The renewed surge in capital flows to emerging economies in the aftermath of the global financial crisis has ignited a lively debate on the nature of "global liquidity" and its transmission across borders. Low interest rates and permissive monetary policy pursued by advanced economy central banks are often cited int he press and popular commentary as a key factor in driving the capital flows. One of the tasks in our paper is to shed light on the validity of this claim.
Our paper develops a theory of global liquidity centered on the fluctuating leverage of cross border banks as the channel through which permissive financial conditions are transmitted globally. We then subject the key predictions to an empirical investigation.
Our theory draws on two themes. The first is the role of financial intermediaries in driving fluctuations in risk premiums and financial conditions, especially in connection with the growing use of wholesale (or market-based) bank funding. When credit is growing rapidly, the core funding such as household deposits available to the banking sector is likely to be insufficient to finance the rapid growth in new lending.
Other sources of wholesale (or "non-core") funding is then tapped to fi nance bank lending. Global banks intermediate such funding, and the composition of their liabilities can be expected to reflect the state of the financial cycle and risk premiums ruling in the financial system.
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Capital Flows, Cross-Border Banking and Global Liquidity
