Chapter

III Prudential Framework for Managing Risk in Cross-Border Capital Flows

Author(s):
Akira Ariyoshi, Andrei Kirilenko, Inci Ötker, Bernard Laurens, Jorge Canales Kriljenko, and Karl Habermeier
Published Date:
May 2000
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One major objective of capital controls is to manage the various risks associated with capital flows.8 Capital control measures focus on specific types of transactions and attempt to manage and reduce risk by influencing the composition of parties to, and the volume of, such transactions. Chapter II examined a number of measures adopted by various countries, ranging from quantitative restrictions to a Tobin tax–like mechanism. The predominant motivations for the use of capital controls were macroeconomic, mainly to facilitate the pursuit of both monetary policy and exchange rate objectives.

An alternative approach to managing the risks associated with capital flows is not to attempt to control the flows directly, but to limit the vulnerability of the economy to the risks associated with such flows. Prudential policies applied to financial institutions can contribute to this goal by influencing risk-taking on the part of financial institutions and by improving the robustness of the financial system to external shocks. As seen in Chapter II, a number of countries have recognized this and taken steps to strengthen bank supervision to cope with capital flows (for example, Argentina, Chile, and India), but it is only recently that the potentially crucial role of prudential policies in managing the risks associated with capital flows and financial intermediation generally has been widely appreciated. The understanding of how prudential policies may affect macroeconomic performance is still at an early stage, and statistical or econometric analysis of such links is a largely uncharted field. This chapter therefore highlights a number of important issues rather than reaching definitive conclusions.

Financial institutions are major parties to international capital transactions. They accept cross-border and foreign currency deposits, initiate external borrowings, make foreign loans and investments, and generally intermediate cross-border transactions. It has sometimes been observed that financial institutions are prone to excessive risk-taking. When this happens in connection with cross-border and foreign currency transactions, sudden and large reversals of capital flows or large currency movements can have damaging consequences on the health of individual financial institutions. Moreover, shifts in sentiment, leverage, and liquidity problems can multiply and transmit shocks throughout the financial system, and in extreme cases they result in financial panics. By requiring more effective risk management in individual institutions, prudential policies can help dampen transmission and contagion, and contribute to stemming the development of a major financial crisis. The experience of the Asian economies since 1997 has underscored the role that a weak financial system can have in accentuating a crisis.9

The distinction between prudential policies and capital controls is not always clear-cut. A rapid and large buildup of foreign assets and liabilities by financial institutions driven by periods of “irrational exuberance” followed by pessimism and a retrenchment of positions can itself be a source of excess volatility of currency prices and capital flows. If prudential regulation and supervision can make individual institutions manage the risks associated with external assets and liabilities more prudently, then the volatility of capital flows may be reduced or the consequences of volatility limited. A targeted prudential measure that seeks to limit a particular risk, for example, banks’ foreign currency exposure, may influence specific types of capital transactions. Moreover, if banks’ activities dominate capital flows in and out of a country, as is often the case, then constraining the risks that can be taken by banks may effectively limit the overall size of capital flows, as well as their riskiness. Thus, measures that are typically considered as prudential may in fact be used for capital control purposes.

Conversely, capital control measures may have prudential effects, for example by restricting banks’ short-term borrowing and thus limiting liquidity and other risks to banks associated with such borrowings. As was seen in Chapter II, countries including Chile, China, and India have on occasion used capital control measures to pursue prudential objectives. The effective use of such measures rests on the existence of an adequate administrative capacity.

Design of Prudential Policies for Managing Risks Associated with Capital Flows

Cross-border capital flows involve the same fundamental categories of risks as do purely domestic transactions, but with added dimensions in each category. Box 2 provides an overview of the principal risks that arise in the context of an open capital account. Many of these relate to the use of foreign exchange, but some also arise from differences in other institutional arrangements.

The basic similarity between the risks of international capital flows and the risks of purely domestic transactions means that they can be addressed within the overall prudential framework by adapting and extending regulations and supervision used in the domestic financial market. Best practice prudential regulations would seek to manage the additional risks inherent in international capital flows by limiting the institution’s risk exposure relative to its risk-taking and management capacity. Thus, while prudential regulations do not target capital flows directly, they can influence their volume, composition, and volatility. Such regulations would include enhanced monitoring, disclosure, and reporting; prudential limits (in the form of certain balance sheet ratios); rules for loan classification, asset valuation, provisioning, and income recognition; norms requiring strong internal risk management procedures; and accounting and control systems.

