Microsoft PowerPoint – C20_ECON7520_week9
Chapter 20
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Financial Globalization:
Opportunity and Crisis
Instructor:
Learning Objectives (1 of 2)
20.1 Understand the economic function of international
portfolio diversification.
20.2 Explain factors leading to the explosive recent
growth of international financial markets.
20.3 Analyze problems in the regulation and supervision
of international banks and non-bank financial institutions.
20.4 Describe some different methods that have been
used to measure the degree of international financial
integration.
Learning Objectives (2 of 2)
20.5 Understand the factors leading to the worldwide
financial crisis that started in 2007.
20.6 Evaluate the performance of the international
capital market in linking the economies of the industrial
countries.
• Gains from trade
• Portfolio diversification
• Players in the international capital markets
• Attainable policies with international capital markets
• Offshore banking and offshore currency trading
• Regulation of international banking
• Tests of how well international capital markets allow
portfolio diversification, allow intertemporal trade, and
transmit information
International Capital Markets
• International asset (capital) markets are a group of markets
(in London, Tokyo, , Singapore, and other financial
cities) that trade different types of financial and physical
assets (capital), including
– bonds (government and private sector)
– deposits denominated in different currencies
– commodities (such as petroleum, wheat, bauxite, gold)
– forward contracts, futures contracts, swaps, options
– real estate and land
– factories and equipment
Gains from Trade (1 of 4)
• How have international capital markets increased the
gains from trade?
• When a buyer and a seller engage in a voluntary
transaction, both receive something that they want and
both can be made better off.
• A buyer and seller can trade
– goods or services for other goods or services
– goods or services for assets
– assets for assets
Figure 20.1 The Three Types of
International Transaction
Residents of different countries can trade goods and services for other goods and
services, goods and services for assets (that is, for future goods and services), and
assets for other assets. All three types of exchange lead to gains from trade.
Gains from Trade (2 of 4)
• The theory of comparative advantage describes the
gains from trade of goods and services for other
goods and services:
– With a finite amount of resources and time, use
those resources and time to produce what you are
most productive at (compared to alternatives), then
trade those products for goods and services that
– Be a specialist in production, while enjoying many
goods and services as a consumer through trade.
Gains from Trade (3 of 4)
• The theory of intertemporal trade describes the gains from
trade of goods and services for assets, of goods and
services today for claims to goods and services in the future
(today’s assets).
– Savers want to buy assets (claims to future goods and
services) and borrowers want to use assets to consume
or invest in more goods and services than they can buy
with current income.
– Savers earn a rate of return on their assets, while
borrowers are able to use goods and services when they
want to use them: they both can be made better off.
Gains from Trade (4 of 4)
• The theory of portfolio diversification describes the
gains from trade of assets for assets, of assets with one
type of risk for assets with another type of risk.
– Investing in a diverse set, or portfolio, of assets is a
way for investors to avoid or reduce risk.
– Most people most of the time want to avoid risk:
they would rather have a sure gain of wealth than
invest in risky assets when other factors are
▪ People usually display risk aversion: they are
usually averse to risk.
Portfolio Diversification (1 of 3)
• Suppose that two countries have an asset of farmland that
yields a crop, depending on the weather.
• The yield (return) of the asset is uncertain, but with bad
weather the land can produce 20 tons of potatoes, while
with good weather the land can produce 100 tons of
• On average, the land will produce
20 100 60tons
• if bad weather and good weather are equally likely (both with a
probability of 1 2).
– The expected value of the yield is 60 tons.
Portfolio Diversification (2 of 3)
• Suppose that historical records show that when the domestic
country has good weather (high yields), the foreign country
has bad weather (low yields).
– and that we can assume that the future will be like the
• What could the two countries do to avoid suffering from a
bad potato crop?
• Sell 50% of one’s assets to the other party and buy 50% of
the other party’s assets:
– diversify the portfolios of assets so that both countries
always achieve the portfolio’s expected (average) values.
