over assets: 4.0 - Deutsche Bank — Ownership: Private — Over equity: 114 — Over assets: 3.3 - HVB (mitigated by integration into UCI group) — Ownership: Private — Over equity: 105 — Over assets: 6.6 - NORD LB — Ownership: Public — Over equity: 89 — Over assets: 2.9 - Commerzbank — Ownership: Private — Over equity: 85 — Over assets: 2.2 - Helaba (mitigated by integration into Cooperative Network) — Ownership: Public — Over equity: 68 — Over assets: 1.1 - DZ-BANK (mitigated by integration into Cooperative Network) — Ownership: Private — Over equity: 61 — Over assets: 1.3 - LBBW — Ownership: Public — Over equity: 59 — Over assets: 1.7 - KfW (mitigated by unlimited sovereign guarantee) — Ownership: Public — Over equity: 58 — Over assets: 2.6 - Several banks—including certain Landesbanken and a major issuer of covered bonds—had to be intervened at significant cost to the German taxpayer: - IKB and Sachsen Landesbank required rescues in summer 2007 after failing to meet liquidity commitments to SIVs. - West LB required a rescue package in early 2008. - Many other private and public banks reported larger than expected write-downs, including Bayern LB and Deutsche Bank. - Following Lehman Brothers’ failure in fall 2008, Hypo Real Estate required substantial financial support and was subsequently nationalized in 2009. - Hypo Real Estate received liquidity support with a package worth €35 billion from the Federal government, banks, and financial sector firms; the package was subsequently increased to €50 billion. - The ad hoc measures demonstrated limitations of the then-existing crisis framework. - A new financial stability framework was introduced in October 2008: - The Special Fund for Financial Market Stabilization (SoFFin) was set up to be administered by the Federal Agency for Financial Market Stabilization (FMSA). - Financial stability support measures comprised guarantees, recapitalizations, asset purchases, and subsequently, the establishment of winding-up institutions. - The authorities also strengthened the mandate of the Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin). ### Policy implications — U.S. mortgage crisis and recommended reforms - The U.S. mortgage crisis reflected many important weaknesses: an unsustainable lending boom fueled by low interest rates and capital inflows; a housing bubble; rapid rise of a "shadow banking system"; decline in underwriting standards; weaknesses in risk management, governance, and compensation structures; and growing use of complex derivative and structured credit instruments whose risk properties and systemic contribution were poorly understood. - Vulnerabilities built due to insufficient market discipline and critical shortcomings and gaps in supervisory and regulatory frameworks at micro- and macro-prudential levels. - Staff recommended reforms in the following areas: - Address supervisory gaps and the shadow banking sector to address regulatory arbitrage that spurred rapid growth of leverage and maturity transformation outside the banking sector. - Measures recommended to level the playing field, improve risk management in repo and other funding markets, and ensure that all systemic institutions and markets are inside the regulatory perimeter. - Increase transparency in areas such as off-balance sheet vehicles and rating agencies. - Authorities should continue efforts to improve CRA procedures, including transparency, governance, and mitigation of conflicts of interest associated with the "issuer pays" model. ### Policy implications — Germany-specific regulatory lessons and reforms - Crisis revealed gaps in regulation and supervision; key recommendations included: - Reduce reliance on external auditors and step up efforts to attract and retain skilled supervisors. - Require more frequent financial statements and encourage more widespread use of IFRS reporting to better capture off-balance-sheet activity. - Establish a bank resolution framework with better incentives for prudent operations: - The insolvency framework should recognize the role of banks in the payment system and macro economy, and incorporate greater flexibility to allow for quick resolutions and dilution of equity claims of shareholders. - A new bank restructuring law, in force since 2011, significantly strengthens the crisis management framework: it grants broad powers and effective instruments to facilitate more timely and efficient resolution of systemically relevant problem banks, including the ability to transfer the banking business to another institution (including a bridge bank) with emphasis on protecting deposits and other systemically significant business parts. - The European Commission is due to publish legislative proposals for a harmonized set of resolution tools across the EU, likely including debt write-down or debt conversion tools. ### Austrian banks in selected Central Eastern and Southeastern European (CESE) countries — key findings - Prior to the global financial crisis, capital inflows from Austrian banks helped drive rapid credit expansion in the CESE region, contributing to indirect foreign exchange and mortgage market risks that proved important vulnerabilities for the Austrian banking sector and source-country macroeconomic instability. - At end-2007, 19 percent of the banking flows to the CESE region originated from Austrian banking groups. - Total claims of Austrian banks to CESE countries amounted to 70 percent of Austrian GDP; corresponding figures for Germany and Italy were 5 percent and 18 percent, respectively. - The six major Austrian banking groups active in CESE were UniCredit Bank Austria, Erste Bank, Raiffeisen Zentralbank Österreich, Volksbank, Bank für Arbeit und Wirtschaft und Österreichische Postsparkasse, and Hypo Group Alpe Adria. - Almost 50 percent of lending extended by the foreign subsidiaries of these groups was denominated in foreign currency. - Intra-group liquidity transfers played a major role in financing subsidiaries, with