An excessively-leveraged banking system increases the risk that a crisis in one country will spread to another, according to a paper presented at a Federal Reserve conference in Jackson Hole, Wyoming.

"A top priority should be reducing leverage in banking systems," Kristin Forbes, an economist at the Massachusetts Institute of Technology, said in a paper presented today at the Kansas City Fed's annual meeting of economists and central bankers. "Countries should also support portfolio investors' efforts to diversify and invest abroad" and not give "preferential treatment for debt financing," she said.

Policy makers are trying to make financial markets more resilient to outside shocks, responding to the credit freeze that damaged global growth in 2008 and a debt crisis in Europe that's damping the recovery. Fed officials said Europe's turmoil presents a "significant downside risk" to the U.S. economic outlook, minutes of their July 31-Aug. 1 meeting showed.

Forbes highlighted four main paths a shock follows in crossing borders. Crises can spread via banks, trade and through investors who may be forced by losses in one country to sell assets in other countries. Turmoil can also be transmitted through "wake-up calls," when new information about a nation's vulnerabilities prompts investors to reassess risks in other countries, said Forbes, 42, a Sloan School of Management professor.

While long-term structural reforms such as reducing bank leverage will be most effective in minimizing contagion, regulators have other options for minimizing the risk of "negative spillovers," Forbes said.

"It is critically important to restore confidence that money deposited in banks will be accessible in the future," she said. "The best alternative" to minimize contagion today in the euro area "appears to be well-designed deposit insurance combined with appropriate banking regulations and supervision."

Forbes said "the analysis and policy implications" of her paper "apply to the current challenges in the euro area."

Europe's focus on sharing liabilities through the European Central Bank, European Stability Mechanism and European Financial Stability Facility may increase contagion risks as investors begin to question the solvency of countries providing bailout funds, she said.

Regulators shouldn't impose capital controls or ease bank regulations because they will make countries more vulnerable to shocks, according to the paper. Policies that increase the debt burden on sovereign nations should also be avoided, Forbes said.

Forbes worked in mergers and acquisitions at Morgan Stanley from 1992 until 1993 and with the World Bank's policy research department from 1993 until 1994. She was deputy assistant secretary for quantitative policy analysis at the Treasury Department from 2001 until 2002. In 2003, she became the youngest member of the White House Council of Economic Advisers and worked there until 2005.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.