Prudential standards need to give particular attention to banks, given their large (though somewhat diminished) role in the provision of credit, their central position in the payments system, the systemic implications of their high leverage, and the mismatch in the liquidity of their assets and liabilities. Also, capital inflows are often intermediated by the banking system, and their reversal may be associated with a banking crisis if banks are not adequately prepared. Even when financial crises were triggered by events in nonbank financial institutions, the eventual severity and duration of the crisis was largely determined by the ability of the banking system to withstand shocks. The public good aspect of the banking system’s services and the potential cost of resolving a banking crisis provide a further rationale for focusing on banks.

Recent experience in Asia has highlighted how vulnerabilities can increase under a weak prudential regime (Baliño and others, 1999). Capital inflows into the banking sector helped fuel rapid credit expansion, with banks being increasingly exposed to credit and foreign exchange risks and to maturity mismatches in foreign currencies. Banks’ foreign currency lending to corporate borrowers that did not have secure foreign exchange revenue streams created major problems once the currencies started to depreciate. More generally, rapid growth of assets also strained banks’ capacity to assess risk adequately. Prudential regulation and supervision that might have mitigated these problems had serious deficiencies, including with respect to foreign currency mismatches.10

Considerable work has been undertaken in international forums to develop principles for prudential regulation and supervision.11 Reflecting the heightened interest and concern about international capital flows, prudential standards and procedures are being updated to reflect the risks in bank intermediation of cross-border capital flows. The Basel Committee has proposed revisions to the capital adequacy framework, the development of methodologies for credit risk and interest rate risk management and modeling, banks’ interactions with highly leveraged institutions (notably, hedge funds), sound practices for loan accounting and credit risk disclosure, bank transparency and internal control systems, and operational risk management. The Basel Committee has also issued papers on authorization procedures and principles for the supervision of banks’ foreign establishments, the information flow between banking supervisory authorities, and the relationship between bank supervisors and external auditors.

Box 2.Risks in Banks’ Cross-Border Transactions

The opening up of the capital account and cross-border activities of banks introduce additional risks that may increase the magnitude, or complicate the management, of the risks that banks typically face in their domestic activities. The key risks with an open capital account and how to cope with these risks are discussed below.1

1. Credit risk is the failure of a counterparty to perform according to a contractual arrangement. It applies not only to loans but also to other on- and off-balance-sheet exposures such as guarantees, acceptances, and security investments. Additional dimensions of credit risk in cross-border transactions include

  • transfer risk: when the currency of obligation becomes unavailable to the borrower;

  • settlement risk: risk in the settlement of foreign exchange operations that arise because of time zone differences; and

  • country risk: risk associated with the economic, social, and political environment of the borrower’s country.

2. Market risk is the risk of losses in banks’ on- or off-balance-sheet positions arising from movements in market prices that change the market value of an asset or a commitment. This type of risk is inherent in banks’ holdings of tradable securities, financial derivatives, open foreign exchange positions, and interest-sensitive bank assets and liabilities.

Foreign exchange risk refers to the risk of losses in on- or off-balance-sheet positions arising from adverse movements in exchange rates. It tends to be most closely identified with cross-border capital flows. Banks are exposed to this risk in acting as market makers in foreign exchange by quoting rates to their customers and by taking unhedged open positions in foreign currencies.

Interest rate risk refers to the exposure of a bank’s financial condition to adverse movements in interest rates; it arises as a result of a mismatch (gap) between a bank’s interest-sensitive assets and liabilities and affects both the earnings of a bank and the economic value of its assets, liabilities, and off-balance-sheet instruments. Excessive interest rate risk may erode a bank’s earnings and capital base. The primary forms of interest rate risk are

  • repricing risk, which arises from timing differences in the maturity and repricing of bank assets, liabilities, and off– balance sheet positions;

  • yield curve risk, which arises from changes in the slope and shape of the yield curve; and

  • basis risk, which arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics.

Risk also exists in derivatives transactions. Derivatives are an increasingly common method of taking or hedging risks. The actual cost of replacing a derivative contract at current market prices is one measure of a derivative position’s exposure to market risk. Since many of these transactions are registered off-balance-sheet, supervisors need to ensure that banks active in these transactions are adequately measuring, recognizing, and managing the risks involved.