substantial variation across CESE countries. - The four main recipients (focus of the note) were the Czech Republic, Romania, Hungary, and Croatia, accounting for 60 percent of Austrian claims on the CESE region. - Financial vulnerabilities in recipient countries stemmed from high credit growth and foreign-currency denominated liabilities: - During 2003–2008, double digit credit growth occurred in all main recipients of Austrian banks’ credit. - Foreign currency lending was small in the Czech Republic but accounted for more than half of total private credit in Romania and Hungary. - In Croatia, foreign currency lending was small but a large part was foreign currency indexed. - Differences in funding patterns and reliance on parent funding mattered: - In the Czech Republic, foreign banks financed local lending by issuing local deposits. - In Romania and Hungary, subsidiaries were largely financed by parents. - Net capital inflows during 2003–2008: Czech Republic cumulative 50 percent of GDP (mostly FDIs) versus Romania 170 percent of GDP. - Both demand and supply-side effects, fostered by European integration, helped explain rapid credit expansion: - Supply-side: foreign banks entered profitable underdeveloped credit markets; presence of foreign banks contributed to availability of foreign currency loans in recipient countries. - Demand-side: large spreads between domestic and foreign borrowing rates, decreasing exchange rate volatility, and prospects of Euro adoption reinforced expectations of stable exchange rates and encouraged foreign-currency borrowing even when borrowers earned in local currency. *Ibid.* ### 38. The outbreak of the global financial crisis and deteriorating growth presented ### 38. The outbreak of the global financial crisis and deteriorating growth presented ### Crisis impact on recipient and source countries - Currencies of Eastern European countries faced strong pressures to depreciate in the first half of 2009, but exchange rates rebounded; overall, between 2007 and the end of 2010, currencies depreciated only between 3 percent and 15 percent in the selected recipient countries. - During 2008–2009, net capital flows dropped by more than 10 per cent of GDP in Hungary, Romania and Croatia. - Net capital inflows remained roughly stable in the Czech Republic. - The deterioration in the quality of Austrian bank loans in CESE countries fed back into Austria: - Two medium-sized Austrian banks—Kommunalkredit and Hypo Group Alpe Adria—were nationalized in 2008–2009. - The Austrian government approved a €100 billion rescue package (36 percent of GDP), composed of both capital support measures and guarantees. - The Lehman Brothers’ bankruptcy accelerated the real and financial sector downturn in the Baltic countries. - Cumulated output decline in 2008–2009 ranged from 14 percent in Lithuania to almost 25 percent in Latvia. ### The “Vienna initiative” and collective-action problems - The “Vienna initiative” was a key policy response involving national regulators, international financial institutions, and the largest international private banks to prevent sudden stops to Eastern European countries. - In bilateral agreements, foreign banks agreed not to reduce their exposures to Romania, Serbia, Bosnia Herzegovina, Hungary, and Latvia, and pledged to maintain adequate capitalization in their foreign subsidiaries. - The IMF provided emergency loans to national governments who agreed to policies to avert the crises. - National central banks committed to perform stress tests according to IMF standards and to a continuous information exchange. - Austrian authorities used moral suasion to stop loans in Swiss francs by Austrian banks in Eastern Europe and called for higher capital requirements for Austrian banking groups with large exposures to Eastern Europe. - Collective-action challenge: - International banks had individual incentives to withdraw foreign lending as the crisis deepened, while recipient-country authorities had incentives to prevent repatriations. - The relatively small number of players and high stakes (including banks viewing Eastern Europe as a long-term investment strategy) reduced the severity of the coordination problem. ### Policy implications — source countries (regulation and supervision) - To better address cross border risk channels, risk monitoring and analysis should include a special regional focus on exposures to the main recipient regions. - After improving the effectiveness of domestic measures, authorities in the source country could assist the development of consumer financial education campaigns in the recipient countries. - Joint supervision and risk assessment by regulators in the source and recipient countries should be strengthened, especially by allowing regulators in the source country to take part in on-site inspections in recipient countries. - The supervisory authority in the source country should be allowed to object to the creation of financial groups combining banks and nonbanks, as these can undermine effective supervision. ### Policy implications — recipient countries (regulation and supervision) - The supervisory authority in the recipient country should be able to monitor the liquidity position of the foreign parent bank, given the ability of foreign parent banks to quickly withdraw liquidity from their foreign subsidiaries. - Risks in the real estate sector should be carefully addressed because foreign funds are often excessively directed to the domestic real estate sector, giving rise to destabilizing boom-bust cycles. - Regulations aimed at curbing bank lending can be circumvented, shifting lending to less regulated markets; example: after credit ceilings for banks were tightened in 2007, corporate entities in Croatia turned to direct borrowing from parent banks abroad. ### Cross-border regulatory coordination and new institutions - Regulatory arbitrage and conflicting interests between different national regulators should be