Chapter 9 Financial Globalization:

Opportunity and Crisis

Learning Objectives
1 Understand the economic function of international portfolio
diversification.
2 Explain factors leading to the explosive recent growth of
international financial markets.
3 Analyze problems in the regulation and supervision of
international banks and nonbank financial institutions.
4 Describe some different methods that have been used to
measure the degree of international financial integration.
5 Understand the factors leading to the worldwide financial crisis
that started in 2007.
6 Evaluate the performance of the international capital market in
linking the economies of the industrial countries.
Preview
• Gains from (asset) trade
– Comparative advantage
– Intertemporal trade
– Portfolio diversification

• Players in the 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
The International Capital Market
International Capital Markets
• International asset (capital) markets are a group of markets (in
London, Tokyo, New York, Singapore, and other financial cities)
that trade different types of financial and physical assets like:
– stocks
– bonds (government and private sector)
– deposits denominated in different currencies
– commodities (like petroleum, wheat, gold)
– forward contracts, futures contracts, swaps, options
contracts
– real estate and land
– factories and equipment
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.
or
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.
Gains from Trade
• 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
1. goods or services for other goods or services
2. goods or services for assets
3. assets for assets
The 3 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.
Comparative Advantage
• 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 you want.
– Be a specialist in production, while enjoying many goods
and services as a consumer through trade.
• Although trading goods for goods doesn’t explicitly require
international capital markets, asset movements help promote
this type of trade by easing transaction costs and hedging risk
(see next slides)
Intertemporal Trade
• The theory of intertemporal trade describes the gains
from trade of goods and services for assets, or in other
words, the trade 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 sell 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.
Portfolio Diversification
• The theory of portfolio diversification describes the
gains from trade of assets for assets, or 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 constant.
 Economist often call this risk aversion
Portfolio Diversification
• Suppose that 2 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
potatoes.
• If bad weather and good weather are equally likely (both
with a probability of 1/2).
– On average, the land will produce:
1 1
× 20 + ×100 = 60 tons
2 2
– The expected value of the yield is 60 tons.
Portfolio Diversification
• 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 past.
• What could the two countries do to avoid suffering from a
bad potato crop?
• Trade 50% of one’s assets (land ownership) to the other
party for 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
• With portfolio diversification, both countries could always
enjoy a moderate potato yield and not experience the ups
and downs 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.
International Capital Markets Actors
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 Actors
2. Nonbank financial institutions
– Investment banks 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 Actors
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 markets.
– Government agencies issue bonds to acquire funds
and may borrow from commercial or investment banks.
Offshore Banking
• Offshore banking refers to banking outside of the boundaries of
a country.
• There are at least 3 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.
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
• 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.
For example, US dollar deposits in Japan
are called Eurodollars and the Japanese
bank that holds them is called a Eurobank!
Offshore Currency Trading
Offshore currency trading has grown for three reasons:
1. growth in international trade and international business
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
• Reserve requirements are a primary example of a
domestic regulation that banks have tried to avoid through
offshore currency trading.
– Depository institutions in the U.S. and other countries
may be 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.
Tax Havens
• We will focus mostly on the instability that financial
globalization can bring. But there are also other
important considerations such as tax havens.
Banking and Financial Fragility
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.
• A high level of interbank depositing (both domestically and
globally) implies that problems affecting a single bank can be
highly contagious and spread quickly to other banks
• In most countries there are several types of regulations to avoid
bank failure or its effects…
Government Safeguards against Financial
Instability
1. Deposit insurance
– Insures depositors against losses up to $250,000 in the
U.S. 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.
– Creates a moral hazard for banks to take excessive risk
because they are no longer fully responsible for failure.
 Moral hazard: lack of incentive to guard against risk
because one is protected from its consequences, e.g.
by insurance
Government Safeguards against Financial
Instability
2. Reserve requirements
– Banks required to maintain some deposits on reserve at
the central bank in case they need cash.
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
5. Lender of last resort
– In the U.S., the Federal Reserve System may lend to
banks with inadequate reserves.
– Prevents bank panics.
– Acts as insurance for depositors and banks, in addition
to deposit insurance.
– Also creates a moral hazard for banks to take
excessive risk because they are not fully responsible
for the risk.
Government Safeguards against Financial
Instability
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.
– Can again create more moral hazard
• Safeguards were not nearly sufficient to prevent the
financial crisis of 2007–2009.
Frequency of Systemic Banking Crises

Generalized banking crises have been plentiful around the world since the mid-
1970s, but in recent years they have been concentrated in richer countries.
Source: Laeven and Valencia, op. cit.
The Challenge of Regulating
International Banking
Difficulties in Regulating International
Banking
Regulations of the type used in the U.S. and other countries
become even less effective in an international environment where
banks can shift their business among different regulatory
jurisdictions.