Portfolio Diversification (3 of 3)
• With portfolio diversification, both countries could always enjoy a
moderate potato yield and not experience the vicissitudes of
feast and famine.
– If the domestic country’s yield is 20 and the foreign country’s
yield is 100, then both countries receive
50% 20 50% 100 60.
– If the domestic country’s yield is 100 and the foreign country’s
yield is 20, then both countries receive
50% 100 50% 20 60.
– If both countries are risk averse, then both countries could
be made better off through portfolio diversification.
Classification of Assets
Assets can be classified as either
1. Debt instruments
– Examples include bonds and deposits.
– They specify that the issuer must repay a fixed amount
regardless of economic conditions.
2. Equity instruments
– Examples include stocks or a title to real estate.
– They specify ownership (equity = ownership) of variable profits
or returns, which vary according to economic conditions.
International Capital Markets (1 of 3)
The participants:
1. Commercial banks and other depository institutions:
– Accept deposits.
– Lend to commercial businesses, other banks,
governments, and/or individuals.
– Buy and sell bonds and other assets.
– Some commercial banks underwrite new stocks
and bonds by agreeing to find buyers for those
assets at a specified price.
International Capital Markets (2 of 3)
2. Non-bank financial institutions such as securities
firms, pension funds, insurance companies, mutual
– Securities firms specialize in underwriting stocks
and bonds (securities) and in making various
investments.
– Pension funds accept funds from workers and
invest them until the workers retire.
– Insurance companies accept premiums from policy
holders and invest them until an accident or
another unexpected event occurs.
– Mutual funds accept funds from investors and
invest them in a diversified portfolio of stocks.
International Capital Markets (3 of 3)
3. Private firms:
– Corporations may issue stock, may issue bonds, or may
borrow to acquire funds for investment purposes.
– Other private firms may issue bonds or may borrow
from commercial banks.
4. Central banks and government agencies:
– Central banks sometimes intervene in foreign exchange
– Government agencies issue bonds to acquire funds, and
may borrow from commercial banks or securities firms.
Offshore Banking (1 of 2)
• Offshore banking refers to banking outside of the
boundaries of a country.
• There are at least three types of offshore banking
institutions, which are regulated differently:
1. An agency office in a foreign country makes loans
and transfers, but does not accept deposits, and is
therefore not subject to depository regulations in
either the domestic or foreign country.
Offshore Banking (2 of 2)
2. A subsidiary bank in a foreign country follows the
regulations of the foreign country, not the domestic
regulations of the domestic parent.
3. A foreign branch of a domestic bank is often
subject to both domestic and foreign regulations,
but sometimes may choose the more lenient
regulations of the two.
Offshore Currency Trading (1 of 3)
• An offshore currency deposit is a bank deposit
denominated in a currency other than the currency
that circulates where the bank resides.
– An offshore currency deposit may be deposited in a
subsidiary bank, a foreign branch, a foreign bank,
or another depository institution located in a
foreign country.
– Offshore currency deposits are sometimes
(confusingly) referred to as eurocurrency deposits,
because these deposits were historically made in
European banks.
Offshore Currency Trading (2 of 3)
Offshore currency trading has grown for three reasons:
1. growth in international trade and international
2. avoidance of domestic regulations and taxes
3. political factors (e.g., to avoid confiscation by a
government because of political events)
Offshore Currency Trading (3 of 3)
• Reserve requirements are the primary example of a
domestic regulation that banks have tried to avoid through
offshore currency trading.
– Depository institutions in the United States and other
countries are required to hold a fraction of domestic
currency deposits on reserve at the central bank.
– These reserves cannot be lent to customers and do not
earn interest in many countries, therefore the reserve
requirement reduces income for banks.
– But offshore currency deposits in many countries are not
subject to this requirement, and thus can earn interest
on the full amount of the deposit.
Banking and Financial Fragility
• Banks fail because they do not have enough or the
right kind of assets to pay for their liabilities.
– The principal liability for commercial banks and
other depository institutions is the value of
deposits, and banks fail when they cannot pay their
depositors.