minimized. - New European regulatory bodies were created to coordinate national regulators and supervisors across the EU, including: - European Systemic Risk Board (ESRB) - European Securities and Markets Authority - European Banking Authority - European Insurance and Occupational Pensions Authority - Colleges of supervisors are being set up to ensure more effective supervision of cross-border groups. ### Sweden and the Baltic countries — boom, bust, and bank exposure - Baltic credit boom in the early 2000s was fueled by capital inflows mainly from Sweden. - Foreign currency loans totaled around 80 percent of GDP in Estonia and Latvia and 40 percent of GDP in Lithuania in 2008, which was 2–4 times higher than levels in 2003. - By the mid 2000s, cheap cross-border bank mortgage lending boosted housing prices and large current account deficits. - Table 1.3: Foreign Capital Inflows into Baltic Countries (In percent of GDP) - FDI: 2004 3.9; 2005 7.3; 2006 5.6; 2007 5.0; 2008 3.3; 2009 0.6 - Portfolio Investments: 2004 2.8; 2005 -5.9; 2006 -2.9; 2007 -1.8; 2008 1.3; 2009 -2.1 - Other Investments: 2004 4.6; 2005 10.7; 2006 18.4; 2007 15.5; 2008 5.8; 2009 -6.3 - Total Capital Inflows: 2004 11.4; 2005 12.2; 2006 21.2; 2007 18.7; 2008 10.4; 2009 -7.8 - Two Swedish parent banks, Swedbank and SEB, funded a large part of the credit expansion through subsidiaries supervised by Baltic authorities and dominated Baltic bank lending. - Swedish banks began to slow credit growth in the summer of 2007 and to decrease lending from September 2008. - Vulnerabilities and exposures: - 30 percent to 40 percent of total credits in the Baltic region were channeled to mortgage lending. - Swedish banks relied substantially on external wholesale financing: 40 percent of total funding at end-March 2008. - To contain the crisis, Swedish authorities acted: - The Riksbank provided ample liquidity to Swedish banks at longer maturities and against broader types of collateral, and provided foreign currency liquidity support to Estonia and Latvia via swap arrangements in February 2009. - Latvia secured external funding through IMF-supported programs. - Supervisory cooperation: - The 2010 Nordic-Baltic memorandum of understanding (MOU) facilitated information sharing, joint risk assessments, on-site examinations, and helped avoid cross-border regulatory arbitrage. - Swedish parent banks maintained presence in the Baltics despite loan losses; Parex bank in Latvia was taken over by the government, while Hansabanka and SEB avoided such problems due to parent bank commitments under the “Vienna Initiative.” - Pre-crisis shortcomings: - Baltic authorities did not fully appreciate impending risks and did not take early and adequately strong policy actions. - The Swedish supervisor lacked resources and sufficient knowledge of asset quality in banks’ operations in the Baltic countries and carried out in-depth studies only in the second half of 2007. - Fund recommendations for Swedish regulatory and supervisory perspective: - Swedish authorities should have monitored credit concentration to a small group of foreign countries. - Swedish supervisors needed to monitor Swedish banks’ business model and restrict, if necessary, foreign currency lending to unhedged borrowers. - National financial authorities should have had sufficient overall capacity and more resources to ensure effective supervision of Swedish parent banks. - Further cooperation and macroprudential policy: - Greater focus on systemic financial stability is needed in Sweden given diffusion of responsibilities and instruments. - The 2010 Nordic-Baltic MOU needs further development: crisis management and burden-sharing arrangements, a more structured assessment framework, templates, and a confidential data warehouse. - Regulatory update note: - In March 2011, the Swedish supervisor announced higher capital requirements, including the conservation capital buffer and the countercyclical capital buffer, for the Swedish banks according to the proposals by the Basel Committee on Banking Supervision; the Swedish supervisor said that the major Swedish banks should prepare for a faster implementation of the regulations in Sweden than what was proposed by the Basel Committee. ### Capital flows bypassing regulated financial institutions (section summary) - Cross-border capital flows that bypass the host country regulatory perimeter create challenges for host countries aiming to limit domestic credit growth. - Key policy implications include: improving macroprudential and microprudential policy coordination, and enhancing cooperation between home and host supervisors. - Residency-based CFMs can be an option in specific circumstances. *Source: IMF staff chapter text.* ### 59. Foreign-owned banks can evade regulatory measures by having their host ### 59. Foreign-owned banks can evade regulatory measures by having their host country borrowers switch their borrowing from the local affiliate to the home country parent bank ### Channels of circumvention and examples - Host-country borrowers can switch borrowing from the local affiliate to the home-country parent bank, bypassing host-country regulatory measures. - Example: Bulgaria introduced bank-by-bank credit ceilings in 2005–06, which seemingly reined in credit growth but also accelerated direct cross-border borrowing by firms from foreign bank parents. - Example: In Croatia, corporate entities turned to direct borrowing from parent banks abroad, instead of channeling loans through the domestic banking system. - Host-country regulations restricting credit growth can be circumvented by switching lending from foreign banks to less regulated local nonbanks. - Example: Leasing institutions owned by foreign banks and outside of the regulatory perimeter were used to provide financing in Serbia. - Nonbank lenders are less likely to be influenced by domestic monetary policy measures, such as domestic interest rates. ### Systemic risks from bypassing regulated