Neighbours matter
Stephen G Cecchetti1
Economic Adviser and Head of the Monetary and Economic Department,
Bank for International Settlements
Remarks prepared for the Second Annual Fall Conferenceof the International Journal of Central Banking,Tokyo, 3 September 2010

Let me start by thanking Frank Smets for inviting me to participate and the Bank of Japan forextending their hospitality. It is a privilege and an honour to speak this afternoon at theSecond Annual Fall Conference of the International Journal of Central Banking. And it is apleasure to visit Tokyo.
We have learned many policy lessons from the crisis. One of them is simple andstraightforward: your neighbours matter. This is especially true for the big ones.
The intuition is very similar to what we carefully consider when buying a house. Neighbours
matter. They determine to a large degree the value of your own house. For instance, even if
you keep your house and yard pristine, the fact that your neighbours don’t will affect yourability to enjoy your house.
This analogy, I believe, translates to monetary and financial policy. Even if you maintaindomestic price and financial stability, you can still be susceptible to disturbances, possibly
severe ones, originating from abroad.
In my remarks, I will discuss why neighbours matter, and then turn to the implications of thisfor policy. First, I describe some straightforward examples that underline what everyone now
knows: financial shocks affect innocent bystanders just as real shocks do. I believe thatthese examples show that good domestic policies are not enough. They are necessary, butthey are definitely not sufficient. For good economic policy, we also need new informationand new tools – to prevent, and perhaps to manage, future crises. In particular, we needinternational cooperation, coordination and consistency.
Crisis propagation mechanisms
One obvious solution to the problem of cross-border shocks is to become self-sufficient. Butautarky is a pretty extreme response to the neighbour problem. You do not respond to theunkemptness of your neighbour’s yard by moving to an island or to an isolated house in themiddle of a forest.
Similarly, severing international financial linkages is not the best way to stop a crisis
propagating. I think that you would all agree that economic globalisation has clear benefits. If
we are to reap those benefits, we have to maintain the momentum towards global financial
integration. Hence, we should not erect new national barriers, as they would also prevent us

1I would like to thank Előd Takáts for his assistance. The views expressed here are those of the author and do notnecessarily reflect those of the BIS.

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from taking advantage of the positive effects of globalisation. Instead, we need to make surethat national authorities are confident that they will not be punished for their openness.
Achieving this goal means first understanding the nature of the shocks and of thetransmission mechanisms that can create problems for even the most conscientious
authorities. In the following remarks, I describe two examples of such cross-border financial
shock propagation. First, what happened in cross-border bank lending to emerging markets.
Second, the experiences of FX swap markets.
During normal times, cross-border bank lending serves to channel funds from advanced toemerging economies. Presumably, international and global banks are shifting resources fromregions with low growth, low marginal product of capital, and low rates of return to those withhigh growth, high marginal product of capital, and high rates of return. This transfer takes
place swiftly and with minimal friction. This would seem like an unambiguously good thing.
However, the system, great in normal times, can turn against us in a crisis (Graph 1). Crossborder bank lending to all emerging market regions developed rapidly until late 2008.
However, during the financial crisis we witnessed a dramatic turnaround (Graph 1, left-handpanel).
Furthermore, this recent decline was primarily a consequence of reduced loan supply(Graph 1, right-hand panel). My BIS colleagues separated the changes in cross-border banklending to emerging market economies into components due to supply and demand. The
analysis suggests that, during the crisis, supply factors were dominant. It seems thatinternational banks limited, or perhaps were forced to limit, cross-border bank lending when it
was possibly most needed in emerging markets. In sum, the strong decline in late 2008 was
not a home-grown problem.
Graph 1
Cross-border lendingConsolidated cross-border foreign claims of reportingbanks on emerging markets1
1,800

