In the Wake of the Crisis: Leading Economists Reassess Economic Policy

10. Global Liquidity

International Monetary Fund
Published Date:
March 2012
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Hyun Song Shin

Low interest rates maintained by advanced-economy central banks in the aftermath of the global financial crisis that began in 2007 have ignited a lively debate about capital flows to emerging economies. The argument is that such capital flows are driven by carry trades that seek to exploit the interest-rate differences between advanced and emerging economies and that such flows result in overheating and excessively permissive financial conditions in the recipient country, posing challenges for policymakers.

The U.S. dollar has special significance in this debate. As well as being the world’s most important reserve currency and an invoicing currency for international trade, the dollar is also the currency that underpins the global banking system. It is the funding currency of choice for global banks. The United States hosts branches of around 160 foreign banks whose main function is to raise wholesale dollar funding in capital markets and then ship it to their head office. Foreign bank branches collectively raise over $1 trillion of funding, of which over $600 billion is channeled to headquarters.1Figure 10.1 shows the interoffice assets of foreign bank branches in the United States—the lending by branches to headquarters. Interoffice assets increased steeply in the last two decades, saw a sharp decline in 2008, and bounced back in 2009.

Figure 10.1Interoffice assets of foreign bank branches in the United States.

Source: Federal Reserve.

It is instructive to compare the role of the dollar with that of the Japanese yen as a funding currency for global banks. Figure 10.2 plots the interoffice assets of foreign banks in Japan. Fueled by the yen carry trade, yen funding grew rapidly before the crisis but has subsequently been unwound in the aftermath of the crisis. Yen interoffice assets are now at their lowest level since the mid-1990s. The persistent strength of the yen after the crisis may be due in part to this unwinding. In net terms, global banks have maintained negative interoffice accounts in yen, except for a brief period at the height of the boom before the global financial crisis, as can be seen in figure 10.3. In other words, the funds obtained from the head office for allocation in Japan have outweighed the yen shipped to headquarters.

Figure 10.2Interoffice assets of foreign bank branches in Japan.

Source: Bank of Japan.

Figure 10.3Net interoffice assets of foreign bank branches in Japan.

Source: Bank of Japan.

However, what is remarkable about the U.S. dollar is that even in net terms, foreign banks have been channeling large amounts of dollar funding to the head office. Figure 10.4 shows the net interoffice assets of foreign banks in the United States. Net interoffice assets were negative in the 1980s and most of the 1990s, but in 1999, net interoffice assets surged into positive territory and increased steeply thereafter.2

Figure 10.4.Net interoffice assets of foreign bank branches in the United States.

Source: Federal Reserve.

We thus face an apparent paradox. Although the United States is the largest net debtor in the world, it is a substantial net creditor in the global banking system. In effect, the United States is borrowing long (through U.S. Treasury and other securities) but lending short through the banking sector. This is in contrast to countries such as Ireland and Spain that financed their current-account deficits through their respective banking sectors and that have subsequently paid the price through runs by wholesale creditors on their banks.

The large net positive interoffice accounts of foreign banks in the United States highlights the potential for cross-border spillovers in monetary policy. Dollar funding that is shipped abroad to headquarters will be deployed globally according to portfolio allocation decisions that seek out the most profitable use of such funds.

Some borrowed dollars will find their way back to the United States to finance purchases of mortgage-backed securities and other assets (remember UBS and its portfolio of subprime centralized debt obligations). But some will flow to Europe, Asia, and Latin America, where global banks are active local lenders. At the margin, the shadow value of bank funding will be equalized across regions through the portfolio decisions of the global banks so that global banks become carriers of dollar liquidity across borders. In this way, permissive U.S. liquidity conditions will be transmitted globally, and U.S. monetary policy becomes, in some respects, global monetary policy.

A glimpse into the dollar’s role as the funding currency of choice for global banks can be had in the identity of banks that took advantage of the emergency liquidity from the U.S. Federal Reserve during the crisis. Figure 10.5 shows the cumulative borrowing under the term auction facility (TAF) that allowed banks to receive term funding while avoiding the stigma of borrowing at the Fed’s discount window. The light bars indicate U.S. banks, and the dark bars indicate non-U.S. banks. The cumulative total overstates the total support that was outstanding at any one time, given the repeated rollover of one month of term funding. But it is notable that the list is dominated by foreign banks, especially from Europe and Japan. Indeed, the largest borrower is Barclays, and three of the top four are U.K. banks.

Figure 10.5.Cumulative borrowing under the Federal Reserve’s term auction facility in twenty-one banks.

Source: Federal Reserve.

After the foreign banks send wholesale dollar borrowings to their headquarters, the trail grows cold since we cannot peer into the internal global portfolio decisions of these banks. However, we can pick up the trail on the other side. Once the dollars are on loan to local borrowers in Europe, Asia, and Latin America, we can pick up the trail again by examining the banking-sector capital flows in the balance-of-payment accounts.

