UC Davis

Financial markets have been central to academic and policy debates for decades and are crucial to the functioning of economies. However they occasionally lead to financial crises, which have been associated with several and severe downturns in economic activity. Particularly since the 2008 Financial Crisis, a lively literature on appropriate financial regulation emerged. At the forefront of regulatory interventions are macroprudential policies. Macroprudential policies are implemented ex-ante and are supposed to reduce the likelihood and costs of a potential future crisis. Common macroprudential policies resort to countercyclical equity buffers or leverage and liquidity constraints. More recently, a new literature emerged that justifies capital controls from a macroprudential perspective. All of these policies are appealing, because they are incentive compatible and do not require a large fiscal or monetary stimulus.

This dissertation evaluates macroprudential policies in an international context both from a theoretical and applied perspective. The international context is important since financial markets are global, yet little is known about the effects of financial interlinkages on financial regulation. A specific focus of this dissertation is on capital controls, which received renewed interest in the policy debate to limit external overborrowing.

In my first chapter I study the strategic interactions between national regulators in a model of international prudential liquidity regulation. The model justifies coordinated liquidity regulation due to an international fire-sale externality. However, I theoretically and empirically argue that domestically oriented regulators from countries with a smaller banking sector do not internalize the global benefits of regulation and therefore do not adhere to international standards. In terms of policy recommendations, the model justifies capital controls if countries do not cooperate. Though capital controls improve the welfare of regulating economies, they also align the interest of free-riding countries with international regulation.

The second chapter (joint work with Florian Loipersberger) empirically analyzes financial spillovers from advanced economies towards emerging markets. The comovement of financial markets has raised concerns about the ability of emerging market economies to insulate their economy from international financial shocks. We empirically show that capital controls are as potent as floating exchange rates in dampening the response of international financial shocks on domestic financial variables and the real economy. We relate this finding to muted boom-bust cycles in short-term non-resident capital flows. However, the benefits of floats or capital controls are reaped in isolation, i.e. either tool is enough. We argue that these patterns can be explained by nominal frictions in labor markets and provide empirical support for this claim.

In the third chapter, I ask a very simple question: How should countries balance macroprudential capital controls and pure domestic or international prudential policies. I introduce a domestic financial market into an otherwise standard small open economy model with an occasionally binding international borrowing constraint. The key result is that capital controls or international macroprudential policies should be accompanied by purely domestic macroprudential instruments even when domestic markets are frictionless. Intuitively, domestic regulation is welfare enhancing because it shifts resources towards agents who are not able to borrow internationally and as a consequence have a higher propensity to consume. I provide a simple formula that links the degree of domestic regulation to the level of international regulation, the cost of regulation, the investment profitability and the underlying inefficiency in the international financial market.