In this fourth part of an OECD working paper, researchers look at the potential that portfolio rebalancing by financial investors can contribute to spreading financial turmoil in a major market event such as the global financial crisis or ensuing sovereign debt crisis in Europe.
In International Capital Mobility and Financial Fragility – Part 4: Which Structural Policies Stabilise Capital Flows When Investors Suddenly Change Their Mind, researchers test for the change in sentiment that contributes to financial contagion.
The paper used bilateral bank data and an instrumental-variables technique that allows for focusing on changes in investors’ country assessments that are unrelated to fundamentals. Changes in investor sentiment are found to drive capital flows.
Sentiment-driven capital flows are found to be smaller in countries with a tougher regulatory stance, such as stricter banking supervision or enhanced financial transparency.
To read the paper, click here.