2Asia
3Latin America
4Emerging Europe
5Africa & Middle East

2005

Demand and supply factors in cross-border banklending to emerging markets62006

2007

1,500

2008

2009

Cross-border lending
8
Demand factors
9
Supply factors

15

7

10

1,200

5900

0600

–5300–100
2010

–15
2005

2006

2007

2008

2009

1In billions of US dollars. 2 China, Chinese Taipei, Hong Kong SAR, India, Indonesia, Korea, Malaysia, the Philippines, Singaporeand Thailand. 3 Argentina, Brazil, Chile, Colombia, Mexico, Peru and Venezuela. 4 The Czech Republic, Hungary, Poland andRussia. 5 Saudi Arabia, South Africa and Turkey. 6 Demand and supply model reported in Table 1 of the June 2010 BIS Quarterly
Review; for each quarter, the graph shows the average estimated forecasts across countries in the sample; average quarter-on-quarterchanges, in per cent. 7 Quarter-on-quarter growth rate (logarithmic) in BIS reporting banks’ cross-border gross claims vis-à-vis eachcountry; actual data, in per cent. 8 Quarter-on-quarter growth rate (logarithmic) in seasonally adjusted nominal GDP in US dollar
terms times its panel coefficient estimate plus a share of constant and country fixed effects. 9 Volatility of the S&P Financials Index
times the panel coefficient plus a share of constant and country fixed effects. The constant and fixed effects are divided between
demand and supply factors in the ratio of the appropriate standalone estimate constants and fixed effects.
Sources: Datastream;BIS estimates.

My second example is the FX basis swap market. FX basis swap spreads can be thought ofas a measure that combines currency shortages and money market stresses. Arbitrage

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theory tells you that, absent currency shortages or money market stresses, the spreadshould be zero. And, in spite of obvious frictions, it usually is close to zero. That is, normallythere are no currency shortages, and neither emerging nor advanced economy money
markets experience any significant stresses.
However, during the financial crisis, emerging market spreads skyrocketed (Graph 2, lefthand panel). The graph shows stress in four markets: Korean won, Hungarian forint, Turkishlira and Malaysian ringgit. The scale is in basis points. The negative spread tells you howmuch you will have to pay for US dollars in a transaction. Interestingly, Graph 2 tells us thatthe stress did not come entirely unexpectedly – there were signs well before Lehman (seethe vertical line). In the case of the Korean won, the spread was more than 200 basis points
before the Lehman failure, rising to 600 basis points at the peak of the crisis.

Graph 2Cross-currency basis swap spreads against the US dollar, one-year maturity1In basis points
Emerging market currencies

Major currencies
2005000–200
KRW
HUF
TRY
MYR

–400

–50
EUR
GBP
JPY–100–600
2006
12007

2008

2009

2010

–150
2006

20072008

2009

2010

The vertical line marks 15 September 2008, the date on which Lehman Brothers filed for Chapter 11 bankruptcy protection.

Source: Bloomberg.

Furthermore, the stress was not only an emerging market phenomenon. The crisis also
massively affected the major advanced economies and their currencies: the euro, sterling
and the yen (Graph 2, right-hand panel). This indicates that it was not only emerging market
money market risk that was moving spreads. Rather, both advanced and emerging
economies were subject to money market stress. Also, there was a shortage of US dollars. Infact, people with dollars were able to, and did, make quite a bit of money.
Good domestic policies are not enough
These examples show that financial shocks travel very quickly across international borders.
Importantly, good domestic policies are not enough to stop these shocks. If foreign banks
decide to stop lending to everyone, you can be the best, most creditworthy borrower in theworld and it won’t help.
My view is that most emerging economies learned the hard lessons from crises in the past
decade. They learned about the dangers of currency mismatches and of weakly capitalisedbanking systems. And they avoided these mistakes this time around. They reformed theirfinancial systems and increased their foreign exchange reserves – in many cases
substantially.

