Working Paper: NBER ID: w14779
Authors: Joshua Aizenman
Abstract: This paper discusses two pertinent issues dealing with the global liquidity crisis -- global prudential regulation reform, and reassessment of using international reserves in the crisis. We point out the paradox of prudential regulations -- while the identity of economic actors that benefited directly from crises avoidance is unknown, the cost and the burden of regulations are transparent. Hence, crises that had been avoided are imperceptible and are underrepresented in the public discourse, and the demand for prudential regulations declines during prolonged good times, thereby increasing the ultimate cost of eventual crises. While the seeds of the present crisis were mostly home grown, international flows of capital magnified its costs. Global financial integration produces the by-product of "regulatory arbitrage" -- capital tends to flow to under regulated countries, frequently resulting in excessive risk taking, in anticipation of future bailout. A coordinated globalized prudential regulation, by increasing the cost of prudential deregulation, may mitigate the temptation to under-regulate during prolonged good-times, thus adding a side benefit. We also analyze the different approaches to the use of reserves during the crisis and what this means for the global financial system. The deleveraging triggered by the crisis implies that countries that hoarded reserves have been reaping the benefits. The crisis illustrates the importance of the self insurance provided by reserves, as well as the usefulness of policies that channel a share of the windfall gains associated with improvements in the terms-of-trade to reserves and sovereign wealth funds. The reluctance of many developing countries to draw down on their reserve holdings raises the possibility that they may now suffer less from the "fear of floating" than from a "fear of losing international reserves", which may signal deterioration in the credit worthiness of a country.
Keywords: prudential regulations; international reserves; global liquidity crisis; financial integration; sovereign wealth funds
JEL Codes: F15; F36; F55
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| performance of regulators (G18) | demand for regulatory oversight (G18) |
| demand for regulatory oversight (G18) | underregulation (L51) |
| underregulation (L51) | financial crises (G01) |
| capital flows to underregulated countries (F32) | excessive risk-taking (G41) |
| excessive risk-taking (G41) | financial crises (G01) |
| failure to implement proper regulations (G18) | moral hazard (G52) |
| moral hazard (G52) | risk-taking behavior (D91) |
| risk-taking behavior (D91) | financial crises (G01) |
| global financial integration (F30) | crisis costs (H12) |
| underregulated markets (G18) | excessive risk-taking (G41) |
| regulatory environment (G38) | systemic risks (F65) |