In Praise of Fragmentation

The required policy response should integrate domestic financial regulation with capital-account management. Tax instruments and reserve requirements that put sand in the wheels of short-term capital inflows should be combined with strong countercyclical measures, such as additional capital requirements, to slow domestic credit creation.

The effectiveness of such measures can be undermined if global banks operate in emerging countries in branch form, providing domestic credit financed by global funding pools. But this danger can be countered by requiring banks to operate as legally incorporated subsidiaries, with locally regulated capital and liquidity reserves, and strong regulatory limits on the maturity of their funding.

Such requirements would not prevent useful capital flows: global banking groups could invest equity in emerging markets and fund their subsidiaries’ balance sheets with long-term debt. In banking, as in other sectors, investment that combines long-term commitment with skill transfer can be highly beneficial, which implies that foreign banks should be free to compete on the same basis as domestic banks.

Neither mandatory subsidiarization nor tax- or regulation-based capital controls will solve all of the problems. But, taken together, they can stem the volatility implied by short-term flows and help to smooth out domestic credit cycles.

Much of the financial industry resists such measures, as do the many economists who remain wedded to the old orthodoxy. Renewed capital controls, they claim, would fragment the global financial market, undermining its ability to allocate capital efficiently.

In the past, policymakers have been at pains to stress that no such fragmentation will be allowed. But we need to be blunt: Free flows of short-term debt can result in capital misallocation and harmful instability. When it comes to global capital markets, fragmentation can be a good thing.

Adair Turner, former Chairman of the United Kingdom’s Financial Services Authority, is a member of the UK’s Financial Policy Committee and the House of Lords.

Copyright: Project Syndicate, 2014.