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First, banks might be systemically important in the host country but not in the home country, leading to differences in perspectives on the importance of supervision or at the time of stress. An example of that are many countries in central and eastern Europe.
Second, internationally active banks might be engaging in activities in host countries that are risky in terms of the macrofinancial stability in those countries, but where the risks are not sufficiently large to threaten the stability of the institutions concerned. An example is the foreign currency lending of some major European banks to unhedged borrowers in central and eastern Europe.
Finally, shocks to the operations of institutions in host countries might have systemic effects on the banking system in the home country, if the host country operations are sufficiently large. An extreme example of that is the Icelandic banking system. However, the other side of that coin is that the banking system in Iceland is more resilient to domestic macroeconomic shocks as its relative exposure to the domestic economy is much less than it used to be.
The setting-up of supra-national (that is global or regional) supervisors requires political will and initiative that is hard to muster. Although there has been some discussion about setting up such a supervisor for internationally active banks at the EU level, it is in the best of cases some time off. However, that does not mean that progress is not being made. On the contrary, policymakers have been dealing with these issues through various other means. Let me mention few examples. First, international standard setting has aimed at co-ordination and harmonisation of rules and supervisory practices. Second, Basel II has set up a common regulatory infrastructure which further reinforces cross-border harmonisation and co-ordination among supervisors. Third, at the level of the European Union there are significant efforts taking place, including joint crisis management exercises. Fourth, as you know very well, the most important supervisors for major global banks get together to discuss supervisory strategy. For example, I could mention the close collaboration of supervisors in the Nordic countries on the supervision of Nordea.
Monetary policy
My final topic is how financial globalisation is affecting monetary policy, especially among small and medium-sized countries that operate open capital accounts and flexible exchange rates.
Although sometimes forgotten when discussing the current plight of countries like New Zealand or Iceland, we know from theory that full financial globalisation will result in real returns on financial assets with similar maturity and risk being equalised across countries. For the small open economy that is unable to affect global financial conditions, this means that monetary policy will not be able to influence domestic real interest rates. Its ability to affect domestic demand through the interest rate channel would then disappear. That still leaves the exchange rate channel, which is sufficient for monetary policy to hit any inflation target in the medium to long run and potentially retain some countercyclical force in the short run, provided of course that monetary authorities do not try to fix the exchange rate.
These results are of course not new. Nobel Laureate Bob Mundell demonstrated in a series of articles in the early 1960s that for the small open economy with free and frictionless capital movements, monetary policy working only through the exchange rate would be a powerful stabilisation tool when the exchange rate floats but totally ineffective when it is fixed. The reverse would hold for fiscal policy.
We are still some way from this state of affairs, although a few small open mature economies might be getting closer. However, in order to know where we are heading, even if we might never completely get there, it might be interesting to speculate on what would happen to monetary policy if globalisation, both real and financial, were to run its full course.
In a similar fashion to financial globalisation, I define real globalisation as the cross-border integration of markets for goods, services and factors of production. In the extreme case when real side globalisation has run its full course, all goods would be traded, there would be no domestic non-traded goods sector. Furthermore, there would be instant factor mobility, implying that real factor returns are equalised across borders and the domestic output gap becomes irrelevant and meaningless. In fact, there would be no specific national resource constraint, except land.
This might seem far-fetched and in some sense it is. Yet it demonstrates the direction we are heading in. Moreover, we already see several signs of these phenomena emerging. You only need to think about how the inflow of labour has played a significant role in relieving labour market pressures in countries like the United Kingdom and Iceland in recent years. Switzerland is another long-standing example.
We now add full financial globalisation to the picture. Then the real risk-adjusted yield curve is, through speedy arbitrage, completely determined by the global curve and unaffected by domestic monetary policy, even in the short run. Monetary policy would then lose all its countercyclical force. It is anyhow not needed as there is no domestic output gap that needs to be stabilised. However, monetary policy would, through the exchange rate channel, be able to deliver any inflation target that the authorities want, by creating deviations of the domestic nominal policy rate from the global rate. Monetary policy has, however, no real effect. It can only determine the inflation rate, which is also neutral in its effect on the real economy.
We are still far from this extreme case. Furthermore, a plausible argument could be made that financial globalisation might progress more rapidly than real globalisation. We would then have a situation where the countercyclical force of monetary policy would still be useful but the interest rate channel would be significantly weakened, or even fully blocked. To what degree that would constitute a problem would depend partly on how well the exchange rate channel operates.
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