– If the value of assets decline, say because many
loans go into default, then liabilities could become
greater than the value of assets and bankruptcy
could result.
• In many countries there are several types of regulations
to avoid bank failure or its effects.
Government Safeguards against
Financial Instability (1 of 5)
1. Deposit insurance
– Insures depositors against losses up to $100,000 in
the United States when banks fail.
– Prevents bank panics due to a lack of information:
because depositors cannot determine the financial
health of a bank, they may quickly withdraw their
funds if they are not sure that a bank is financially
healthy enough to pay for them.
Government Safeguards against
Financial Instability (2 of 5)
– Creates a moral hazard for banks to take excessive
risk because they are no longer fully responsible for
▪ Moral hazard: a hazard that a party in a
transaction will engage in activities that would
be considered inappropriate (e.g., too risky)
according to another party who is not fully
informed about those activities
2. Reserve requirements
– Banks required to maintain some deposits on
reserve at the central bank in case they need cash.
Government Safeguards against
Financial Instability (3 of 5)
3. Capital requirements and asset restrictions
– Higher bank capital (net worth) means banks have more
funds available to cover the cost of failed assets.
– Asset restrictions reduce risky investments by preventing
a bank from holding too many risky assets and
encourage diversification by preventing a bank from
holding too much of one asset.
4. Bank examination
– Regular examination prevents banks from engaging in
risky activities.
Government Safeguards against
Financial Instability (4 of 5)
5. Lender of last resort
– In the United States, the Federal Reserve System
may lend to banks with inadequate reserves (cash).
– Prevents bank panics.
– Acts as insurance for depositors and banks, in
addition to deposit insurance.
– Creates a moral hazard for banks to take excessive
risk because they are not fully responsible for the
Government Safeguards against
Financial Instability (5 of 5)
6. Government-organized bailouts
– Failing all else, the central bank or fiscal authorities
may organize the purchase of a failing bank by
healthier institutions, sometimes throwing their own
money into the deal as a sweetener.
– In this case, bankruptcy is avoided thanks to the
government’s intervention as a crisis manager, but
perhaps at public expense.
• Safeguards were not nearly sufficient to prevent the
financial crisis of 2007–2009.
Figure 20.2 Frequency of Systemic Banking
Crises by Country Income Level, 1976–2017
Generalized banking crises have been plentiful around the world since the mid-1970s,
mainly in poorer countries, but starting in 2008, a substantial number of richer
countries were also hit hard.
Source: Reproduced from Laeven and Valencia, op. cit. Thanks to for
supplying these data
Difficulties in Regulating International
Banking (1 of 4)
1. Deposit insurance in the United States covers losses up
to $100,000, but since the size of deposits in
international banking is often much larger, the amount
of insurance is often minimal.
2. Reserve requirements also act as a form of insurance
for depositors, but countries cannot impose reserve
requirements on foreign currency deposits in agency
offices, foreign branches, or subsidiary banks of
domestic banks.
Difficulties in Regulating International
Banking (2 of 4)
3. Bank examination, capital requirements, and asset
restrictions are more difficult internationally.
– Distance and language barriers make monitoring
difficult.
– Different assets with different characteristics (e.g.,
risk) exist in different countries, making judgment
difficult.
– Jurisdiction is not clear in the case of subsidiary
banks: for example, if a subsidiary of an Italian bank
is located in London but primarily has offshore U.S.
dollar deposits, which regulators have jurisdiction?
Difficulties in Regulating International
Banking (3 of 4)
4. No international lender of last resort for banks exists.
– The IMF sometimes acts a “lender of last resort”
for governments with balance of payments
5. The activities of nonbank financial institutions are
growing in international banking, but they lack the
regulation and supervision that banks have.
Difficulties in Regulating International
Banking (4 of 4)
6. Derivatives and securitized assets make it harder to
assess financial stability and risk because these assets
are not accounted for on the traditional balance
– A securitized asset is a combination of different
illiquid assets like loans that is sold as a security.
