Higher interest rates can also reduce the probability of a banking sector crisis through the same leaning channel (𝜙𝑖 < 0), but do not increase resilience directly. The banking sector only provides a proportion (𝑏) of credit to the economy, the remaining (1 − 𝑏) share is provided by the market based finance sector (𝐵1𝑀 ). While higher interest rates have the same effect in reducing credit and the crisis probability in both sectors, increasing the CCyB leads to a leakage of credit from the banking sector to the market based sector, so the marginal effect of a higher CCyB on marketbased finance is to increase its growth rate (𝜙𝑠𝑀 > 0). This increases the probability of a crisis originating in the market based finance sector (𝛾1𝑀 ). In addition, there is no resilience benefit from a higher CCyB working to reduce the probability of crises originating in the market-based finance sector. The overall probability of a financial crisis is equal to the sum of the probabilities in each sector, weighted by their market-share. Both sectors are subject to shocks (𝜉1𝐵 , 𝜉1𝑀 ). A single policymaker sets both instruments, the CCyB and the interest rate, to minimise the joint loss function given below under discretion.
In the scenario where all credit is the economy is provided by banks (the blue line), the policymaker can use this tool in response to a 15pp increase in credit growth in the domestic economy over three years to reduce the probability of a crisis to well below 1% before the cost (in the form of lost output) becomes material. However, if 25% of credit in the economy is provided by market-based finance (red line), the policymaker struggles to reduce the probability of a crisis significantly below 2.5% as tightening the countercyclical capital buffer does not reduce the provision of market-based finance. Acting locally to address the risks of market-based finance  So how can we address risks emanating from global, market based finance? This is the subject of several panel discussions over the course of this conference, and indeed major international workstreams including of the FSB. So rather than pretend to have the answers, I will limit myself to two simple observations about how policymakers acting in their own best interest can help reduce these risks. The first is that by building strong domestic institutional frameworks and deepening domestic capital markets, recipients of global flows can reduce their susceptibility to volatility in those flows. Central bank credibility, a robust macroprudential framework, and fiscal stability all reduce the risk of a sudden stop, and liquid domestic capital markets make it easier to absorb larger inflows. As such they are prerequisites to being able to enjoy the benefits of open capital markets sustainably.