Fickle capital flows and retrenchment: Evidence from bilateral banking data

We empirically examine the response of cross-border capital flows to economic uncertainty. Using bilateral banking flow data, we show that while banks reduce their exposure to a foreign country when it becomes more risky, they tend to increase their exposure to their home country in bad times (a retrenchment). To further understand this puzzle, we examine how the differential response to foreign and domestic uncertainty is affected by country-specific characteristics, bilateral characteristics and crises. Our analysis suggests that most of the current theories, based on either information asymmetries between foreign and domestic investors or institutional risk, cannot explain bilateral data well. On the other hand, our results show that global crises have an asymmetric impact on the risk attitudes of banking institutions towards country-specific uncertainty: global crises make investors more risk-averse towards foreign uncertainty, but have no effect on the responsiveness to domestic uncertainty.