Destination of Global Liquidity Before the Global Financial Crisis: Role of Foreign Bank Presence and the EU Effect

Abstract

AbstractThe global liquidity cycle, or extraordinary supply and acute retrenchment of cross-border bank flows before and after the global financial crisis, was one of the major factors of the crisis. While the cause and development of the post-crisis retrenchment of bank flows have been examined, we have less understood the development of the pre-crisis over-expansion of bank flows and the status of the cross-country distribution of global liquidity during its surge period before the crisis. We explore the determinants of cross-country variabilities in global liquidity inflows between 2004 Q2 and 2008 Q1 by running cross-country regressions on 97 countries and defining cross-border bank-to-bank credit inflows as global liquidity. Our empirical results highlight the presence of foreign banks in host banking systems at the beginning of the global liquidity surge period is a significant pull factor of global liquidity inflows. In addition, the volume of global liquidity inflow to a country is affected by the region to which the country belongs. Before the global financial crisis, global liquidity flows were highly concentrated in EU members’ banking systems. Banks located in EU member countries have received cross-border bank credit (relative to the 2004 GDP) by 20–30 percentage points larger than banks outside the EU. This EU effect cannot explain other possible determinants of cross-border bank inflows, such as the development of institutions and banking system stability. Countries with less strictly regulated banking systems received larger inflows of global liquidity, in line with the predictions of the regulatory arbitrage hypothesis.KeywordsCross-border bank flowsDestination of capital flowsForeign banks’ penetrationEuropean UnionRegulatory arbitrage