Thanos Andrikopoulos is associate professor in finance at the University of Hull
There has been a remarkable push towards liberalising international capital flows around the world in recent years.
Conventional wisdom regarding capital inflow liberalisation is that it supports economic growth and attracts foreign investment. However, as I discovered in a recent study, there are less-discussed aspects of this narrative that threaten individual banks’ solvency. This, in turn, increases the risk of a banking crisis.
Together with Kexin Li of Peking University and Zhongfei Chen of Jinan University, I analysed the impact of capital inflow liberalisation on bank credit risk. We used data from 2207 banks across 45 emerging economies between 2009 and 2020, using non-performing loans as a proxy for bank credit risk and focusing on individual banks.
Emerging market example
There is a reason for the emphasis on emerging economies, which are characterised by greater volatility in capital flows. Since this makes them more susceptible to the consequences of liberalisation, understanding its effect on emerging economics is vital to the shaping of effective financial market regulation.
The definition of financial liberalisation, with a specific focus on capital inflows, is also central. When talking about financial liberalisation, it is also important to focus on capital inflows since these weigh more heavily on domestic financial markets than outflows.
As the gates of international capital flows open wider, emerging market banks struggle with increased competition and greater demand for riskier loans, which damages their traditional revenues. Meanwhile, the intensified competition resulting from capital inflow liberalisation leads to lower credit growth (a measure of traditional banking activities) and a higher ratio of non-interest income to bank operating revenues (a measure of non-traditional banking activities) compared to pre-liberalisation levels.
Increased competition in certain markets could also wipe out smaller banks as they struggle with lending to riskier clients without the strong risk management capabilities of their larger counterparts. Larger banks, in contrast, enjoy a distinct advantage as they can leverage their superior risk management skills to weather the storm of problem loans with relative ease. Their market power and ability to comply with regulatory requirements further reinforce their resilience.
Macroprudential policies can be instrumental in moderating liberalisation shocks, as they play a key role in balancing the objectives of promoting banking competition and mitigating bank credit risk — ultimately promoting a more stable banking environment.
Central banks and regulatory agencies have several regulatory measures at their disposal to enhance the stability of the banking system. These can broadly be categorised as institution-based or supply-side tools (such as limits to credit growth and loan loss provisions); and demand-side or borrower-based tools (such as loan-to-value and debt-service-to-income ratios).
The right tools
The importance of institution-based macroprudential policy tools, as opposed to borrower-centric approaches, cannot be overstated, especially in emerging and developing economies with underdeveloped financial markets.
Moreover, institution-based tools have the advantage of directly targeting banks. A major example is countercyclical capital buffers, which act as automatic stabilisers for the banking system since they require banks to accumulate additional capital during economic expansion.
It is crucial to understand the transmission mechanisms part of the complex relationship between capital inflow liberalisation and bank credit risk. From expanding companies’ financing channels to the weakening of banks’ market power, these mechanisms emphasise the need for focused attention and strategic responses.
An important implication for policymakers, especially in emerging economies, is that they need to closely monitor the risks arising from capital inflow liberalisation. Specifically, they should pay attention to the credit risk profiles of individual banks amid liberalisation to ensure the health of the financial system.
Protecting financial stability requires an approach that considers the unique challenges and opportunities faced by banks within their domestic markets. The implementation of careful macroprudential policies can help policymakers to promote a more stable banking environment, and ensure the benefits of liberalisation are realised while mitigating its associated risks.