institutions - Flows that bypass regulated financial institutions can generate systemically important cross-border risks. - Unregulated—by the host country—providers of capital flows that finance credit do not have the incentive to internalize the systemic risks of their lending. - Borrower risks: - Nonfinancial entities (firms or households) could take on an excessively risky external liability structure that exposes the borrower to exchange rate risk and foreign exchange liquidity risk. - Lender risks: - The lender is exposed to indirect exchange rate risk, foreign exchange liquidity risk, and credit concentration risk. ### Policy implications and recommended measures - The regulatory perimeter should be widened. - All financial markets and institutions, including banks and nonbanks, that are systemically important in a host country should be properly regulated in order to close loopholes used to circumvent host country regulation and supervision. - Micro- and macro-prudential measures can be designed to address systemic risks. - Some countries were partially able to discourage foreign currency lending in the run-up to the crisis. For example, Belarus, Moldova, and Turkey effectively restricted household borrowing in foreign currencies through long-standing prudential regulations. - A more widespread effective discouragement of foreign currency loans, such as currency-specific limits on loan-to-value ratios and payment-to-income ratios (earning), could slow credit growth and prevent the buildup of large currency mismatches in the private sector. - Better cooperation between home and host supervisors would likely make prudential measures to control credit growth more successful. - Such cooperation should include adequate mechanisms for effective communication, information sharing, and joint analysis of common concern, and the formulation of effective responses. - Residency-based CFMs are more likely to be an option when prudential measures have no traction. - These should be utilized only when appropriate macroeconomic conditions are already in place. - Non-prudential CFMs that do not discriminate on a residency basis, if available, may be preferable. ### Related empirical and contextual findings (summary from adjacent policy notes) - Cross-border capital flows have trended upward over the past two decades and become more volatile and riskier; surges of capital occur sequentially and are persistent, and both surges and sudden stops are becoming increasingly synchronized. - Advanced economies: gross flows account for the bulk of external assets and gross capital flows; other investment flows (mainly banking-related, mostly driven by European banks) and portfolio flows have been the most volatile in recent years. - Emerging market economies (EMEs): capital flows are larger on a net basis and more directly affect macroeconomic stability through the funding channel. - Example statistic: foreign currency denominated loans accounted for nearly 80 percent of total loans in the Baltic countries on the eve of the crisis, and constituted the majority of loans in Hungary, Bulgaria, and Romania. - Structural shifts in EMEs over the last decade: - Gross external debt liabilities of the median EME declined from 55.5 percent of GDP in 2000 to 42 percent in 2009. - FDI liabilities rose from about 20 percent to over 40 percent of GDP during the same period. - Empirical analysis of surge determinants: - Occurrence of a surge: global push factors matter strongly (e.g., lower real U.S. interest rates and higher world real GDP growth rate raise the probability of a capital inflow surge; greater uncertainty in international markets reduces the likelihood). - Magnitude of a surge: domestic pull factors are more important (e.g., current account imbalance, trade and financial openness, exchange rate regime, and stock of foreign exchange reserves to imports). *International Monetary Fund (excerpt)._ ### 74. About one-quarter of the surge episodes were followed by sudden reversals ### 74. About one-quarter of the surge episodes were followed by sudden reversals ### Incidence and regional patterns - About one-quarter of the surge episodes were followed by sudden reversals. - One-third of the surge episodes that ended in abrupt reversals were in Latin America—reflecting the crises of the 1980s and 1990s—followed by Europe. - Asia has the highest percentage of crash endings, with about 50 percent of the regional surge episodes ending in sudden outflows, followed by Europe and Latin America. - To identify post-surge abrupt reversals the study uses a three-year window with a negative net flow larger than 1 percent of GDP occurring in the first, second, or third year after the end of the surge episode. ### Determinants of sudden reversals (qualitative findings) - Global policy shifts: A sharp increase in the real U. S. interest rates marks a higher probability of an abrupt reversal, indicating that foreign investors respond quickly to yield differences. - Domestic macro fundamentals: - A deterioration in the current account balance (to GDP) over the surge episode increases the likelihood of exiting into a crash. - A rapid expansion of domestic credit (to GDP) over the surge episode increases the likelihood of exiting into a crash. - Mitigating factors: - Greater real currency appreciation during the episode is associated with a lower likelihood of a hard landing. - A higher FDI to GDP ratio during the episode is associated with a lower likelihood of a hard landing. ### Quantitative estimation highlights (Table 2.4) - Dependent variable: binary indicator equal to one if a surge episode ended in a crash and zero otherwise. - Sample and fit: - Observations: 100 (in all reported specifications). - Pseudo R2 ranges reported across specifications: 0.127, 0.133, 0.203, 0.166, 0.184, 0.194, 0.341. - Selected estimated coefficients (change computed over surge episode unless otherwise noted; robust standard errors in parentheses): - Real