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During this crisis, the problems came from outside. As Guillermo Ortiz, former Governor of
the Bank of Mexico, said: “This time, it was not us!” Advanced economies didn’t think they
could possibly be the source of this sort of problem. After all, they had learned how to runmonetary policy. They used interest rate instruments to hit inflation targets, which they
thought would isolate financial shocks within the financial system and ensure real stability.
However, when the policies of the advanced economies failed, the problems travelled at thespeed of light to the emerging economies. And domestic price and financial stability inemerging markets didn’t stop these shocks.
This raises the question: what else do we need if domestic price and financial stability are notenough?
Need for new information and new instruments
In short, we need new information and we need new instruments. And, you will not be
surprised to hear me say, effective international cooperation.
Starting with information, we need to know what risks are present and how they are likely to
be transmitted. In general, the problem is not what we know and monitor, but what we do not
know. There are data gaps. We at the BIS have identified several data gaps and are working
hard to fill them.
Some of these data gaps we have plugged using existing BIS data (Graph 3). Let me now
focus on US dollar positions, although we have done the exercise for all major currencies.
The red line shows the amount of US dollar funding needed by banks with long US dollar
positions, ie banks with more US dollar assets than liabilities. This funding can come either
from US dollar borrowing or FX swaps. Hence, the graph also measures exposure to FX
swap markets. You can see that this exposure has tripled in eight years. Moreover, it is stillrising!
Graph 3USD-long banks’ US dollar positions1
in trillions of US dollars
1.2

0.9

0.6

0.3

0.000

0102

03

040506

0708

09

1

Includes Canadian, Dutch, German, Japanese, Swiss and UK banks.

Sources: BIS consolidated statistics (immediate borrower and ultimate riskbasis); BIS locational statistics by nationality.

However, we cannot fill all identified data gaps with existing data and some clever
economics. We need more raw data to be able to monitor developing risks. In my view, firstand foremost, we need balance sheet information.
Besides new information, we also need new instruments. First, we need new instruments toprevent future crises. This means better regulation. I believe that the new Basel banking

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capital regulations, along with the application of macroprudential tools, will provide basic
elements of crisis prevention.
Moreover, we need new instruments to deal with the fallout from future crises. We willprobably never be able to avoid crises entirely. Hence, we need tools to cushion the blow
when the next crisis comes. Among other things, that means mechanisms for crisis
resolution. Strengthening the financial infrastructure would also increase the resilience of thefinancial system during crises. In this regard, the creation of central counterparties forderivatives clearing and settlement would not only increase resilience but also provide
additional information.
In general, when thinking about new instruments, we need to keep the system flexible. We
need to remember that regulation is an arms race between financial institutions andregulators. We need to make sure that the regulators have the right arsenal, while financial
institutions redeploying their resources. Furthermore, I personally think that the regulatory
perimeter requires much more attention going forward. We’ve done a great job on banks, but
shadow banking is not going away.
Last but definitely not least, we need international cooperation, coordination and consistency
in our efforts. Remember: neighbours matter. We need to ensure that there is no “race to thebottom” and that there are no regulatory loopholes. Again, this is very similar to our housing
example. We need zoning and covenants that require everyone in a neighbourhood to meetcertain standards.
Conclusion: neighbours matterI conclude where I started. Your neighbours matter. What happens abroad might affect you –and not necessarily in a good way. Financial crises can happen often and with devastatingconsequences. And they travel fast from one country to another.
We need new information and new instruments ideally to prevent new crises or at least tostop their propagation. Flexibility in the future remains crucial. No single static instrument will
suffice, as new risks and vulnerabilities will inevitably emerge. Furthermore, all these newlessons do not mean that we should forget old lessons. Current account imbalances, credit
growth or currency mismatches will continue to matter.
Looking at monetary policy, everyone now agrees that that domestic price stability is notenough. This lesson, drawn by Bill White, has become part of the mainstream thinking.
However, I would go even further and say that even domestic financial stability is not
sufficient.
Your neighbours matter – more precisely, your neighbours’ financial stability matters. If weare to continue to reap the benefits of globalisation, we need to ensure that shocks from yourneighbours’ financial systems will not propagate to your financial system – as they did in thiscrisis. In short, we need international cooperation, coordination and consistency.
References
Cecchetti, S, I Fender and P McGuire (2010): “Toward a global risk map”, BIS Working
Papers, no 309, May.
McGuire, P and G von Peter (2009): “The US dollar shortage in global banking”, BIS
Quarterly Review, March.
Takáts, E (2010): “Was it credit supply? Cross-border bank lending to emerging market
economies during the financial crisis”, BIS Quarterly Review, June.

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