Risk Sensitivity Varies Over Time

The study, which incorporates the VIX, U.S. monetary policy, and various global and borrowing country-level controls, defines OAEs as advanced economies excluding those considered “safe havens.” The Euro Area is treated as a single advanced economy due to its shared currency.

Analysis of the post-GFC period shows a decline in risk sensitivity for OAEs compared to pre-GFC levels, a trend that persisted through the end of 2024. Before the GFC, OAE EMPs had a risk sensitivity of approximately 4.6 percentage points. A similar pattern was observed for EMEs, with a pre-break sensitivity of 4.2 percentage points under the EMP measure, higher than the 3.3 percentage points recorded for exchange rate depreciation.

Immediately following the GFC, risk sensitivities spiked across both OAEs and EMEs. The EMP’s risk sensitivity surged from 4.2 to 12.3 percentage points by 2013, reflecting heightened global risk sensitivity in response to the crisis. Later, risk sensitivity fell below pre-GFC levels, potentially due to tighter regulations mitigating capital flow pressures. For EMEs, the EMP more strongly captured the response to elevated risk compared to exchange rates alone, with risk sensitivities of 3.5 and 3.1 percentage points,respectively. OAEs showed similar performance between the EMP and exchange rates, with a post-GFC sensitivity of 2.7 percentage points under the EMP.

“During the period immediately following the GFC, we see a spike in risk sensitivities across both OAEs and EMEs.”

Financial Institution conditions Matter

The research indicates that higher bank capitalization in OAEs reduces the risk sensitivity of exchange market pressure. Specifically, an increase in bank capitalization decreases the EMP sensitivity to risk by 1.5 percentage points, equivalent to raising bank capitalization levels from 5.3 to 6.2. This aligns with the hypothesis that better-capitalized banks face less currency pressure during periods of heightened risk.

Conversely, increased leverage of nonbank financial institutions (NBFI) elevates the EMP sensitivity to risk by 1.9 percentage points, suggesting that more leveraged NBFI lenders increase currency pressure on borrowing countries.

Permanent or Transitory Changes?

While source country banking sector capitalization lowers risk sensitivity,other factors may also play a role. The study acknowledges that it does not account for the characteristics of domestic financial institutions involved in sourcing or receiving international capital flows, nor the impact of micro and macroprudential instruments implemented to address cyclical and structural vulnerabilities.