The Financial Trilemma (1 of 4)
• Regulations of the type used in the United States and
other countries become even less effective in an
international environment where banks can shift their
business among different regulatory jurisdictions.
• To see why an international banking system is harder to
regulate than a national system, look at how the
effectiveness of the U.S. safeguards described earlier is
reduced as a result of offshore banking activities.
The Financial Trilemma (2 of 4)
1. Deposit insurance is essentially absent in international
2. While Eurobanks derived a competitive advantage
from escaping the required reserve tax, there was a
social cost by reducing the stability of the banking
The Financial Trilemma (3 of 4)
3. Bank examination to enforce capital requirements and
asset restrictions is difficult in an international setting.
4. Several governments may have to share operational
and financial responsibility for a rescue or
reorganization.
The Financial Trilemma (4 of 4)
• A financial trilemma constrains what policymakers in
an open economy can achieve. At most two goals from
the following list of three are simultaneously feasible:
1. Financial stability.
2. National control over financial safeguard policy.
3. Freedom of international capital movements
International Regulatory Cooperation (1 of 3)
• Basel accords (in 1988 and 2006) provide standard
regulations and accounting for international financial
institutions.
– 1988 accords tried to make bank capital
measurements standard across countries.
– They developed risk-based capital requirements,
where more risky assets require a higher amount
of bank capital.
International Regulatory Cooperation (2 of 3)
• Core principles of effective banking supervision was developed by
the in 1997 for countries without adequate banking
regulations and accounting standards.
• The financial crisis made obvious the inadequacies of the
I regulatory framework, so in 2010 the proposed a tougher set of capital standards and
regulatory safeguards for international banks, II.
International Regulatory Cooperation (3 of 3)
• In April 2009, at the height of the global crisis, the
Financial Stability Forum became the Financial Stability
Board (FSB), with a broader membership (including a
number of emerging market economies) and a larger
permanent staff.
• Many countries have embarked on far-reaching
national reforms of their financial systems.
The Macroprudential Perspective
• Ensuring that each individual financial institution is
sound will not ensure that the financial system as a
whole is sound.
• National financial regulators often face fierce lobbying
from their home financial institutions, which argue that
stricter rules would put them at a disadvantage relative
to foreign rivals.
• The Basel multilateral process plays an essential role in
allowing governments to overcome domestic political
pressures against adequate oversight and control of the
financial sector.
The Global Financial Crisis of 2007–2009 (1 of 3)
• The global financial and economic meltdown of 2007–2009
was the worst since the Great Depression.
• Banks throughout the world failed or required extensive
government support to survive; the global financial system
froze; and the entire world economy was thrown into
recession.
• Unlike some recessions, this one originated in a shock to
financial markets, and the shock was transmitted from
country to country by financial markets, at lightning speed.
• The crisis had a seemingly unlikely source: the U.S. mortgage
The Global Financial Crisis of 2007–2009 (2 of 3)
• In the mid-2000s, U.S. interest rates were very low and
U.S. home prices bubbled upward, with mortgage
lenders extending loans to borrowers with shaky credit.
• Then U.S. interest rates started moving up as the
Federal Reserve gradually tightened monetary policy to
ward off inflation.
– U.S. housing prices started to decline in 2006.
• As subprime borrowers increasingly missed their
payments during 2007, lenders became more aware of
the risks they faced and pulled back from markets.
The Global Financial Crisis of 2007–2009 (3 of 3)
• Despite central banks providing markets with extensive
liquidity support, stock markets fell everywhere.
• The U.S. economy slipped into recession late in 2007,
pushed by lack of credit and a collapsing housing
• American money market mutual funds suffered a run
and had their liabilities guaranteed by the U.S. Treasury.
• The U.S. Congress allocated $700 billion to buy troubled
assets from banks, in hopes that of allowing them to
resume normal lending.
• These problems spread globally. Recovery was quite
Cross-Border Bank Positions in Dollars
and Euros, 1999–2019
Data on international banking transactions illustrate how the U.S.
dollar is the world’s premier funding currency, far outstripping the
Source: Bank fo
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