During the past two decades, financial markets around the world have become increasingly interconnected. Financial globalization has brought considerable benefits to national economies and to investors and savers, but it has also changed the structure of markets, creating new risks and challenges for market participants and policymakers.
THREE decades ago, a manufacturer building a new factory would probably have been restricted to borrowing from a domestic bank. Today it has many more options to choose from. It can shop around the world for a loan with a lower interest rate and borrow in foreign currency if foreign-currency loans offer more attractive terms than domestic-currency loans; it can issue stocks or bonds in either domestic or international capital markets; and it can choose from a variety of financial products designed to help it hedge against possible risks. It can even sell equity to a foreign company.
A look at how financial globalization has occurred, and the form it is taking, offers insights into its benefits as well as the new risks and challenges it has generated.
Forces driving globalization
What has driven the globalization of finance? Four main factors stand out.
Advances in information and computer technologies have made it easier for market participants and country authorities to collect and process the information they need to measure, monitor, and manage financial risk; to price and trade the complex new financial instruments that have been developed in recent years; and to manage large books of transactions spread across international financial centers in Asia, Europe, and the Western Hemisphere.
The globalization of national economies has advanced significantly as real economic activity—production, consumption, and physical investment—has been dispersed over different countries or regions. Today, the components of a television set may be manufactured in one country and assembled in another, and the final product sold to consumers around the world. New multinational companies have been created, each producing and distributing its goods and services through networks that span the globe, while established multinationals have expanded internationally by merging with or acquiring foreign companies. Many countries have lowered barriers to international trade, and cross-border flows in goods and services have increased significantly. World exports of goods and services, which averaged $2.3 billion a year during 1983–92, have more than tripled, to an estimated $7.6 billion in 2001. These changes have stimulated demand for cross-border finance and, in tandem with financial liberalization, fostered the creation of an internationally mobile pool of capital and liquidity.
The liberalization of national financial and capital markets, coupled with the rapid improvements in information technology and the globalization of national economies, has catalyzed financial innovation and spurred the growth of cross-border capital movements. The globalization of financial intermediation is partly a response to the demand for mechanisms to intermediate cross-border flows and partly a response to declining barriers to trade in financial services and liberalized rules governing the entry of foreign financial institutions into domestic capital markets. Global gross capital flows in 2000 amounted to $7.5 trillion, a fourfold increase over 1990. The growth in cross-border capital movements also resulted in larger net capital flows, rising from $500 billion in 1990 to nearly $1.2 trillion in 2000.
Competition among the providers of intermediary services has increased because of technological advances and financial liberalization. The regulatory authorities in many countries have altered rules governing financial intermediation to allow a broader range of institutions to provide financial services, and new classes of nonbank financial institutions, including institutional investors, have emerged. Investment banks, securities firms, asset managers, mutual funds, insurance companies, specialty and trade finance companies, hedge funds, and even telecommunications, software, and food companies are starting to provide services similar to those traditionally provided by banks.
Changes in capital markets
These forces have, in turn, led to dramatic changes in the structure of national and international capital markets.
First, banking systems in the major countries have gone through a process of disintermediation—that is, a greater share of financial intermediation is now taking place through tradable securities (rather than bank loans and deposits). Both financial and nonfinancial entities, as well as savers and investors, have played key roles in, and benefited from, this transformation. Banks have increasingly moved financial risks (especially credit risks) off their balance sheets and into securities markets—for example, by pooling and converting assets into tradable securities and entering into interest rate swaps and other derivatives transactions—in response both to regulatory incentives such as capital requirements and to internal incentives to improve risk-adjusted returns on capital for shareholders and to be more competitive. Corporations and governments have also come to rely more heavily on national and international capital markets to finance their activities. Finally, a growing and more diverse group of investors are willing to own an array of credit and other financial risks, thanks to improvements in information technology that have made these risks easier to monitor, analyze, and manage.
Second, cross-border financial activity has increased. Investors, including the institutional investors that manage a growing share of global financial wealth, are trying to enhance their risk-adjusted returns by diversifying their portfolios internationally and are seeking out the best investment opportunities from a wider range of industries, countries, and currencies. At the wholesale level, national financial markets have become increasingly integrated into a single global financial system. The major financial centers now serve borrowers and investors around the world, and sovereign borrowers at various stages of economic and financial development can access capital in international markets. Multinational companies can tap a range of national and international capital markets to finance their activities and fund cross-border mergers and acquisitions, while financial intermediaries can raise funds and manage risks more flexibly by accessing markets and pools of capital in the major international financial centers.
“Global gross capital flows in 2000 amounted to $7.5 trillion, a fourfold increase over 1990.”
Third, the nonbank financial institutions are competing—sometimes aggressively—with banks for household savings and corporate finance mandates in national and international markets, driving down the prices of financial instruments. They are garnering a rising share of savings, as households bypass bank deposits to hold their funds in higher-return instruments—such as mutual funds—issued by institutions that are better able to diversify risks, reduce tax burdens, and take advantage of economies of scale, and have grown dramatically in size as well as in sophistication.