3. Liquidity risk arises from the inability of a bank to accommodate decreases in its liabilities or to fund an increase in its assets at a reasonable cost or liquidate its assets at a reasonable price in a timely fashion. Inadequate liquidity, then, affects profitability and, in extreme cases, can lead to insolvency. There are no internationally agreed prudential standards on bank liquidity, but supervisors require banks to have adequate systems to monitor and control their liquidity needs and establish contingency plans for periods of liquidity stress. Regulation of liquidity risk focuses on the degree of mismatch between maturities of assets and liabilities and dependability of access to funds in future periods.

1 This draws on Johnston and Ötker-Robe (1999).

Ensuring an adequate capitalization of banks is central to limiting banking system risks, including those arising from international capital flows. The central objective of the new draft capital adequacy framework (which would replace the 1988 Accord) is to promote safety and soundness in the international financial system, and it gives even more attention than in the past to the activities of large, internationally active banks (see Basel Committee, 1999a). The proposed framework would maintain a modified version of the existing accord as the standard approach to minimum capital requirements, but also considers the option of providing greater scope for the use of internal credit ratings and portfolio models in establishing minimum capital. The coverage of the framework would also be extended to fully capture the risks in a banking group, with a view to accurately representing an institution’s risk profile. Supervisory evaluation and market discipline through increased disclosure are additional pillars of the capital adequacy regime. The revised framework does not propose to change the minimum capital adequacy ratio of 8 percent. This level is not likely to be sufficient for those institutions that are systematically exposed to greater risk, such as those in emerging markets, where the authorities are already in many cases requiring or encouraging banks to maintain higher capital. The advantage of higher capital adequacy ratios would be to make financial system failures less likely; and when failures do occur, a higher portion of the cost would be borne by the private sector. The incentives of banks, as leveraged institutions, to “gamble for resurrection” would also decrease. The principal disadvantage of higher minimum capital ratios is that they raise banks’ costs and thus encourage further disintermediation. Differences in minimum capital ratios across countries can also distort competition among banks and influence decisions on where to incorporate, and thereby also possibly affect cross-border capital flows. The new framework proposes to address this issue by giving a larger role to supervisory review in setting capital requirements for individual financial institutions that appropriately reflects risks borne by the institution. Specific proposals affecting banks’ international activities include the following: 12

  • External risk assessments prepared by rating agencies would be used to establish risk weights for sovereign borrowers.13 Under the 1988 Accord and its amendments, sovereign risk weights were based mainly on whether or not a country is a member of the OECD.14 The draft proposes that only those countries rated most highly would be eligible for a zero risk weight (a minimum Standard & Poor’s rating of AA–), with the risk weight rising in stages to 150 percent for claims on countries with a rating of B– or below. Furthermore, sovereign risk could be weighted at less than 100 percent only if the country has subscribed to the Fund’s Special Data Dissemination Standard (SDDS).

  • Subject to some limitations, external risk assessments would also be used to establish risk weights for exposures to banks, other governmental entities, securities firms, and corporates. Under the existing procedures, all claims on banks incorporated in OECD countries and short-term claims (i.e., up to one year) on banks incorporated in non-OECD countries have received a 20 percent risk weight, while longer-term claims on non-OECD banks were risk1weighted at 100 percent. This standard has been criticized on the grounds that it may have biased credit flows to emerging markets toward shorter-term maturities.

Although the use of external risk assessments in assigning risk weights aims to better reflect the actual risk of assets than the current uniform and somewhat arbitrary risk weights, there is still considerable debate about the quality of external assessments. Credit ratings have come under close scrutiny since the outbreak of the Asian crisis, when a number of assessments proved to be far too favorable in retrospect.

Consideration is also being given to the need for prudential oversight of highly leveraged institutions (including hedge funds). There are concerns that the operations of highly leveraged institutions have contributed to the volatility of capital flows to emerging markets. Ongoing discussion has focused on whether the activities of highly leveraged institutions should be directly regulated, or whether their creditors, particularly bank creditors, need to be held to tighter prudential standards in their dealings with such institutions. The Basel Committee has emphasized the latter approach:

  • Before conducting business with highly leveraged institutions, a bank should establish clear policies governing its involvement with these institutions consistent with its overall credit risk strategy. Sufficiently sophisticated risk management procedures need to be in place to identify and measure the specific risks associated with highly leveraged institutions, particularly the risks associated with derivatives. A preemptive approach rather than one informed mainly by net asset values is essential.

