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POLICY PANEL 3

Is policy intervention required more than in the past?

Valentina Bruno

American University, Washington DC · NBER · CEPR · ECGI

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The system has been rewired

1

Portfolio flows at the center stage in driving financial conditions.

2

Sovereign debt outgrows private credit.

3

Nonresident NBFIs in EME markets and portfolio investments.

NBFIs can improve market liquidity and absorb risk in normal times.

During stress, they become consumers of liquidity rather than providers of liquidity.

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Risk does not disappear — it reallocates it

Each financing choice moves risk somewhere else in the financial system.

1

Foreign-currency borrowing

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Original sin

Depreciation raises the domestic-currency value of debt. The mismatch sits directly on sovereign, corporate and bank balance sheets.

2

Local-currency borrowing from nonresidents

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Original sin redux

Currency and duration risk move to foreign investors. Their sales push local yields up and the currency down.

3

Domestic-bank absorption of sovereign debt

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Fiscal–bank nexus

Banks become more exposed to the sovereign, while the sovereign depends more on banks to absorb issuance.

4

Market-based funding through NBFIs

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Market-based fragility

A broader investor base, but risk-bearing may sit with redemption-prone, leveraged or funding-dependent holders.

The policy problem is to identify where the risk has moved — and whether the system can absorb it in stress.

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Policy must follow where the risk sits

WHERE RISK SITS

POLICY MUST ADDRESS

1

Foreign-currency debt

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Currency mismatch, FX liquidity, reserve buffers

2

Local-currency debt held by foreigners

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Foreign investor base, hedging, market depth, dealer capacity

3

Domestic-bank absorption of public debt

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Sovereign concentration, fiscal credibility, bank–sovereign feedback

4

NBFI and market-based funding

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Leverage, liquidity mismatch, margins, repo and FX-swap intermediation

Regulation should be congruent with risk, while liquidity support should be temporary and targeted.

The policy implication is not that every borrowing channel needs to be restricted, and it is not that every market movement requires intervention. The implication is that policy should follow the location of risk. If the risk is a currency mismatch, the priority is FX resilience, reserve buffers and limits on unhedged foreign-currency exposure. If the risk sits with foreign holders of local-currency debt, the priority is investor-base data, hedging-market depth and dealer capacity. If it sits on domestic bank balance sheets, fiscal policy and prudential policy have to be considered together. And if the marginal investor is an NBFI, the relevant tools concern leverage, liquidity mismatch, margins, repo and derivative exposures. The objective is to reduce the need for intervention in stress. But when market functioning breaks down, central banks may need to act — to support the functioning of FX, repo or government-bond markets, not to guarantee returns or prevent necessary price adjustment.

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IS POLICY INTERVENTION REQUIRED MORE THAN IN THE PAST?

The system has reconfigured.

WHAT HAS CHANGED

Intermediation: banks → NBFIs + capital markets
Dollar demand: via FX swaps + Treasury futures
Fragility: concentrated bank balance sheets → leveraged, market-based layers

WHAT HAS NOT CHANGED

Dollar centrality (60% of reserves, 86% of FX trades)
Backstop: still the Federal Reserve
Dealer banks at the centre of market functioning
No credible safe-asset substitute

Takeaway: A quiet domestic market is not evidence of a resilient one. With nonresident holders and dollar-funded banks, vulnerabilities can accumulate offshore and arrive all at once.