US interest rate: 0.111* (0.063) in column (1); other columns report 0.105*, 0.179**, 0.109*, 0.115*, 0.120*, 0.189**. - Current account balance/GDP: -0.082*** (0.027) in column (1); other columns report -0.081***, -0.064**, -0.085***, -0.077***, -0.116***, -0.144***. - Total domestic credit/GDP: 0.031*** (0.012) in column (1); other columns report 0.036***, 0.056***, 0.028**, 0.035**, 0.047***, 0.035*. - REER (change over episode): coefficients reported include -0.008, -0.014, -0.008, -0.017, -0.004, -0.034** (last value with (0.016)). - Primary balance/GDP (average over episode): -0.209*** (0.066) and -0.289*** (0.092) reported in two specifications. - Output gap (average over episode): 0.157** (0.074) and 0.146* (0.084) in two specifications. - Exchange rate overvaluation (average over episode): 9.084* (4.836) and 8.303** (4.234) in two specifications. - FDI/GDP (average over episode): -0.116*** (0.043) and -0.100** (0.040) in two specifications. - Short term debt/Forex reserves (value in last surge year): 0.002 (0.002) reported in one specification. - Notes on estimation: - Crashes defined using a three-year window and threshold of negative net flow larger than 1 percent of GDP in first, second, or third year after the surge episode. - Real GDP growth rate, trade openness, and (log of) real GDP per capita in the year before the surge episode included as initial conditions in all specifications. - Robust standard errors in parentheses. ***, **, and * indicate significance at 1, 5 and 10 percent levels, respectively. ### International regulatory and supervisory architecture (context relevant to capital flows) - Institutional roles and mandates: - G-20: forum of 19 countries and the EU for discussion of key global economy issues; financial regulatory reform has been a major focus since the crisis. - Financial Stability Board (FSB): comprises high-level officials from central banks, regulators, treasuries from 24 jurisdictions and the ECB and EU, six international standard-setting bodies, and four international financial institutions (including the IMF); coordinates international work of national authorities and standard setters; membership does not impose legal obligations; has a small secretariat in Basel. - BIS: membership of 58 central banks; hosts meetings of central bank heads; serves as a bank for central banks; permanent staff of 589; membership does not impose legal obligations. - IMF: has legal oversight over members' exchange rate, reserve and related policies; bilateral surveillance (especially FSAP assessments) and multilateral surveillance encompass regulation and supervision. - World Bank: assesses certain financial standards and helps conduct FSAP assessments. - Standard setters and their coverage: - BCBS (Basel Committee on Banking Supervision): 27 member countries; hosted by the BIS; central for banking supervision standards. - IOSCO: association of securities regulators based in Madrid. - IAIS: represents insurance regulators and supervisors of some 190 jurisdictions; hosted by the BIS. - Other relevant standard setters: CPSS, IASB, IADI, IOPS, IAASB. - The FSB helps coordinate the work of standard setting agencies. - Information-sharing and supervisory coordination fora: - Committee on the Global Financial System (CGFS) under the BIS: senior central bankers prepare reports on stability and structural changes. - Senior Supervisors Group (SSG): established in 2007; nine supervisory agencies from 7 countries; secretariat hosted by the New York Federal Reserve Bank. - Supervisory colleges: composed of national financial authorities; aim to enhance consolidated supervision of international banking groups and facilitate cross-border cooperation and information sharing; G-20 and the EU have been active in developing colleges and best practices. - Numerous working groups and committees (BIS, G-20 requested groups) contribute to operational and technical design and implementation of regulatory and supervisory policies. ### Current reforms (progress and timelines) - Basel III and related capital/liquidity standards: - Tighter requirements on trading book assets and contingent liabilities introduced in July 2009. - Basel III approved in July 2010; calibration of new minimum requirements and capital buffers approved in September 2010. - Implementation planned to start on January 1, 2013, with completion by January 1, 2019. - Liquidity Coverage Ratio (LCR): implementation in January 2015 after an observation period (began in 2011 and extended until mid-2013); BCBS to issue final technical details and calibration of the LCR in June 2012. - Net Stable Funding Ratio (NSFR): to become a minimum standard by January 2018 after an observation period starting in 2012. - Timing of implementation may vary considerably across countries. - Global systemically important banks (G-SIBs): - Additional loss absorbency (capital surcharge) finalized at the September 2011 Basel Committee meeting. - Surcharge to be met with Common Equity Tier 1 (CET1) capital ranging from 1 percent to 2.5 percent depending on systemic importance; surcharges could reach up to 3.5 percent if systemic importance rises. - Implementation will begin in January 2016, becoming fully effective on January 1, 2019. - Methodology for identifying G-SIBs subject to changes and additional testing by March 2012; disclosure of names of G-SIBs remains unsettled; extension to other sectors (insurance, nationally systemic institutions) requires more work and G-20 agreement. - OTC derivatives market infrastructure: - G-20 agreement (Pittsburgh, September 2009): standardized OTC derivatives should be traded on exchanges/electronic platforms and cleared through central counterparties (CCPs) by end of 2012; contracts should be reported to trade repositories. - FSB, IOSCO, and CPSS formed working groups and prepared recommendations; BCBS concluded in September 2011 that most agreement would be met by end-2012 but urged pressure on national jurisdictions due to slow progress. - Regulatory perimeter and shadow banking: - FSB approved initial recommendations (July 2011 plenary in Paris) from its Shadow Banking Task Force. - Five areas for further work: regulation of banks' interactions with shadow banking entities; regulatory reform of MMMFs; regulation of other shadow banking entities; regulation of securitization; regulation of activities related to securities lending and repos. - FSB set up dedicated workstreams in each area with progress reports to be submitted by July (timing and year as stated in source). *Source: IMF staff estimates and authors' calculations as presented in the source content.