Fourth, banks have expanded beyond their traditional deposit-taking and balance-sheet-lending businesses, as countries have relaxed regulatory barriers to allow commercial banks to enter investment banking, asset management, and even insurance, enabling them to diversify their revenue sources and business risks. The deepening and broadening of capital markets has created another new source of business for banks—the underwriting of corporate bond and equity issues—as well as a new source of financing, as banks increasingly turn to capital markets to raise funds for their own investment activities and rely on over-the-counter (OTC) derivatives markets—decentralized markets (as opposed to organized exchanges) where derivatives such as currency and interest rate swaps are privately traded, usually between two parties—to manage risks and facilitate intermediation.
Banks have been forced to find additional sources of revenue, including new ways of intermediating funds and fee-based businesses, as growing competition from nonbank financial intermediaries has reduced profit margins from banks’ traditional business—corporate lending financed by low-cost deposits—to extremely low levels. This is especially true in continental Europe, where there has been relatively little consolidation of financial institutions. Elsewhere, particularly in North America and the United Kingdom, banks are merging with other banks as well as with securities and insurance firms in efforts to exploit economies of scale and scope to remain competitive and increase their market shares.
Benefits versus risks
All in all, the radical change in the nature of capital markets has offered unprecedented benefits. But it has also changed market dynamics in ways that are not yet fully understood.
One of the main benefits of the growing diversity of funding sources is that it reduces the risk of a “credit crunch.” When banks in their own country are under strain, borrowers can now raise funds by issuing stocks or bonds in domestic securities markets or by seeking other financing sources in international capital markets. Securitization makes the pricing and allocation of capital more efficient because changes in financial risks are reflected much more quickly in asset prices and flows than on bank balance sheets. The downside is that markets have become more volatile, and this volatility could pose a threat to financial stability. For example, the OTC derivatives markets, which accounted for nearly $100 trillion in notional principal and $3 trillion in off-balance-sheet credit exposures in June 2001, can be unpredictable and, at times, turbulent. Accordingly, those in charge of preserving financial stability need to better understand how the globalization of finance has changed the balance of risks in international capital markets and ensure that private risk-management practices guard against these risks.
Another benefit of financial globalization is that, with more choices open to them, borrowers and investors can obtain better terms on their financing. Corporations can finance physical investments more cheaply, and investors can more easily diversify internationally and tailor portfolio risk to their preferences. This encourages investment and saving, which facilitate real economic activity and growth and improve economic welfare. However, asset prices may overshoot fundamentals during booms and busts, causing excessive volatility and distorting the allocation of capital. For example, real estate prices in Asia soared and then dropped precipitously before the crises of 1997–98, leaving many banks with nonperforming loans backed by collateral that had lost much of its value. Also, as financial risk becomes actively traded among institutions, investors, and countries, it becomes harder to identify potential weaknesses and to gauge the magnitude of risk. Enhanced transparency about economic and financial market fundamentals, along with a better understanding of why asset market booms and busts occur, can help markets better manage these risks.
Finally, creditworthy banks and firms in emerging market countries can reduce their borrowing costs now that they are able to tap a broader pool of capital from a more diverse and competitive array of providers. However, as we saw during the Mexican crisis of 1994–95 and the Asian and Russian crises of 1997–98, the risks involved can be considerable—including sharp reversals of capital flows, international spillovers, and contagion. (Even though the extent of contagion seems to have decreased, for reasons that are still unclear, since the 1997–98 crises, the risk of contagion cannot be ruled out.) Emerging market countries with weak or poorly regulated banks are particularly vulnerable, but such crises can threaten the stability of the international financial system as well.
Safeguarding financial stability
The crises of the 1990s underscored the need for prudent sovereign debt management, properly sequenced capital account liberalization, and well-regulated and resilient domestic financial systems, to ensure national and international financial stability.
Private financial institutions and market participants can contribute to financial stability by managing their businesses and financial risks well and avoiding imprudent risk taking—in part by responding to market incentives and governance mechanisms, such as maximizing shareholder value and maintaining appropriate counterparty relationships in markets. In effect, the first lines of defense against financial problems and systemic risks are sound financial institutions, efficient financial markets, and effective market discipline.
But, because financial stability is also a global public good, national supervisors and regulators must also play a role. Indeed, this role is becoming increasingly international in scope—for example, through a strengthening of coordination and information sharing across countries and functional areas (banking, insurance, securities) to identify financial problems before they become systemic.
The IMF itself has an important role to play. In accordance with its global surveillance mandate, it has launched a number of initiatives to enhance its ability to contribute to international financial stability: identifying and monitoring weaknesses and vulnerabilities in international financial markets; developing early warning systems for international financial market imbalances; conducting research into the nature and origins of international financial crises and the channels of contagion; and seeking ways to contain and resolve crises quickly and smoothly, for example, by involving the private sector.
I would like to acknowledge the assistance of my colleagues in the International Capital Markets Department in preparing this article, in particular, the Financial Market Stability Division.