122 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Ninth Edition
that issues in this area are directly related to other issues already discussed in the course, including
macroeconomic stability, the role of government intervention, and the gains from trade.
Using the same logic that we applied to show the gains from trade in goods or the gains from
intertemporal trade, we can see how the international exchanges of assets with different risk
characteristics can make both parties to a transaction better off. International portfolio diversification
allows people to reduce the variability of their wealth. When people are risk-averse, this diversification
improves welfare. An important function of the international capital market is to facilitate such
welfare-enhancing exchanges of both debt instruments, such as bonds, and equity instruments, such as
stocks.
Offshore banking activity is at the center of the international capital market. Central to offshore banking
are Eurocurrencies (not to be confused with euros), which are bank deposits in one country that are
denominated in terms of another country’s currency. Relatively lax regulation of Eurocurrency deposits
compared with onshore deposits allows banks to pay relatively high returns on Eurocurrency deposits.
This has fostered the rapid growth of offshore banking. Growth has also been spurred, however, by
political factors, such as the reluctance of Arab OPEC members to place surplus funds in American
banks after the first oil shock for fear of confiscation by the U.S. government following the confiscation
of Iranian deposits in 1979.
The text also introduces issues of regulating capital markets. Central to this task is the notion of how banks
fail, and what can be done to prevent bank failures. Bank regulation presents a trade-off between
financial stability and moral hazard. You want to promote confidence in the banking system through
financial support, but too much support encourages risk taking by the banks. Deposit insurance,
regulations, and lenders of last resort can all help prevent the lack of confidence in a banking system
that can generate a run on the banking assets. International banking presents additional challenges as
rules are not uniform, responsibility can be unclear and enforcement is difficult.
Industrialized countries are involved in an effort to coordinate their bank supervision practices to
enhance the stability of the global financial system. Common supervisory standards set by the Basel
Committee were developed. Potential problems remain, however, especially regarding the clarification
of the division of lender-of-last-resort responsibilities among countries and the increasingly large role of
nonbank financial firms which makes it harder for regulators to oversee global financial flows. The text
highlights these regulatory difficulties using a case study of the near collapse of the hedge fund LTCM
and the problems in the subprime mortgage market in the United States. This case study is also used to
illustrate the difficult balance regulators face between creating moral hazard and maintaining financial
stability. The financial crisis of 2007–2009 also highlights the increasingly important role played by non
bank financial institutions, the so-called “Shadow Banking System.” Though these institutions operate
much like banks and their profits are intertwined with those of commercial banks, they are not regulated
like commercial banks. Much of the riskiest behavior that contributed to the financial crisis was
initiated
by these institutions. In response, the U.S. Congress recently passed the Dodd-Frank Act, which allows
the government to regulate these institutions like banks. This represents another example of the
difficulty in balancing financial support (the bailouts of financial institutions) with moral hazard
(increased supervision and regulation).
The global aspect of the financial crisis is also highlighted with a case study on Central Bank Swap
Lines. European banks heavily invested in mortgage backed securities because they were given good
credit ratings and thus allowed these banks to hold less capital against their purchases of these assets.
However, these banks did not want exposure to currency risk, so they financed their purchases by
borrowing dollars in short-term markets. When mortgage-backed securities plummeted in value, these
European banks were faced with a dilemma. They could not be bailed out by their local central banks
since they needed to pay back their debts in dollars. However, they did not want to sell their
dollar-denominated assets at such a low price. To resolve this dilemma, the Federal Reserve stepped in
and lent central banks around the world dollars, which they could in turn use to bail out their local
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