1. Comment on Macro prudential Policy and Monetary Aggregates by Hyun Song Shin and Kwanho Shin
Kyungsoo Kim
Institute for Monetary and Economic Research,
The Bank of Korea
This presentation is prepared for The Changing Role of Central Banks The Bank of Korea International Conference 2010, May 31-June 1, Seoul Korea
Disclaimer: This presentation should not be reported as representing the views of the Bank of Korea. The views expressed are those of the author and do not necessarily represent those of the Bank of Korea or the Bank of Korea’s policy.

2. Message of this paper
By exploiting maturity transformation the banking sector can capitalize potential arbitrage profits at the risk of maturity mismatch. Maturity mismatch tends to be pro-cyclical. During boom maturity transformation becomes active and amasses liquidity or NCL, vulnerable to systemic spillovers.
In cross border trading the potential arbitrage profits are even greater because additional risk, the risk of currency mismatch, emerges. Capital flows to emerging market country is even more pro-cyclical and accompanies even greater systemic spillovers (capital inflows problem).
A levy on NCL can serve as a very effective Pigovian tax. It not only targets activities that cause negative side effects but can not be easily evaded.

3. Since the EA crisis deep financial linkage has been established

4. Leveraged foreign capital flows have had greater influence than ever

5. Capital inflows problem I: pro-cyclicality of Korea’s FX banking sector

6. Capital inflows problem I: pro-cyclicality of Korea’s FX banking sector
Foreign debt and asset growth of Korea’s banking sector ( )
Foreign asset growth(%)

7. Capital inflows problem II: risk of currency mismatch
External asset/debt

8. Capital inflows problem II: risk of maturity mismatch
ST external asset/debt

9. Currency mismatch problem appears trivial in emerging countries
AECM Index (Goldstein and Turner, 2004)
90-99
2000
2001
2002
2003
2004
2005
2006
2007
USA
-2.2
-12.6
-23.7
-31.1
-35.4
-33.8
-29.8
-30.9
-33.2 UK
-23.6
-32.7
-44.3
-65.4
-88.0
-101.3
-90.2
-95.9
-124.3
Germany
-2.0
-18.0
-7.8
-11.8
-14.3
-14.6
-6.5
-3.6
5.4
JPN
0.7
3.4
6.0
6.9
5.6
6.2
8.4
8.7
10.0
AUST
-31.0
-48.7
-56.4
-64.4
-102.0
-117.9
-101.8
-120.6
-115.5
Canada
-17.9
-12.3
-11.9
-15.3
-13.6
-9.1
-12.1
Korea
0.3
0.9
1.0
4.0
3.9
3.8
Malaysia
-21.4
-14.7
-10.0
-3.9
-0.6
-0.7
0.8
1.5
China
0.6
0.5
Indonesia
1.3
1.7
2.1
Taiwan
-0.2
2.0
2.2
2.5
13.0
Mexico
-1.5
0.2
1.1
1.2
0.1
Brazil
-8.6
-17.2
-30.0
-21.5
-11.5
-4.4
3.3
Source: Kim and Suh (2010)

10. In 2007 over 85% of foreign liquidity flowed in was recycled.
Uses & Sources of FX Liquidity (2007)
Uses (billion USD)
Sources
External Assets
External Liabilities
General government
3.0
21.5
Banks
13.2
56.3
Domestic banks
10.3
26.8
Foreign bank branches
2.9
29.5
Other
-0.0
33.0 MA
15.1
12.3
Overseas equity Investment
52.6
Foreign equity Investment
-28.9
Overseas FDI
15.6
Foreign FDI
1.8
Financial derivatives
-5.4
0.2
Other investment
2.4 CA
5.9
Other capital account
7.8
Errors and Omissions
-2.1
Total
102.0
Source: ECOS, BOK

11. It was MA that funded deleverage in 2008.
Uses & Sources of FX Liquidity (2008)
Uses (billion USD)
Sources
External Assets
External Liabilities
General government
-10.6
Banks
6.3
-23.5
Domestic banks
7.4
-12.0
Foreign bank branches
-1.1
-11.5
Other
-6.5
19.5 MA
-56.4
9.4
Overseas equity Investment
-7.1
Foreign equity Investment
-33.5
Overseas FDI
18.9
Foreign FDI
3.3
Financial derivatives
14.8
-0.2
Other investment
-0.1 CA
-5.8
Other capital account
Errors and Omissions
0.6
Total
-41.3
Source: ECOS, BOK

12. Levy on NCL can alleviate capital inflows problem
By raising funding cost a levy on NCL can effectively reset the US interest rate.
The volume of derivative transactions and the U.S. interest rate are important determinants of maturity mismatch in domestic banks. (Kim et al., 2010)
It is a useful macro-prudential policy in response to the massive capital inflows and the consequent fragility of the financial system.

13. Identifying systemically important financial institution matters
Head Office
Foreign bank branch
Domestic bank

14. Not all capital inflows are treated equal (levy)
WCM TB
DBK
FBB HO
FX Lending
KRW √
KRW
USD
USD √

15. Not all capital inflows are treated equal (No levy)TB
DBK
SPOT
KRW
USD HO
Exporter
Sell USD
Forward

16. First best policy: paying risk premium
On foreign currency funding the central banks in emerging countries serve as the insurer of last resort to the banking sector (or more broadly private sector).
They insure the risk of currency and maturity mismatches borne by the banking sector.
Cost of insurance
Therefore, appropriate premium should be paid.
Balance between risk and return on maturity transformation
Greenspan rule
Easier said than done