  • Overall credit limits need to be established, and collateral and early termination provisions should take into account the ability of highly leveraged institutions to rapidly change trading strategies, risk profile, and leverage.

Sound practices for loan accounting, credit risk disclosure, bank transparency, and related matters will also help to mitigate the risks associated with international capital flows. The Basel Committee recently issued a paper listing 26 sound practices for loan accounting and recognizing credit risk exposure (Basel Committee, 1999b). The suggested practices reflect the judgment that capital adequacy standards lack meaning, and risk management is seriously impaired, if loans are not properly valued and loan losses are not adequately recognized and provisioned for in banks’ balance sheets. Generally good practices in this field are found in a number of advanced economies, but these may not be easily transferable to countries with less developed financial and regulatory infrastructures. In such countries, more mechanical approaches relying on simple quantitative criteria may be more appropriate. Box 3 discusses the experience of the United States, with a particular emphasis on the treatment of cross-border loans.

International capital flows also generate additional risks for financial institutions in terms of market risk and liquidity risk. For market risk, the 1996 Amendment to the Capital Accord to incorporate market risks required internationally active banks to hold capital against risks related to exchange rate changes and movements in the price of assets held for trading purposes. For liquidity risk, the Committee’s 1992 paper “Framework for Measuring and Managing Liquidity” provides a summary of practices and techniques employed by major international banks in measuring and managing liquidity, and provides a benchmark for liquidity management by banks. Management of foreign currency liquidity is particularly important because, unlike in domestic currency, there are limits on the ability of central banks to provide assistance to banks to tide over temporary liquidity problems.

Box 3.The U.S. Supervisory Approach to Loan Classification and Provisioning 1

In determining the adequacy of loan valuation and loss provisioning, U.S. supervisors evaluate each bank’s risk management capacity and internal policies and procedures (internal credit review procedures, loss evaluation techniques, and the adequacy of loan-loss provisions) relative to its individual portfolio composition and risk profile. Evaluations are performed according to general guidelines, which eschew the application of mechanical rules. The same principles and methodology are applied to both domestic and cross-border credit exposures but additional requirements are applied to a bank’s internal policies and procedures for managing material cross-border transfer risk. 2

Loan Grading

Supervisory guidelines establish five categories (pass, special mention, and classified credits, consisting of substandard, doubtful, and loss), based on a defined set of key factors, for grading the risk quality of loans.3 Delinquent (overdue) credits are also distinguished but do not automatically determine the risk category, and performing (nondelinquent) loans with well-defined credit weaknesses may be adversely classified. Additional factors are taken into account in evaluating partially charged off or formally restructured credits, as well as guarantees and off-balance-sheet items.

Loan-Loss Provisioning

Banks are required to establish a loan– loss reserve (“allowance for loan and lease losses” or ALLL), charged against current income. All loans, or portions of loans, recognized (classified) as “loss” must be charged off immediately.4 For all loans not classified as loss, the ALLL must be increased by (1) losses estimated over the remaining effective lives of loans and leases classified as substandard or doubtful, (2) all losses estimated for the forthcoming 12 months on credits not classified, and (3) estimated losses from transfer risk exposures. A bank’s management is responsible for grading the loan portfolio and making the necessary provisions or charge-offs at least quarterly. Estimated losses on individual credits should meet the criteria for accrual of a loss contingency set forth in U.S. generally accepted accounting principles (GAAP). In addition, supervisors evaluate the adequacy of the overall level of the ALLL based on an analysis of the bank’s policies, practices, and procedures, its historical credit-loss experience and the reasonableness of the management’s overall methodology. Reasonableness is assessed by comparing the actual level of the ALLL against the sum of 50 percent of doubtful and 15 percent of the substandard loans 5 plus estimated losses on other credit exposures (excluding those classified as loss) over the forthcoming 12 months. Shortfalls from this alternative calculation trigger a more intensive review of management’s analysis, but management’s estimates are usually accepted when it has (1) maintained effective systems and controls for identifying, monitoring, and addressing asset-quality problems in a timely manner, (2) reasonably analyzed all significant factors affecting the collectibility of the portfolio, and (3) established an acceptable ALLL evaluation process.

