Financial integration and banking crisis. A critical analysis of restrictions on capital flows

• Author: John Nkwoma Inekwe,Maria Rebecca Valenzuela
• Date: 01 February 2020
• Published date: 01 February 2020
• DOI: http://doi.org/10.1111/twec.12855

506

|

wileyonlinelibrary.com/journal/twec World Econ. 2020;43:506–527.

© 2019 John Wiley & Sons Ltd

Received: 12 December 2018

|

Revised: 11 June 2019

|

Accepted: 5 August 2019

DOI: 10.1111/twec.12855

ORIGINAL ARTICLE

Financial integration and banking crisis. A critical

analysis of restrictions on capital flows

John NkwomaInekwe1

|

Maria RebeccaValenzuela2

1Centre for Financial Risk,Macquarie University, Sydney, NSW, Australia

2Queensland Productivity Commission, Brisbane, QLD, Australia

KEYWORDS

banking crisis, capital restrictions, financial markets, financial networks

1

|

INTRODUCTION

There has been a surge in financial globalisation over the past few decades (Binici, Hutchison, &

Schindler, 2010). Financial integration is viewed to be a blessing to many economies as it provides

opportunities for portfolio diversification and expansion of operation of domestic markets, firms and

investors. Through greater access to world capital markets, investors might obtain higher risk‐adjusted

rates of return. The argument is that as countries can borrow from each other and have access to capital

markets, they share international risk and smooth consumption in the face of adverse shocks. Large

and stable welfare gains and growth potential accrue because of this opportunity (Obstfeld, 1994).

Financial openness has received interest from policymakers, researchers and academics over the

past few decades (Lane & Milesi‐Ferretti, 2007, 2008; Schiavo, Reyes, & Fagiolo, 2010). The opening

of borders to the international flow of capital, labour, goods and services has been encouraged by most

governments in both developing and developed economies. On the contrary, abrupt reversals in capital

flows may constitute a significant cost. Cross‐border financial risks may abound for countries with

relatively weak supervision and regulatory structures.

The view of international capital flows on the provision of welfare gain and as a means of harming

domestic economies has been a divergent one. The framework of policy trilemma often comes to the

minds of international macroeconomics and financial experts such that the monetary policy of the

centre country is exported to the periphery in a fixed exchange rate system for a financially integrated

world. In essence, having a floating exchange rate gives room to have independent monetary policies

under free capital flows (Obstfeld & Taylor, 2004).

After the global financial crisis of 2007–08, the roles of financial openness in financial and eco-

nomic stability have been scrutinised. Among policymakers and academics, there has been a vigorous

and broad discussion on increased financial integration and its associated opportunities and risks. The

debate centres mainly on the feasibility and the essentiality of limiting the composition and volume of

capital inflows and outflows. Among researchers and policymakers, the understanding of the channels

|

507

INEKWE aNd VaLENZUELa

and links between financial integration and financial crisis is important, as having an appropriate

knowledge on this issue will aid in the formulation of policies on cross‐border flows.

Some studies have tried to link financial globalisation to a banking crisis. Some researchers

have examined the relationship between financial integration and banking crises (Bonfiglioli, 2008;

Gourinchas & Obstfeld, 2012). In recent times, network methods have also been developed to capture

systemic risk and the connectedness of the global economy. For example, Caballero (2015) employs

a network science approach to show that the de facto financial integration of banks increases the inci-

dence of systemic banking crises in a country. Owing to the risk involved in financial connectedness,

the complete removal of restrictions to capital flows is far from being a reality.

Another strand of literature has also tried to analyse the relationship between capital control and

financial crises. At the microlevel, arguments for and against capital control are not lacking in the

extant literature. Because of higher capital requirements, banks may increase their asset portfolio risk,

which partially invalidates the essence of capital control (Kahane, 1977; Koehn & Santomero, 1980).

Challenging this proposition, Furlong and Keeley (1989); Keeley and Furlong (1990) argue that the

result is the opposite for insured, value‐maximising banks. At the macrolevel, the argument that inter-

national capital flows/restrictions contribute effectively to economic stability/disturbances and global

contagion is not lacking (Fernández, Klein, Rebucci, Schindler, & Uribe, 2015).

Thus, in this study, we will analyse the economy as having financial openness but with some forms

of restriction. We aim to examine the relationship between financial integration and banking crises,1

assuming a country has a restriction on the nature and amount of capital (in and out) flows. In this

study, we shed light on this topic by using a novel approach that captures the dimension of connected-

ness among countries and firms.2 We build a panel of connections among countries using lending and

borrowing information of firms that participate in the international market for syndicated loans.

The examination of capital control is essential as various countries impose restrictions on capital

flows at certain periods. This prohibition from the transfer of funds to foreign countries by domestic

and foreign investors runs contrary to the expectation of proponents of international financial and

economic integration. Besides the consequences of financial integration, capital restrictions have their

implications. On the one hand, the literature argues that capital controls could provide the room for

central banks to maintain fixed exchange rates and stimulate the economy by implementing easy

monetary policy. On the other hand, capital controls could hinder inflows and consequently affect new

investment spending and this may affect recovery from an economic crisis. It becomes essential to

examine whether a capital restriction is relevant in an integrated economy that faces a banking crisis.

We restrict our analysis to the size of loan flows. In constructing the country‐level indicators of

financial integration, we use microlevel data on international syndicated loans. This becomes useful

in the visualisation of various forms of financial linkages and helps in the generation of financial

integration from micro to macroperspective. Aggregate information is mainly used in the generation

of banking network in the extant literature (von Peter, 2007), and some studies have concentrated on

specific countries (Cocco, Gomes, & Martins, 2009). Few studies have used firm‐level information in

generating financial integration indices, and examples include recent works by Caballero (2015) and

Hale (2012). The benefit of using microlevel data is that it provides information on the formation of

new relationships and the origination time of claims (Hale, 2012).

1 van Ewijk and Arnold (2015) find that cross‐border bank capital flows adversely affect business cycle synchronisation.

2 Equity market integration is presented in Arouri and Foulquier (2012) and Jouini (2015). Orefice and Rocha (2014) examine

integration and production networks.