IMF: Mapping Cross-Border Financial Linkages - A Supporting Case for Global Financial Safety Nets

Objectives. This paper maps cross-border financial linkages and identifies factors that drive them, contributing to the discussion on the appropriate design of a global financial safety net (GFSN). It builds on previous staff work and complements the findings of the companion paper on the Analytics of Systemic Crises and the Role of Global Financial Safety Nets. This paper notes the growing roles of financial linkages and complexity in injecting latent instability into the global financial system, underscoring the value of a GFSN design that is effective in forestalling the risk that a localized liquidity shock propagates through the global financial network turning into a large-scale systemic crisis.

Mapping the linkages. Cross-border financial linkages have increased dramatically over time and have become more complex. Yet, a few ―core‖ advanced economies (AEs), including some financial centers, still dominate the web of linkages across asset classes and regions, both as sources and recipients. As a result, emerging markets‘ (EMs) strongest linkages remain with AEs, even though cross-EM linkages have increased very rapidly during the last decade (from a low base).

Systemic instability. Increased cross-border financial linkages promote risk diversification at the individual country level, reducing exposure to localized shocks. However, increased interconnectedness, by facilitating transmission of shocks, also generates a network externality that makes the global financial network more prone to systemic risk—the risk that shocks to a ―core‖ node leads to a breakdown of the entire network. Moreover, as the extent and complexity of cross-border financial linkages grow, investor information about specific exposures becomes less certain, amplifying systemic risks from panic responses to shocks.

Shock transmission. The paper points out that (i) countries with shallow domestic financial markets and concentrated exposures to a few lenders are more prone to synchronized shifts in cross-border flows; and (ii) common factors (such as global risk aversion) increasingly drive global financial markets and tend to intensify abruptly during periods of stress, amplifying shock transmission. These features point to potentially large costs of systemic shocks to ―crisis bystanders‖ (countries with relatively strong fundamentals for which the likelihood of an idiosyncratic crisis is normally low), and reinforce the case for a GFSN that is designed to help ring-fence such countries from systemic shock contagion.

Determinants of linkages. Empirical evidence shows that geographical and historical factors remain important determinant of cross-border linkages—in particular, stronger linkages occur among economies closer to each other, and those that are larger, more developed, and financially more advanced. Beyond providing general principles that could underpin the design of a GSFN, these findings suggest that an insurance mechanism against sudden shifts in cross-border exposures driven by aggregate or global shocks is essential to complement local or regional risk-sharing mechanisms.