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Topics in Financial Stability

Paper Session

Friday, Jan. 4, 2019 10:15 AM - 12:15 PM

Atlanta Marriott Marquis, M102
Hosted By: American Economic Association
  • Chair: Jonathan Kreamer, Florida State University

How ETFs Amplify the Global Financial Cycle in Emerging Markets

Nathan Converse
Federal Reserve Board
Eduardo Levy Yeyati
Torcuato di Tella University
Tomas Williams
George Washington University


Since the early 2000s exchange-traded funds (ETFs) have grown to become an important investment
vehicle worldwide. In this paper, we study how their growth affects the sensitivity of international capital flows to the global financial cycle. We combine comprehensive fund-level data on investor flows with a novel identification strategy that controls for unobservable time-varying economic conditions at the investment destination. For dedicated emerging market funds, we find that the sensitivity of investor flows to global risk factors for equity (bond) ETFs is 1.5 (1.25) times higher than for equity (bond) mutual funds. In turn, we show that in countries where ETFs hold a larger share of financial assets, total cross-border equity flows and prices are significantly more sensitive to global risk factors. We conclude that the growing role of ETFs as a channel for international capital flows amplifies the incidence of the global financial cycle in emerging markets.

How International Reserves Reduce the Probability of Debt Crises

Inter-American Development Bank


Many emerging economies maintain significant positions in both external sovereign debt and foreign reserves, paying spreads of over 250 basis points on average. Arguments advanced in empirical work and policy discussions suggest that governments may do this because international reserves play a role in reducing the likelihood of sovereign debt crises, improving a country's access to debt markets. This paper proposes a model that justifies that argument. The government makes optimal choices of debt and reserves in an environment in which self-fulfilling rollover crises a-là Cole-Kehoe and external default a-là Eaton-Gersovitz coexist. This allows for both fundamental and market-sentiment-driven debt crises. Self-fulfilling crises arise because of a lender's coordination problem when multiple equilibria are feasible. Conditional on the country's Net Foreign Asset position, additional reserves make the sovereign more willing to service its debt even when no new borrowing is possible, which enlarges the set of states in which repayment is the dominant strategy, reducing the set of states that admit a self-fulfilling crisis. From an ex-ante perspective, reserves reduce the probability of crises in the future which lowers current sovereign spreads. The result depends on the existence of roll-over risk and debt not being limited to one period debt. This paper advances existing models by highlighting the role of reserves not only as insurance against self-fulfilling crises but also in reducing the probability of these events. The results line up with the empirical literature on vulnerability measures to sovereign debt crises that shows the connection between reserves, the probability of debt crises and sovereign spreads. Quantitatively the model can explain 50\% of Mexico's international reserves holdings, while accounting for key cyclical facts, showing the relevance of the proposed mechanism.

Interest Rates, Market Power, and Financial Stability

Rafael Repullo
David Martinez-Miera
University Carlos III of Madrid


This paper analyzes the effects of policy rates on financial intermediaries' risk-taking decisions. We consider an economy where (i) intermediaries have market power in granting loans, (ii) intermediaries monitor borrowers which lowers their probability of default, and (iii) monitoring is not observable which creates a moral hazard problem. We show that lower policy rates lead to lower intermediation margins and higher risk-taking when intermediaries have low market power, but the result reverses for high market power. We also show that when intermediaries have high market power competition from (nonmonitoring) financial markets results in a U-shaped relationship between policy rates and risk-taking. The paper examines the robustness of these results to introducing heterogeneity in monitoring costs, entry and exit of intermediaries, and funding with deposits and capital.

Gambling Traps

Anil Ari
International Monetary Fund


I propose a dynamic general equilibrium model in which strategic interactions between banks and depositors may lead to endogenous bank fragility and slow recovery from crises. When banks' investment decisions are not contractible, depositors form expectations about bank risk-taking and demand a return on deposits according to their risk. This creates strategic complementarities and possibly multiple equilibria: in response to an increase in funding costs, banks may optimally choose to pursue risky portfolios that undermine their solvency prospects. In a bad equilibrium, high funding costs hinder the accumulation of bank net worth, leading to a persistent drop in investment and output. I bring the model to bear on the European sovereign debt crisis, in the course of which under-capitalized banks in default-risky countries experienced an increase in funding costs and raised their holdings of domestic government debt. The model is quantified using Portuguese data and accounts for macroeconomic dynamics in Portugal in 2010-2016. Policy interventions face a trade-off between alleviating banks' funding conditions and strengthening risk-taking incentives. Liquidity provision to banks may eliminate the good equilibrium when not targeted. Targeted interventions have the capacity to eliminate adverse equilibria.

Sovereign Debt in Emerging Markets: A Sign of Growth or a Crisis?

Aleksandr V. Gevorkyan
St. John's University
Ingrid Harvold Kvangraven
University of York


This paper critically evaluates the recent trends of rising foreign and local currency indebtedness in smaller economies in a broad emerging markets group—across Eastern Europe, Central Asia, Africa, Latin America, and Southeast Asia. The paper develops a unique dataset for representative countries from each region and empirically assesses evidence on drivers of the different forms of debt. The significant build-up in sovereign debt has prompted concerns over a crisis in the periphery. Here, exchange rate risks remain significant for the smaller import-dependent economies, despite the recent rise in local currency bonds. At the same time, ability to tap international capital markets in attracting multi-currency debt subscriptions could indicate improving macroeconomic and governance structures. This paper finds a range of factors affecting emerging borrowers’ terms and costs of borrowing. Aside from the internal macroeconomic conditions, much of those factors remain outside of the control of the countries in question. The main results of this paper find practical application across economic development spectrum as well as inform the influential ESG-driven global asset allocation models.
JEL Classifications
  • F3 - International Finance