Credit Exposures Involving Cross-Border Transfer Risk

Banks are required to report quarterly on individual country exposures that are significant relative to their capital and the country’s economic performance and to have in place additional procedures for managing associated transfer risk as well as for grading and provisioning against these exposures. An official Interagency Country Exposure Review Committee (ICERC) evaluates and classifies transfer risk exposures to specific countries based on criteria as set forth in the International Lending Supervision Act of 1983.6 Banks are informed about classifications of only those loans specific to their portfolios and adequate safeguards are required to prevent such information being divulged to unauthorized personnel.7 An ICERC classification takes precedence over the general classification guidelines only when it is more severe. The ICERC framework also includes a nonclassified category of exposures that supervisors incorporate into their general assessment of a bank’s asset quality and adequacy of its reserves and capital. This category includes exposures to countries taking economic adjustment measures, generally as part of an IMF program, to restore debt service, or to countries where recent debt service performance indicates that an earlier classification is no longer warranted. The ICERC generally accords more favorable treatment to performing trade credits and bank credits. Measurement of country exposure is also adjusted for guarantees and collateral and the risk is reallocated to the country where the guarantor resides, the collateral is held, or the issuer of stocks or bonds used as collateral resides. The International Lending Supervision Act of 1983 requires banks to set up a separate loss reserve “Allocated Transfer Risk Reserves (ATRR)” for loss provisions on transfer risk exposures classified as “value impaired.” Required provisions are based on mandated percentages unless the loss is directly charged off. The ATRR must be segregated from the ALLL and cannot be considered as part of capital. Allocations to ATRR are not initially required when new loans are made in the context of an IMF-supported or other appropriate economic adjustment program that generally enhances the debt service capability of the country concerned. However, such allocations could be required subsequently on the basis of performance U.S. branches of foreign banks are not subject to the regulations establishing the ATRR but are expected to have in place policies for recognizing and writing off losses on transfer risk exposures. U.S. supervisors evaluate their transfer risk and related procedures.

Source: Board of Governors of the Federal Reserve System (1994), and various supplements updated through May 1999.1 As set forth in the “Interagency Policy Statement on the Allowance for Loan and Lease Losses” issued December 21, 1993.2 Transfer risk is a subset of country credit risk and refers to the borrower’s capacity to obtain the foreign exchange required to service its cross-border debt.3 Banks’ own loan grading systems, when different, must be reconcilable with the regulatory framework.4 The value of credit (net of the realization of the net liquidated value of collateral or realization of guarantees) and the ALLL account must both be reduced by the amount of the loss. All applicable unpaid interest accrued during the current year should be charged against current income and unpaid interest accrued in prior years should be charged off to the ALLL.5 These weights are based on the industry average loss experience over time for these classifications.6 “Substandard” is applied to countries that (1) are not complying with external obligations; (2) are not in the process of adopting an IMF or other suitable economic adjustment program or adhering to such a program; and (3) the country and its bank creditors have not negotiated a viable rescheduling and are unlikely to do so in the near future. “Value impaired” is applied to a country with protracted arrearages as indicated by more than one of the following factors: (1) it has not fully paid interest for six months; (2) it has not complied, nor are there immediate prospects for complying, with an IMF program; (3) it has not met rescheduling terms for over one year; and (4) prospects for an orderly restoration of debt service in the near future are indefinite. “Loss” applies when the loan is considered uncollectible. This classification would apply, for example, if a country were to repudiate its obligations to banks, the IMF, or other lenders.7 The approach for exposures to transfer risk parallels an approach used for credits to large domestic borrowers, the “Shared National Credit Program.”

Implementation of Prudential Standards

To effectively manage the risks from international capital flows, authorities must establish adequate prudential standards in all markets. Recent financial crises have shown that prudential standards fell well short of best practices in many countries, even when judged against norms that do not take account of the more recent advances in this area. Although conforming to prudential standards is often in the self-interest of banks and other financial institutions, prudential standards are also designed to combat moral hazard and related incentives for excessively risky behavior. When prudential regulations and practices differ markedly across countries, this will create opportunities for regulatory arbitrage, reduce the effectiveness of the regulations, and increase systemic risks. In these circumstances, prudential standards in one country will need to take account of the adequacy of prudential standards in other countries. As discussed previously, the Basel Committee’s draft framework for banks’ capital adequacy takes account of countries’ implementation of the Core Principles in setting risk weights; but there may be scope for more systematically using information on countries’ prudential standards. Prudential regulators and supervisors in both advanced economies and emerging markets might have been able to mitigate the Asian financial crisis—the former by taking adequate steps to discourage financial institutions and other investors from exposing themselves to excessive risks in the emerging markets; the latter by putting in place sound and transparent prudential standards that would have limited and made clearer the risks facing international investors.

