Institutional quality and cross-border asset trade: are banks less worried about diversification abroad?

We build a model of cross-border asset trade where countries’ institutional quality impacts on the expected returns of the assets, and investors’ sensitivity to quality varies with their financial stress condition. Changes in “perceived quality” influence the portfolio allocation decisions and the patterns of international financial flows over time. We run econometric estimations for cross-border bank flows from advanced to emerging economies, over the period 2005-2014. We find that deteriorating conditions in financial markets, before the crisis, lead to higher demand for institutional quality. A strong regulatory environment is perceived as a protection against adverse future losses, and countries with goods institutions are less exposed to capital retrenchment. In the aftermath of the crisis, the liquidity easing in advanced economies drives down concerns for EMEs' developments, boosting flows and challenging EMEs' ability to use capital controls to mitigate unbridled flows.