In the aftermath of the financial crisis, there is consensus on the need of macroprudential policies to smooth the financial system and therefore enhance its resilience. However, in a globally interconnected banking system, countries have less control over their own financial stability. National policies to contain risks from a rapid build-up of domestic credit can lead to an increase in the share of credit that is provided across borders, a phenomenon that has come to be known as "leakage." Thus, foreign banks can "undo" the intended effects of the domestic regulatory action. One example of such spillovers is where branches of foreign banks increase lending as a result of tighter financial regulation on domestic banks, if they are not subject to the same regulation as domestic banks. Then, if there is no reciprocity in policies across countries, that is, different regulatory regimes, credit activities may move from the regulated system to the non-regulated one.
In this paper, the author touches upon these issues, providing an analytical framework to disentangle the mechanisms behind the empirical evidence on the topic. Within this setting, the author studies how domestic regulation affects the share of foreign borrowing, that is, if there are leakages coming from macroprudential policy. Then, analysis takes place on how reciprocity agreements affect the dynamics of the model, financial stability and welfare. Finally, the author performs an optimal policy analysis to assess the most effective macroprudential policy to maximize welfare, taking into account spillovers. Results show that, in the presence of foreign lending, macroprudential policy does leak. The share of domestic borrowing not only is inversely related to stricter domestic regulation but also to loose regulation in foreign lending. Therefore, when domestic macroprudential policies do not reciprocate, inward spillovers appear. This has implications for financial stability and welfare. Macroprudential policies represent a welfare gain and an improvement in financial stability with respect to a situation in which there are not such policies. However, gains in terms of welfare and financial stability are larger under reciprocity agreements. Finally, the author searches for the optimized macroprudential policy that maximizes welfare, and finds that it is optimal for policies to reciprocate. However, given the preference of borrowers for domestic lenders, macroprudential policies should be applied less aggressively to foreign lenders than to the domestic ones.
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Posted on Thursday 26th October 2017