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A Gravity Model of Geopolitics and Financial Fragmentation
Do geopolitical tensions between countries influence the cross-border asset allocation of investment funds? Our answer is yes. We estimate gravity models and find that investment funds allocate smaller shares of their portfolios to recipient countries that are geopolitically more distant to their country of origin—with geopolitical distance measured by dissimilarity in countries’ voting behavior in the United Nations General Assembly. We also find an investment diversion effect: a recipient country attracts additional investments when its source countries get geopolitically more distant to third-party countries. These results are robust to instrumenting geopolitical distance and using alternative distance measures.
Geoeconomic Fragmentation and International Diversification Benefits
This paper applies the two-country open-economy model with trade in stocks and bonds of Coeurdacier et al. (2010) to quantify the loss of international diversification benefits for major advanced economies, which have a significant presence in international financial markets, under geoeconomic fragmentation. We perform counterfactual simulations under different hypothetical fragmentation scenarios in which these economies are unable to trade with geopolitically distant countries, as measured by voting disagreement on foreign policy issues at the United Nations General Assembly meetings during 2012-2021. The simulation results imply a potentially significant loss of international diversification benefits of financial openness for the considered advanced economies by limiting trading to partner countries that are geopolitical allies with highly synchronized business cycles.
Corporate Funding and the COVID-19 Crisis
This paper assesses whether corporate liquidity needs in the G7 economies were met during the containment phase of the COVID-19 pandemic (February-June 2020) using various approaches to identify credit supply shocks. The pandemic crisis adversely affected nonfinancial corporate sector cash flows, generating liquidity and solvency pressures. However, corporate borrowing surged in March and into the second quarter, thanks to credit line drawdowns and unprecedented policy support. In the United States, the bond market was buoyant from the end of March onward, but credit supply conditions for bank loans and the syndicated loan market tightened. In other G7 economies, credit supply conditions generally eased somewhat across markets during the second quarter. Among listed firms, entities with weaker liquidity or solvency positions before the onset of COVID-19, as well as smaller firms, suffered relatively more financial stress in some economies in the early stages of the crisis. Residual signs of strain remained as of the end of June. Policy interventions, especially those directly targeting the corporate sector, had a beneficial effect on credit supply overall.
Cryptic Connections
Crypto assets have emerged as an increasingly popular asset class among retail and institutional investors. Although initially considered a fringe asset class, their increased adoption across countries—in emerging markets, in particular—amid bouts of extreme price volatility has raised concerns about their potential financial stability implications. This note examines the extent to which crypto assets have moved to the mainstream by estimating the potential for spillovers between crypto and equity markets in the United States and in emerging markets using daily data on price volatility and returns. The analysis suggests that crypto and equity markets have become increasingly interconnect...
Post-Crisis Changes in Global Bank Business Models: A New Taxonomy
The Global Financial Crisis unleashed changes in the operating and regulatory environments for large international banks. This paper proposes a novel taxonomy to identify and track business model evolution for the 30 Global Systemically Important Banks (G-SIBs). Drawing from banks’ reporting, it identifies strategies along four dimensions –consolidated lines of business and geographic orientation, and the funding models and legal entity structures of international operations. G-SIBs have adjusted their business models, especially by reducing market intensity. While G-SIBs have maintained international orientation, pressures on funding models and entity structures could affect the efficiency of capital flows through the bank channel.
The COVID-19 Impact on Corporate Leverage and Financial Fragility
We study the impact of the COVID-19 recession on capital structure of publicly listed U.S. firms. Our estimates suggest leverage (Net Debt/Asset) decreased by 5.3 percentage points from the pre-shock mean of 19.6 percent, while debt maturity increased moderately. This de-leveraging effect is stronger for firms exposed to significant rollover risk, while firms whose businesses were most vulnerable to social distancing did not reduce leverage. We rationalize our evidence through a structural model of firm value that shows lower expected growth rate and higher volatility of cash flows following COVID-19 reduced optimal levels of corporate leverage. Model-implied optimal leverage indicates firms which did not de-lever became over-leveraged. We find default probability deteriorates most in large, over-leveraged firms and those that were stressed pre-COVID. Additional stress tests predict value of these firms will be less than one standard deviation away from default if cash flows decline by 20 percent.
Is Digital Financial Inclusion Unlocking Growth?
Digital financial services have been a key driver of financial inclusion in recent years. While there is evidence that financial inclusion through traditional services has a positive impact on economic growth, do the same results carry over for digital financial inclusion? What drives digital financial inclusion? Why does it advance more in some countries but not in others? Using new indices of financial inclusion developed in Khera et. al. (2021), this paper addresses these questions for 52 developing countries. Using cross-sectional instrument variable procedure, we find that the exogenous component of digital financial inclusion is positively associated with growth in GDP per capita during 2011-2018, which suggests that digital financial inclusion can accelerate economic growth. Fractional logit and random effects empirical estimation identifies access to infrastructure, financial and digital literacy, and quality of institutions as key drivers of digital financial inclusion. These findings are then used to help inform policy recommendations in areas related to the digitization of financial services to promote financial inclusion.
Global Financial Stability Report, April 2021
Extraordinary policy measures have eased financial conditions and supported the economy, helping to contain financial stability risks. Chapter 1 warns that there is a pressing need to act to avoid a legacy of vulnerabilities while avoiding a broad tightening of financial conditions. Actions taken during the pandemic may have unintended consequences such as stretched valuations and rising financial vulnerabilities. The recovery is also expected to be asynchronous and divergent between advanced and emerging market economies. Given large external financing needs, several emerging markets face challenges, especially if a persistent rise in US rates brings about a repricing of risk and tighter fi...
Money Creation in Fiat and Digital Currency Systems
To support the understanding that banks’ debt issuance means money creation, while centralized nonbank financial institutions’ and decentralized bond market intermediary lending does not, the paper aims to convey two related points: First, the notion of money creation as a result of banks’ loan creation is compatible with the notion of liquid funding needs in a multi-bank system, in which liquid fund (reserve) transfers across banks happen naturally. Second, interest rate-based monetary policy has a bearing on macroeconomic dynamics precisely due to that multi-bank structure. It would lose its impact in the hypothetical case that only one (“singular”) commercial bank would exist. We link our discussion to the emergence and design of central bank digital currencies (CBDC), with a special focus on how loans would be granted in a CBDC world.
Global Financial Stability Report, October 2021
Financial stability risks have been contained so far, reflecting ongoing policy support and a rebound in the global economy earlier this year. Chapter 1 explains that financial conditions have eased further in net in advanced economies but changed little in emerging markets. However, the optimism that propelled markets earlier in the year has faded on growing concerns about the strength of the global recovery, and ongoing supply chain disruptions intensified inflation concerns. Signs of stretched asset valuations in some market segments persist, and pockets of vulnerabilities remain in the nonbank financial sector; recovery is uneven in the corporate sector. Chapter 2 discusses the opportunities and challenges of the crypto ecosystem. Crypto asset providers’ lack of operational or cyber resilience poses risks, and significant data gaps imperil financial integrity. Crypto assets in emerging markets may accelerate dollarization risks. Chapter 3 shows that sustainable funds can support the global transition to a green economy but must be scaled up to have a major impact. It also discusses how a disorderly transition could disrupt the broader investment fund sector in the future.
