Managing Financial Risk: A Risk-Analysis Framework for International Capital Flows

Abstract

Recently, leading industrialized nations have begun consider­ing specific ways to "strength[en] the architecture of the international financial system" and thereby meet the potential danger of systemic instability that follows from the increasing integration of the global economy (Rubin 1998). This paper concerns itself with a key feature of the increasingly integrated global economy: international capital flows. It analyzes the relationship between these flows and financial stability and also suggests a framework, an "international capital flows framework" or IKFF, for policy makers to use as an analytic tool in evaluating and managing the risks associated with such flows. The IKFF suggests thinking of economic markets (EMs) as financial institutions that need to manage their international cash flow "statements" and "balance sheets" in much the same way as international financial institutions (IFIs). The IKFF consists of an integration of a simplified account of the IMF's balance of payments model and the risk-management and capital adequacy standard for IFIs proposed by the Basie Committee for Banking Supervision. More particularly, the IKFF applies the methodology of investment disaggregation and risk-weighting used in the capital adequacy standard to the different components of the capital account of the balance of payments. This application yields an analytically determined "adequate" level of foreign reserves that policy makers and private investors could use as a rule of thumb in evaluating the risk of financial instability and insolvency associated with different EMs. Until better, more sophisticated models are available, constructed through careful and rigorous study of accurate data on the vector of international capital flows, this rough-and-ready rule of thumb can serve as an analytic tool for EM financial analysis.