5 The overall effects of global financial integration on the stability of the financial sector can be expected to be positive in the long run, because greater liquidity and the adoption of risk-sharing and riskmitigating techniques both strengthen the overall resilience and shock-absorption capacity of the global financial system. Cross-border capital flows not only benefit the recipient economies, but also the countries of origin, as they facilitate international risk-sharing and participation in returns abroad. Trade in goods and services and cross-border capital flows have clearly increased the spillovers of macroeconomic fluctuations globally. 6 However, one should welcome the recent developments in  5  For a comprehensive analysis on the determinants of global portfolio reallocation, see De Santis and Gérard (2006). 6  See Kose et al. (2003) for an assessment of the impact of globalisation on the synchronisation of business cycles.http://www.iza.org/en/webcontent/publications/papers/viewAbstract?dp_id=702. BIS Review 43/2006  3  international financial integration, because they reflect trends towards an efficient allocation of resources and, in this way, support growth and promote welfare in the global economy. How much further will financial globalisation deepen? In order to answer this question, we examine developments in countries’ home bias, i.e. how much investors prefer to invest in domestic assets rather than fully diversifying their portfolio internationally. 7 In a world without transaction and information costs, all countries would hold the same portfolio and would diversify their investment in other countries in proportion to the size of their financial markets.

My co-authors and I have started with the observation that in the face of truly systemic housing shocks, governments always intervene. It is not hard to imagine why: given the importance of housing to Americans and our economy, at some level of housing market stress, the government faces intense pressure to take action. We cannot eliminate the risk that the government may have to intervene. So we need to acknowledge that risk and establish a system to reduce and manage it, or we will recreate an implicit guarantee that puts the taxpayer at unacceptable risk. In my view, the private sector (and the borrower) must absorb all losses up to an agreed point, with the government absorbing all further losses. The level at which the government steps in must be well known in advance and credible to the market, meaning that there should be no speculation as to when and how the government would intervene. When should the government intervene? If markets believe that the government will intervene sooner than it claims, then this will generate uncertainty, and financial markets will speculate on the timing and nature of the intervention. This uncertainty could have a destabilizing effect, leading to higher losses that the government would ultimately have to absorb. A government guarantee that is unclear or not credible, even if it is explicit and priced, will result in greater costs to the government and, ultimately, the taxpayer. What should parties pay the government for its willingness to intervene?