Key policy messages
- The experience of recent years has underlined the need for reducing financial fragility and the risk of financial crises.
- As with earlier episodes of financial crises, countries that were severely hit via their external account during the global financial crisis had for the most part previously seen a substantial run-up in the share of debt in total external liabilities.
- New empirical analysis covering OECD and emerging economies over the past four decades finds that the structure of a country’s external liabilities, more than the overall level, is a key determinant of the vulnerability to financial crises.
- The analysis shows more specifically that factors which increase crisis risk include a bias in gross external liabilities towards debt, in particular bank debt, currency mismatch and shorter banking debt maturities.
- The analysis also finds that the extent and nature of international financial integration, in particular of the banking sector, have contributed to the propagation of the crisis.
- On the one hand, integration through FDI is not found to raise financial risk, but on the other hand international banking integration has been a major vector of contagion, and even more so when cross-border bank lending was primarily short-term.
- Vulnerability to contagion has been lower in situations of abundant global liquidity, underlining the importance of major central banks ensuring that ample international liquidity is provided at times of financial turmoil.
- Structural policies can increase financial stability, typically through their effects on the external financial account structure or on the vulnerability to contagion-induced financial shocks.
- The trends towards lower barriers on foreign direct investment, and the easing of product market regulations in the majority of advanced economies have increased financial stability by shifting external liabilities from debt, including bank debt, towards FDI.
- In contrast, tax systems that continue to favour debt finance over equity finance have undermined stability by increasing the share of debt, including external debt, in corporate financing.
- Targeted controls on capital inflows from credit operations, where they have been applied, appear to have reduced the impact of financial contagion, not least by shifting the structure of external liabilities.
- Adequate financial regulation, banking supervision and macroprudential regulation have also strengthened financial stability.
- Stricter information disclosure rules and capital requirements, as well as strong supervisory authorities have been found to reduce countries' financial crisis risk. Nonetheless, action by individual countries in this area – while warranted – risks leading to regulatory arbitrage and greater harmonisation and international cooperation of supervision would therefore be desirable.
- Macroprudential regulations that protect against excessive domestic credit growth reduce the risk of financial crises. Similarly, the removal of policy-induced distortions favouring mortgage debt and the build-up of housing price bubbles would help raising stability.