All countries (especially emerging markets that would benefit directly from reduced risk to their own financial systems) have an interest in establishing adequate prudential standards, but countries with large and advanced markets have a particular responsibility to ensure that their investors and financial institutions are heedful of the risks involved in cross– border transactions. The size of institutional portfolios in the major advanced economies is such that modest changes in their asset distribution can have a significant macroeconomic impact on smaller open economies. The magnitude and rapidity of such portfolio adjustment can be substantial, which leads to excessive inflows into smaller countries and to their later reversal. Rapid portfolio shifts have a number of causes, which fall into two major categories: a failure to draw adequate distinctions between different countries in a region, or different assets in a country; and a “run” on a country or region similar to a bank run.15 Prudential authorities in the large advanced countries will have an interest in limiting these problems to enhance systemic stability. Establishing a regulatory and supervisory framework that obliges investors to more accurately analyze and differentiate countries and assets reduces the first type of shortcoming, generally helps to improve risk management, and may thereby also contribute to limiting the risk of runs.

The establishment and maintenance of prudential standards rest on three pillars: public regulation and supervision, internal practices and controls, and market discipline. Moreover, the prudential supervision and regulation framework must continually adapt to the evolving state of market development and internal governance in individual institutions. Especially in developing countries, one or more of these pillars may be weak. In mature markets, rapid innovations in financial technology pose particular challenges, in that management and supervision cannot sufficiently keep pace with these developments and fail to identify risks in the financial institutions and in the financial system. Large losses incurred by even the most sophisticated institutions in their derivatives and global trading activity point to the seriousness of the risks.

Countries with weak supervisory agencies often, but not always, also suffer from relatively weak skills in the private financial sector, and thus from serious shortcomings in the ability and incentives of financial institutions to adequately manage risk. Directed and connected lending, evergreening of loans, and excessive credit concentration are known to have been the immediate cause of major banking problems in countries, and they may be compounded by weaknesses in the legal system and other governance problems that impede effective monitoring by counterparties and shareholders as well as loan collection efforts. Such financial systems are sometimes said to suffer from a weak “credit culture.” The absence of satisfactory disclosure rules and the inability of the supervisory authorities to enforce them may further weaken the operation of market discipline in such systems. Resolution of these problems is usually not quick, and it must be viewed as part of the overall process of long-term economic development.

Effectiveness of Prudential Measures in Limiting Risks Associated with Capital Flows and the Role of Capital Controls

Prudential policies could contribute importantly to reducing the risks associated with international capital flows, by strengthening the ability of the financial system to withstand volatile market conditions. They may also be useful in reducing the volatility of flows involving financial institutions, which may actually be a principal element of destabilizing capital flows. As discussed in Chapter II, countries that have made substantial progress in this field—for example, Argentina and Chile—have been quite successful in containing the risks from international capital flows.16 On the other hand, a number of the most sophisticated financial institutions have exposed themselves to excessive risks in their cross-border transactions, which underscores the need to adapt prudential policies to innovation in the marketplace. Shortcomings in internal risk management procedures and the failure of supervisors to detect and correct these problems were partly at fault. There may also have been an element of moral hazard in the actions of some financial institutions, brought on by expectations of a bailout. An important potential benefit of improved prudential standards and practices is that supervisors can more easily recognize and prevent financial institutions from engaging in behavior that may in the end necessitate a bailout by the public sector.

While prudential policies are intended to promote soundness, it must be recognized that prudential standards, if not carefully designed and applied, may have unintended and undesirable consequences by providing distorted incentives that result in excessive risk-taking in specific areas, as well as facilitating contagion. Notably, risk-weighting schemes in capital adequacy regulations that do not adequately reflect the riskiness of different borrowers could encourage banks to take on greater than warranted exposure to high-risk borrowers. Similarly, when investments made by institutional investors are required to carry a minimum credit rating, large amounts of capital may be pulled out from a country whose credit rating has been downgraded, thus generating a self-fulfilling downturn in that country. Sophisticated, statistically based risk management techniques, if used to maximize trading profits by exploiting correlations between markets without good judgment as to the limitation of such correlations, may prove to be quite vulnerable in periods of stress when historical relationships between markets break down. In such cases, a rush to close down loss-making positions may further accentuate market volatility.