Figure 10.6 is a chart from the April 2010 issue of the International Monetary Fund’s Global Financial Stability Report, showing total capital inflows into forty-one countries, including many emerging economies. The flows are disaggregated into the four main categories of capital flows—bank loans, bonds, equity, and foreign direct investment (FDI). We see that FDI flows are steady and portfolio equity flows are small in net terms. However, banking-sector flows display the signature procyclical pattern of surging during the boom, only to change sign abruptly and surge out with the deleveraging of the banking sector.

Figure 10.6.Components of U.S. capital flows to forty-one countries: loans, bonds, equity, foreign direct investment.

Source: Global Financial Stability Report (April 2010), 123.

A more detailed picture emerges when we examine the noncore liabilities for the Korean banking sector, given in figure 10.7. The first peak comes immediately prior to the 1997 financial crisis. After a lull in the early 2000s, noncore liabilities again pick up speed and increase rapidly up to the 2008 financial crisis. Figure 10.8 normalizes noncore liabilities of the Korean banking sector as a fraction of M2 (bank deposits and close substitutes). We see the procyclicality and substantial variation, ranging from around 15 percent to a peak of 50 percent during the crisis of 2008.

Figure 10.7.Noncore liabilities of the Korean banking sector.

Source: Bank of Korea; Hyun Song Shin and Kwanho Shin, “Procyclicality and Monetary Aggregates,” National Bureau of Economic Research Working Paper 16836 (2010),

Figure 10.8.Noncore liabilities of the Korean banking sector as a proportion of M2.

Source: Bank of Korea; Hyun Song Shin and Kwanho Shin, “Procyclicality and Monetary Aggregates,” National Bureau of Economic Research Working Paper 16836 (2010),

The growth in foreign-currency liabilities and debt-security liabilities of Korean banks in the period between 2003 and 2007 (see figure 10.7) can be seen as the mirror image of the increase in net interoffice accounts of foreign banks in the United States (see figure 10.4). In effect, figure 10.4 reflects the liabilities side of global banks’ balance sheets, and figure 10.7 reflects (a small part of) the asset side of global banks’ balance sheets.

Figure 10.9 is a monthly chart of flows in the equity and the banking sectors in Korea. The equity sector actually saw net inflows during the crisis in the autumn of 2008, as selling by foreigners was more than matched by the repatriation flow of Korean investors who sold their holdings of foreign equity. However, the banking sector saw substantial outflows in the deleveraging episode following the bankruptcy of Lehman Brothers.

Figure 10.9.Net capital flows of the Korean equity and banking sector.

Source: Bank of Korea; Hyun Song Shin and Kwanho Shin, “Procyclicality and Monetary Aggregates,” National Bureau of Economic Research Working Paper 16836 (2010),

Letting the currency appreciate in response to capital inflows may mitigate the pressure from surging capital flows. However, when banking-sector flows form the bulk of the inflows and the leveraging and deleveraging cycle amplifies distortions to liquidity conditions, additional prudential measures may be necessary to lean against the buildup of vulnerabilities to sudden reversals and deleveraging.

Macroprudential policy that leans against the buildup of noncore banking-sector liabilities has some merit in this regard. Korea has announced that it will introduce a macroprudential levy in the form of a levy on the foreign-exchange-denominated liabilities of the banking sector, with a higher rate applying to short-term liabilities. The levy is intended to lean against excess liquidity and the buildup of vulnerabilities to the sudden reversals that are associated with deleveraging.

The levy can be expected to work as an automatic stabilizer since the base of the levy is larger during booms. The automatic stabilizer element is a virtue, given the political-economy impediments to relying on discretionary policy. Another advantage of the macroprudential levy is that it also leaves the core intermediation function largely untouched, operating primarily on the bubbly portion of the banking-sector liabilities.

Although the levy will have some effect on exchange rates, holding down the exchange rate should not be the primary objective of such a levy. By the same token, a debate that focuses exclusively on exchange rates and trade imbalances undervalues the financial stability role of macroprudential policy. Policymakers would do well to remember the main lesson from the global financial crisis—that the leveraging and deleveraging cycle of the banking sector is the driver of financial instability, for both advanced and emerging economies.

The IMF’s Financial Stability Contribution (FSC) proposed a broad-based levy on the noncore liabilities of the banking system and could have been expected to exert some restraint on the leverage cycle of the global banks.3 However, the IMF’s FSC did not find sufficient support among the Group of Twenty governments and was shelved at the G20 Toronto summit in June 2010.

The failure of the G20 to adopt the FSC may reflect in part the framing of the debate in terms of raising revenue and “punishing” the banks. It may also reflect the dynamics of the complex multilateral process that the G20 represents. However, the imperative for well-designed macroprudential policies in a world with monetary policy spillovers increases the attractiveness of revisiting the merits of the FSC.

. “Funding Patterns and Liquidity Management of Internationally Active Banks,” Bank for International Settlements, Center for Global Financial Studies Paper 39 (May 2010),

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