* ### 2012. Given the heterogeneity of institutions and the wide-ranging differences in their ### _102111 - 2012. Given the heterogeneity of institutions and the wide-ranging differences in their ### Supervisory intensiveness and effectiveness - Significant efforts to improve intrusiveness and effectiveness of prudential supervision, particularly for complex G-SIBs. - FSB recommendations for enhanced supervision issued in November 2010 addressing supervisory mandates, independence and resources, supervisory powers, techniques, consolidated supervision, supervisory colleges, and macroprudential surveillance. - Implementation of these recommendations is ongoing. - More work needed to ensure national supervision is fully commensurate with potential risks G-SIBs pose to domestic and international financial systems. - As of September 2011, four peer reviews were completed under the FSB‘s “Framework for Strengthening Adherence to International Standards.” ### Effectiveness of supervisory colleges - Core supervisory colleges with a small number of key jurisdictions perform well for both banks and supervisors. - Broader colleges with more jurisdictions are working less effectively. - September 2010 BCBS suggestion: allow host jurisdictions to participate in supervisory colleges of G-SIBs whose affiliates are systemically important in the host country. - Agreement reached to continue monitoring college effectiveness, emphasizing better information sharing between home and host jurisdictions. ### Adherence to standards - BCBS and FSB established a rigorous framework to monitor and review members’ adherence to International Standards via FSAPs, periodic peer reviews, thematic reviews, and a toolbox of measures. - BCBS will publish the status of members’ adoption of the standards and update the report regularly. - BCBS will review consistency of members’ legislation or regulations with the international minimum standard to identify differences that could raise level playing field concerns, especially in terms of risk weighted asset calculations for banking and trading books in G-SIB home jurisdictions. - IMF, BCBS, and FSB agreed to coordinate assessments to avoid duplication. ### Review of the literature on international coordination of supervisory policies - Cross-country supervisory coordination can produce diverse outcomes; different assumptions may lead to opposite policy implications (coordination can be good or bad). - Regulatory arbitrage evidence: banks may gravitate to weakly regulated jurisdictions. - Tradeoff: coordination reduces regulatory arbitrage but can reduce national flexibility. Selected literature findings (as described) - Dell’Ariccia and Marquez (2005): three-stage model — higher standards in one country improve foreign stability; international regulator preferred only if it sets higher universal standards; third-country presence creates free rider problems; results hinge on financial integration. - Morrison and White (2009): multilateral regulatory coordination can lead to weak regulations under assumptions including no deposit insurance and limited bank licenses per country; weakly regulated countries may close capital accounts or agree on low common standards, limiting benefits for better-regulated economies. ### Empirical analysis of multilateral effects of Capital Flow Management measures (CFMs) — overview - Analysis tests impact of announcements of recent CFMs in one country on equity returns and equity fund flows of other countries in the same region using event studies. - Results: CFMs can have both positive and negative effects on equity returns and flows of other countries. ### Model specification and data - Main dependent variable: changes in equity prices in U.S. dollar terms (proxy for equity investment returns for foreign investors). - Methodology follows Bayoumi and Bui (2011). - Daily data: January 2003 to September 2011 for five Latin American countries (Brazil, Chile, Colombia, Mexico, and Peru) and five Asian countries (Indonesia, Korea, Malaysia, the Philippines, and Thailand). - Responses measured using single-day response in equity market prices in U.S. dollar terms; one-day window chosen to focus on multilateral effects and avoid noise. - Robustness checks: similar results with windows of 2, 5, and 10 days. - Specification (described verbally): neighboring-country equity return in USD regressed on CFM-implementing country return in USD, CFM-event dummies, and matrix of domestic and global control variables (global risk aversion, oil and non-oil commodity prices, U.S. asset prices; domestic policy rates and sovereign risks). - For Asia, U.S.