Prudential policies must also strike an appropriate balance between reducing the threat of excessive risk-taking and constraining the freedom of institutions to take the normal risks inherent in financial intermediation. In this connection, care must be taken so that regulations are not oriented toward controlling capital flows at the expense of weakening the role of prudential policies in maintaining the safety and soundness of financial institutions. Although cross-border transactions often entail added dimensions of risk (such as foreign exchange risk), this does not necessarily mean that these transactions or assets are inherently riskier than domestic assets. Nor, for that matter, do the risks related to external transactions and assets usually comprise a major part of risks run by institutions. Indeed, prudential regulations based excessively on the foreign-domestic distinction will not be effective in addressing financial risks.

Although prudential measures and improved risk management at individual institutions can help to limit the risks associated with international capital flows, they will not be able to discourage all unsustainable flows. Prudential measures cannot be so strict as to kill off risk-taking activity altogether, and carefully managed risk-taking strategies could unravel under unexpected shocks. Sentiments can also override the best prudential measures. Moreover, prudential measures target financial intermediaries that manage other people’s money, and are not intended to regulate the portfolio decisions of individuals and nonfinancial corporations that invest their own funds.17 For example, cross-border portfolio investment may lead to a speculative asset price bubble, just as a bubble may arise in domestic financial markets. The collapse of a bubble can have serious macroeconomic consequences, partly because declining asset prices affect wealth and private consumption. Prudential regulations may help to reduce the effects of an asset price deflation on financial institutions, thereby mitigating its consequences for real activity, but they may not be able to prevent such an event from occurring.

When prudential standards and practices are weak, and possibly when institutions that are outside the scope of prudential policies (such as nonfinancial firms) are an issue, other measures, including capital controls, may prove useful in managing the specific risks associated with international capital flows.18 As discussed in Chapter II, capital controls differ in how effectively they perform a prudential function (when they are used for this purpose); and in how severely they distort resource allocation in financial and other markets. Capital controls also differ in how difficult they are to administer and how effectively they can be enforced. As with all types of economic regulation, including prudential regulation, unintended side effects may arise, and individual controls must be judged not in isolation but only in the context of a country’s overall regulatory and institutional framework.

The design of a well-functioning system of capital controls to serve a prudential function is thus a complex task. Outright prohibitions of capital transactions may be easiest to administer and enforce, but only when controls are fairly comprehensive. If current payments and some capital transactions have been liberalized, such controls may be circumvented, for example by disguising controlled transactions as uncontrolled ones; or by duplicating the payoffs of a restricted contract with an unrestricted one. The principal drawback of a blanket prohibition is that it will preclude sound as well as risky transactions, and may therefore be highly distortionary. Introducing elements of administrative discretion—such as a licensing system for capital flows—can alleviate this problem somewhat but is administratively more costly and may raise governance issues. Price-based controls modeled on prudential regulations, such as the unremunerated reserve requirement on inflows used by Chile, are less distortionary. However, such controls are generally more difficult to administer and enforce than outright prohibitions, and possibly than quantitative restrictions. Loopholes in their coverage will need to be identified and closed as they are progressively exploited by arbitrageurs. The ultimate complexity and demands on a country’s administrative capacity of such controls may thus be similar to that of prudential regulation and supervision. They may nonetheless prove useful in countries where other pillars of a functioning prudential system (market discipline, transparency and internal controls in financial institutions) are weak.

Conclusions

The use of prudential policies in coping with the risks associated with capital flows needs to be analyzed further, in terms of both understanding how they best function and studying actual implementation by countries. Despite the relatively favorable experiences of a number of countries that have strengthened their supervisory regimes, country experiences still offer only limited evidence on how well prudential measures can limit the risks associated with capital flows, and additional work is needed on this point. Nonetheless, the discussion above highlights the need for a careful design of policy, the risks of targeting capital flows at the expense of the safety and soundness of institutions, and the importance of implementation capacity—a particularly demanding challenge for emerging markets.

The use of capital controls in pursuing prudential objectives is more controversial. The positive role that controls may potentially play in an environment of weak supervisory systems is tempered by the difficulty of administering a sophisticated system of controls and the distortionary effects that simpler direct controls may have.

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