Financial Globalization, Opportunity and Crisis

Lecture Ten
Chapter 21

Financial Market
 Financial markets match buyers and sellers to set a
price for financial assets.
 International Transactions.
 The market in which residents of different countries
trade assets.

The International Capital Market and the Gains from

Trade

The International Capital Market and International Banking

• Specialized institutions have sprung up to bring together buyers and sellers of assets located
in different countries.
• The structure of the international capital market.
1. Commercial Banks

Commercial banks are at the center of the international capital market, not only because they
run the international payments mechanism but also because of the broad range of financial
activities they undertake.

2. Multinational Corporations

Multinationals are concerned always with financing their operations either through loans or
issuing bond/equity.

3. Nonbank Financial Institutions

Nonbank institutions such as insurance companies, pension funds, mutual funds, and hedge
funds have become important players in the international capital market as they have moved
into foreign assets to diversify their portfolios.

4. Central Banks

Central banks are routinely involved in the international financial markets through foreign
exchange intervention. In addition, other government agencies frequently borrow abroad.

• The term offshore banking is used to describe the business that banks’ foreign offices
conduct outside of their home countries. Banks may conduct foreign business through
any of three types of institutions:

1. An agency office located abroad, which arranges loans and transfers funds but
does not accept deposits.

2. A subsidiary bank located abroad. A subsidiary of a foreign bank differs from a

local bank only in that a foreign bank is the controlling owner. Subsidiaries are
subject to the same regulations as local banks but are not subject to the regulations
of the parent bank’s country.

3. A foreign branch, which is simply an office of the home bank in another country.
Branches carry out the same business as local banks and are usually subject to
local and home banking regulations. Often, however, branches can take
advantage of cross border regulatory differences.
Regulating International Banking

Bank Failure

A bank fails when:

1. It is unable to meet its obligations to its depositors and other creditors.

2. Banks use borrowed funds to make loans and to purchase other assets, but some of a
bank’s borrowers may find themselves unable to repay their loans.

3. The bank’s assets may decline in value for some other reason.

• When this happens, the bank might be unable to repay its short-term liabilities, including
deposits, which are largely payable on demand.

• If an atmosphere of financial panic develops, therefore, bank failure may not be limited to
banks that have mismanaged their assets. It is in the interest of each depositor to withdraw
his or her money from a bank if all other depositors are doing the same, even when the
bank’s assets are basically sound.

• Bank failures obviously inflict serious financial harm on individual depositors who lose their
money.

• But beyond these individual losses, bank failure can harm the economy’s macroeconomic
stability.

• One bank’s problems may easily spread to sounder banks if they are suspected of having lent
to the bank that is in trouble.

• Such a general loss of confidence in banks undermines the credit and payments system on
which the economy runs.

• A rash of bank failures can bring a drastic reduction in the banking system’s ability to finance
investment, consumer-durable expenditure, and home purchases, thus reducing aggregate
demand and throwing the economy into a slump.
• There is strong evidence that the string of U.S. bank closings in the early 1930s helped start
and worsen the Great Depression, and financial panic certainly worsened the severe
worldwide recession that began in 2007.

Precautionary Measures Against Bank Failure

Deposit insurance: a legacy from the great depression, in which the federal deposit insurance
corporation (FDIC) insures bank depositors against losses.

Reserve requirements: force the bank to hold a portion of its assets in a liquid form that is
easily mobilized to meet sudden deposit outflows.

Capital requirements and asset restrictions: bank regulators set a by-law minimum capital
requirement for banks which considered a second line of defense against financial vulnerability.
Besides, there are clear rules that forbidden banks from hold too risky assets or even lend a large
portion of money to a single entity.

1. Deposit insurance: a legacy from the great depression, in which the federal deposit
insurance corporation (FDIC) insures bank depositors against losses.

2. Reserve requirements: force the bank to hold a portion of its assets in a liquid form that
is easily mobilized to meet sudden deposit outflows.

3. Capital requirements and asset restrictions: bank regulators set a by-law minimum
capital requirement for banks which considered a second line of defense against financial
vulnerability. Besides, there are clear rules that forbidden banks from hold too risky
assets or even lend a large portion of money to a single entity.

4. Bank examination: government supervises the banks’ transactions and take the required
set of actions.
5. Lenders of last resort facilities (LLR): banks can take loans from the central bank in
order to avoid financial panic.
6. Government organized bailouts: Failing all else, the central bank or fiscal authorities
may organize the purchase of a failing bank by healthier institutions.
How Well Have International Markets Allocate Capital and Risk?

 International portfolio diversification.

 The extent of inter-temporal trade: a smoothly working international capital market
allows countries’ domestic investment rates to diverge widely from their saving rates.
 Onshore- offshore interest differentials on similar assets and currency: If the world
capital market is doing its job of communicating information about global investment
opportunities, these interest rates should move closely together and not differ too greatly.
Large interest rate differences would be strong evidence of unrealized gains from trade.
Arbitrage.
 The efficiency of the foreign exchange market.