-based control variables use a one-day lag due to time differences. - Only CFM events that had a noticeable impact on the implementing country (domestic markets moved by at least one standard deviation over the full horizon) were selected. - Flow analysis: daily net flows into dedicated Latin American country equity funds from January 2008 to July 2011 (EPFR); only Brazil’s CFM events considered due to data limits. Event dummy set to unity for the day after the CFM announcement for flows. ### CFM events selected (examples shown in source) - Brazil: 19-Oct-09 (effective 20-Oct-09) Imposed 2 percent IOF tax; 4-Oct-10 (5-Oct-10) Imposed 4 percent IOF tax; 18-Oct-10 (19-Oct-10) Imposed 6 percent IOF tax (bonds); 6-Jan-11 (14-Apr-11) Imposed 60% reserve requirements on bank short USD positions above US$3 billion; 28-Mar-11 (29-Mar-11) Imposed 6 percent IOF tax on ST FX loans with maturities of 360 days or less; 6-Apr-11 (7-Apr-11) Imposed IOF tax on ST FX loans with maturities extended from 360 to 720 days; 27-Jul-11 (27-Jul-11) Imposed 1 percent IOF tax on increases in banks' net short FX derivatives positions. - Colombia: 6-May-07 (7-May-07) Imposed 40 percent URR on foreign borrowing; 23-May-07 (24-May-07) Extended URR to nonresidents' portfolio investments. - Korea: 19-Nov-09 (19-Nov-09) Introduced measures on banking sector; 13-Jun-10 (14-Jun-10) Introduced measures on banks aiming to reduce their short-term debt; 18-Nov-10 (1-Jan-11) Re-instated withholding tax on foreign investors' earnings from government bonds; 19-Dec-10 (1-Aug-11) Proposed levy on banks’ non-deposit FX liabilities; 19-May-11 (1-Jun-11) Reduced banks’ FX derivatives ceiling. - Thailand: 18-Dec-06 (19-Dec-06) Imposed 30 percent URR on all inflows; 12-Oct-10 (13-Oct-10) Re-instated withholding tax on interest income and capital gains from public bonds. ### Results — equity returns (selected estimates from Table 2.6) - Control variables (examples, percent change in returns in USD terms): - CDS: Brazil -0.000350***; Colombia -0.000492***. - VIX: Brazil -0.000699***; Colombia -0.000499**. - Non-oil commodity price: Brazil 0.130***; Colombia 0.104***. - U.S. equity index: Brazil 0.0652**; Colombia 0.427***. - LIBOR: Brazil -0.000269***; Colombia -6.41E-05. - Equity returns relationship coefficients (examples): - Brazil's measures: Chile 0.282***; Colombia 0.196***; Mexico 0.432***; Peru 0.231***. - Colombia's May 2007 URR: Chile 0.180***; Brazil 0.374***; Mexico 0.222***; Peru 0.140***. - Impact of CFM events on neighboring countries (examples): - Brazil's measures: - Chile -0.151 (standard error 0.1180) - Colombia 0.0688 (0.2900) - Mexico -0.507*** (0.1490) - Peru 0.146* (0.0804) - Colombia's May 2007 URR: - Chile -0.176*** (0.0561) - Brazil 0.479*** (0.0713) - Mexico 0.219*** (0.0487) - Peru 0.179** (0.0852) - Sample statistics: - Brazil's 2009-11 measures: Observations 7,468; R-squared 0.453. - Colombia's May 2007 URR: Observations 7,430; R-squared 0.504. - Significance note: Robust standard errors reported; significance markers (*** p<0.01, ** p<0.05, * p<0.1). ### Results — Asian examples (selected estimates from Table 2.6) - Control variables (examples): - Indonesia/Korea/Thailand columns show CDS negative and significant in some specifications. - U.S. equity index and oil price coefficients vary by specification. - Equity returns relationship coefficients (examples): - Thailand's measures: Indonesia 0.348***; Malaysia 0.167***; Philippines 0.224***; Thailand 0.276***. - Korea's 2010 measures: Indonesia 0.453***; Korea 0.454***; Malaysia 0.221***; Philippines 0.223***. - Impact of CFM events (examples): - Korea's 2010 measures: Indonesia -0.253***; Korea -0.400***; Malaysia -0.0703***; Philippines -0.162***. - Thailand's December 2006 URR: Indonesia -0.0303; Malaysia 0.143***; Philippines -0.0025; Thailand 0.126***. - Sample statistics: - Thailand's December 2006 URR: Observations 7,489; R-squared 0.315. - Korea's 2010 measures: Observations 7,397; R-squared 0.315. ### Results — flows to Brazil equity funds (selected estimates from Table 2.7) - Flows to Brazil as regressors (coefficients, robust s.e. in parentheses): - Chile 0.0283 (0.0023) - Colombia 0.101** (0.0009) - Mexico 0.0156 (0.0299) - Peru 0.00472 (0.0041) - Interaction (Flows to Brazil * Brazil's CFM events): - Chile 0.0542** (0.0396) - Colombia -0.0191 (0.0069) - Mexico -0.0372* (0.1840) - Peru -0.106*** (0.0368) - Control variables (selected): - VIX: Chile -0.0359 (0.0104); Peru -0.103** (0.0491) - Change in U.S. equity index: Chile 0.0534* (9.4110); Mexico 0.135*** (45.0600) - Sample statistics: - Observations: Chile 878; Colombia 603; Mexico 883; Peru 528. - R-squared: Chile 0.077; Colombia 0.155; Mexico 0.102; Peru 0.142. - Number of lag dependent variables: 4 in each regression. - Interpretation: Determinants of daily flows to Brazil equity funds are largely driven by persistence of flows; correlations between flows to Brazil and neighbors mostly not significant. Chile and Peru (and to lesser extent Mexico and Korea) exhibit significant responses on Brazil’s CFM dates, often with directions differing from equity return estimates. ### Variable definitions and sources (selected, from Table 2.8) - Equity returns in USD: (1+%ΔEquity indices)*(1+%ΔBilateral USD exchange rate) -1 — Bloomberg, Datastream. - Equity indices: Daily equity indices from each market — Bloomberg. - Bilateral USD exchange rate: Daily local currency per U.S. dollar — Datastream. - VIX: Daily Chicago Board Options Exchange Market Volatility Index — Datastream. - Oil prices: Daily oil prices — Datastream. - Non-oil commodity prices: Daily non-oil commodity price indices — Datastream. - US yield: Daily U.S. generic 10-year treasury yields — Bloomberg. - US equity: Daily S&P 500 indices — Bloomberg. - CDS: Daily 5-year CDS spreads — Markit, Datastream. - Policy rates: Relevant central bank policy rates (daily) — Datastream, Haver. - LIBOR: Daily overnight LIBOR — Haver. - Daily flows to equity funds: Daily flows to each EM-dedicated equity funds — EPFR. *Prepared by IMF staff (chapter/section excerpt).