Capital inflows and bank stability around the financial crisis: The mitigating role of macro-prudential policies

Abstract

While capital inflows bring a number of benefits to recipient countries, they may also exacerbate some risks including financial instability. In this paper, we propose that cross-country differences in the financial stability of individual banks can be explained, among other things, by cross-country differences in capital inflows. Using disaggregated inflows for 85 developing countries over the period 2000–2014, we find some empirical evidence supporting our proposition. In particular, we find that before the crisis (2000–2007), bank financial stability improved ifmore capital flows – in the form of lending investments – were directed to developing countries. On the other hand, after the crisis (2010–2014), bank financial stability decreased if more foreign capital – in the form of portfolio and/or lending investments – moved to such countries. These findings emphasize the destructive role financial crises play by preventing developing economies from reaping the financial stability benefits of cross-border flows. Given the recent popularity of macro-prudential policies as tools for promoting financial stability, we next examine whether cross-country activations of prudential instruments effectively alleviate such adverse effects of capital inflows on bank stability. We find that the negative impact of capital inflows is indeed mitigated if countries adopt macro-prudential measures, specifically by imposing limits on foreign currency lending.