International coordination of macroprudential policy

Given cross-border spillovers from macroprudential policy, international policy coordination may improve global welfare. This paper's contribution is to investigate the benefits of policy coordination in a setting where some countries are "foreign-banked", meaning their bank sector assets are mostly held by foreign credit institutions. I use a two-country model where one of the countries is foreign-banked, and where each country has a borrower subject to a collateralised borrowing constraint. The constraint depends on the value of the borrower's housing and the country's loan-to-value ratio limit, which is the instrument of macroprudential policy. The main finding is that policy coordination is beneficial for welfare. Specifically, in the uncoordinated steady state, the foreign-banked country exerts direct control over net foreign assets through its loan-to-value ratio, which it uses to its advantage. In effect, in a foreign-banked country, borrower-targeting macroprudential policy doubles as a capital control. In reality, the effect is not limited to strongly foreign-banked countries. Rather, it may apply to any country whose bank sector assets are not purely domestically owned. Given that coordination is beneficial, I use the model to characterise the coordinated optimal policy response to a housing demand shock. Such policy consists of moving each country's loan-to-value ratio inversely proportionally to its house price, which nullifies the shock's effect on debt. Coordinated policy thereby maintains household consumption and welfare at their steady state levels, preventing any adverse effects of the shock.