* ### 95. This note summarizes the trade policy literature with a view to informing ### 95. This note summarizes the trade policy literature with a view to informing ### Overview - The note summarizes the trade policy literature to inform consideration of the multilateral implications of capital flow policies. - There is a considerable amount of analysis and policy experience in trade policies that can be tapped to help better understand policies affecting capital flows. (Paragraph 95) ### Theoretical foundation for free trade - Since Ricardo‘s seminal work on comparative advantage, economists have viewed free international trade as the optimal regime. (Paragraph 96) - General view: free trade allows a country to produce and export goods it produces with relatively greater efficiency and to import goods more efficiently produced abroad; every country is better off in a free trade regime. (Paragraph 96) - Reference overview: Gene M. Grossman and Kenneth Rogoff, 1995, Handbook of International Economics, vol. III, Elsevier Science. (Footnote 69) ### Prevalence of interventionist trade policies and motivations - Real world trade policies are often interventionist, motivating theoretical attempts to justify them. (Paragraph 97) - Economic rationales for interventionist policies are usually based on market imperfections. (Paragraph 98) - Example: International firms transacting in oligopolistic markets can gain extra profits; export subsidies can help domestic firms pursue aggressive market penetration strategies and ―shift‖ profits from foreign competitors. (Paragraph 98; Footnote 70: James Brander and Barbara Spencer, 1985) - Example: Import tariffs can increase returns in production from learning by doing and other economies; temporary protection of ―infant‖ industries enables domestic firms to grow and exploit increasing returns to scale. (Paragraph 98; Footnote 71: Alwyn Young, 1991) ### Political economy explanations - Political economy considerations are important: the Stolper-Samuelson theorem on international factor price equalization implies international trade can have large and asymmetric effects on incomes of production factors. (Paragraph 99) - Trade should decrease prices of factors that are relatively scarce domestically but abundant internationally, and increase prices of factors that are domestically abundant but internationally scarce. (Paragraph 99) - This produces gains for some domestic groups and losses for others; interventionist trade policies can result from groups lobbying the government. (Paragraph 99; Footnote 72: Gene M. Grossman and Elhanan Helpman, 1994) ### Skepticism about active (strategic) trade policy - Economists remain skeptical about the effectiveness of active trade policies because of strong informational requirements. (Paragraph 100) - There is no general argument in favor of active (―strategic‖) trade policies; optimality of intervention relies on very specific conditions that are hard to achieve and require the government to have access to extensive information. (Paragraph 100) - Quotation: Krugman — “theoretical work has shown that the appropriate strategic policy is highly sensitive to details of market structure that governments are unlikely to get right.” (Paragraph 100; Footnote 73: Paul Krugman, 1993) ### Negative spillovers and externalities - Active trade policies can have negative one-way spillover effects on trading partners; even if unilaterally optimal, they often increase domestic welfare at the expense of trading partners. (Paragraph 101) - “Profit shifting” policies explicitly aim to increase profits for domestic firms by reducing production and profitability of foreign competitors. (Paragraph 101) - Policies that shift demand to domestic infant industries reduce production abroad, negatively affecting foreign countries‘ abilities to exploit their increasing returns to scale. (Paragraph 101) - Negative trade policy spillovers pose an externality because the policymaker lacks incentives to factor into decision-making the welfare of adversely impacted trading partners. (Paragraph 101) ### Risk of trade policy wars and prisoner’s dilemma - Negative spillovers can trigger inefficient trade policy “wars.” (Paragraph 102) - Countries have incentives to protect themselves from another country‘s beggar-thy-neighbor policies, potentially leading to a chain reaction of rising protectionist barriers worldwide. (Paragraph 102) - This can induce a “prisoner‘s dilemma” equilibrium, with every country worse off than in the free trade regime. (Paragraph 102) ### Historical example: 1930s and the Great Depression - Trade policies during the 1930s are often cited as a contributing factor in worsening the Great Depression. (Paragraph 103) - As the Depression unfolded, trade measures to protect domestic industries caused negative one-way spillovers to similar industries in other countries; trading partners responded with matching protectionist measures. (Paragraph 103) - The Smoot-Hawley Act (1930) of the U.S. and similar laws passed in Europe had the effect of doubling import tariffs in the world‘s largest economies. (Paragraph 103) - Because trade was concentrated in material inputs, the collapse of international trade attributable to the tariff war negatively impacted productivity and investment, worsening the recession. (Paragraph 103; Footnote 74: Mario J. Crucini and James Kahn) - Some authors dismiss the importance of the trade war in causing the Great Depression. (Paragraph 103; Footnote 75: Dornsbush and Fischer, 1984) ### Role of international trade agreements and institutions - International trade agreements and institutions, such as the WTO, were established to avoid trade policy wars. (Paragraph 104) - Trade agreements respond to the possibility of repeated trade policy actions between governments; repeated interactions allow participants to punish a partner that deviates from the agreement. (Paragraph 104) - A credible trade agreement emerges from sufficiently strong punishment for unilateral deviation; this requires credible punishments and that countries find it optimal to enact the punishment when necessary. (Paragraph 104) - Because verification of deviations can be difficult, international organizations, such as the WTO, assess potential deviations and coordinate corresponding punishment in case of violation. (Paragraph 104; Footnote 76: Raymond Riezman, 1991) *Source: IMF staff note summarized in paragraphs 95–104.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2011/_102111.pdf_