1. Deposit insurance in the U.S. covers losses up to $250,000,

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
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 always clear: 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?
4. No international lender of last resort for banks exists.
5. The activities of nonbank financial institutions are growing in
international banking, but they lack the regulation and
supervision that banks have.
The Financial Trilemma
• The preceding difficulties show that 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
• In other words, the only way to fully achieve financial stability
and free flow of international capital is probably the creation of a
global financial authority
• However, this possibility seems remote at present, so countries
have instead turned to a process of ever-increasing international
cooperation…
International Regulatory Cooperation
• In 1974, 11 industrialized countries set up the Basel Committee
to “strengthen the regulation, supervision and practices of banks
worldwide” to promote financial stability
• Basel accords I (1988) and II (2004) provide standard
regulations and accounting for international financial institutions.
– They tried to make bank capital measurements standard
across countries.
– They also developed risk-based capital requirements, where
more risky assets require a higher amount of bank capital.
• In 1997, the Basel Committee also issued its core principles of
effective banking supervision for emerging economies without
adequate banking regulations and accounting standards.
International Regulatory Cooperation
• The 2007-09 financial crisis made obvious the
inadequacies of the existing regulatory framework and
several additional measures were put in place
– In 2010 the Basel Committee proposed a tougher set of
capital standards and regulatory safeguards for international
banks, Basel III.
– 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 several
emerging market economies) and a larger permanent staff.
– Many countries have also embarked on far-reaching
national reforms of their financial systems.
 e.g. Dodd-Frank act in the U.S.
The Macroprudential Perspective
• As also made clear with the financial crisis, ensuring that
each individual financial institution is sound will not ensure
that the financial system as a whole is sound.
• Macroprudential policies are aimed at ensuring the
stability of the financial system as a whole
• Following the crisis, there has been growing consensus
about the need to re-orient the regulatory framework
towards a macroprudential perspective
The Macroprudential Perspective
The Macroprudential Perspective
• However, 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.
How Well Have International
Financial Markets Allocated
Capital and Risk?
International Capital Market
Performance
• Well-functioning international capital markets can be
beneficial through:
1. International portfolio diversification
2. Allocating savings to most productive uses through
intertemporal trade
3. Transmitting information about global investment
opportunities

• Let’s examine the available evidence on how well the

international capital market is performing in each of these
domains…
International Portfolio Diversification
• In 2008, U.S.-owned assets in foreign countries equaled 46%
of U.S. capital.
– In 1970 it was only 6%, indicating that international capital
markets have allowed investors to diversify.
• Likewise, foreign assets and liabilities have grown for many
other countries (see next slide).
• Still, some economists argue that it would be optimal if
investors diversified more by investing more in foreign assets,
avoiding the “home bias” of investment.
– In a fully diversified world economy, U.S. residents’ claims
on foreigners would equal around 80% of U.S. capital (the
U.S. share of global output is about 20%).
Gross Foreign Assets and Liabilities of Selected Industrial
Countries, 1983–2011 (percent of GDP)
Blank 1983 1993 2011
Australia Assets 12 34 83
Australia Liabilities 43 87 140
France Assets 63 80 256
France Liabilities 46 89 289
Germany Assets 38 64 230
Germany Liabilities 31 54 205
Italy Assets 22 43 106
Italy Liabilities 26 55 131
Netherlands Assets 93 148 450
Netherlands Liabilities 72 133 421
United Kingdom Assets 150 202 694
United Kingdom Liabilities 134 198 711
United States Assets 31 40 146
United States Liabilities 26 46 173

Source: Philip R. Lane and Gian Maria Milesi-Ferretti, “The External Wealth of Nations, Mark II: Revised
and Extended Estimates of Foreign Assets and Liabilities, 1970–2004,” Journal of International
Economics 73 (November 2007), pp. 223–250. The table’s 2011 figures come from the updated data
reported on Philip Lane’s home page, [Link].
Savings Allocation
• In an idealized world, saving seeks out its most
productive uses worldwide, regardless of location
• In this case, some countries should borrow for
investment projects while others lend to these countries,
and national saving and investment levels need not be
highly correlated.
• In reality, national saving and investment levels are
highly correlated (see next slide)
Saving and Investment Rates for 24
Countries, 1990–2015 Averages

OECD countries’ saving and investment ratios to output tend to be positively related. The
straight regression line in the graph represents a statistician’s best guess of the level of the
investment ratio, conditional on the saving ratio, in this country sample.
Source: World Bank, World Development Indicators.
Savings Allocation
• Does this imply international capital markets are unable to
allocate savings optimally?
• Not necessarily: factors that generate a high saving rate,
such as rapid growth in production and income, may also
generate a high investment rate.
• Governments may also enact policies to avoid large
current account deficits or surpluses.
– Recall that national saving – investment = current account.
Information Transmission – Offshore
Interest Rates
• We should expect that interest rates on offshore currency
deposits (e.g. Eurodollars) and those on domestic currency
deposits (e.g. dollars in a US bank) should be the same if
1. the two types of deposits are treated as perfect
substitutes
2. assets can flow freely across borders
3. international capital markets can quickly and easily
transmit information about any differences in rates
• In fact, differences in interest rates have approached zero (in
normal times) as financial capital mobility has grown and
information processing has become faster and cheaper
through computers and telecommunications (see next slide)
Comparing Onshore and Offshore
Interest Rates for the Dollar

The difference between the London and U.S. interest rates on dollar deposits is
usually very close to zero, but it spiked up sharply in the fall of 2008 as the
investment bank Lehman Brothers collapsed.
Why the spike?
Information Transmission – Exchange
Rates
• If assets are treated as perfect substitutes, then we expect
interest parity to hold on average:

Rt − R ∗ (
=
e
E t +1 − Et )
t
Et
• Under this condition, the interest rate difference is the market’s
forecast of expected changes in the exchange rate.
– If we replace expected exchange rates with actual future
exchange rates (once realized), we can test how well the
market predicted exchange rate changes.
– Turns out, interest rate differentials fail to predict large
swings in actual exchange rates and even fail to predict in
which direction actual exchange rates change.
Information Transmission – Exchange
Rates
• Given that there are few restrictions on financial capital in
most major countries, does this mean that international
capital markets are unable to process and transmit
information about interest and exchange rates?
• Not necessarily: if assets are imperfect substitutes, then

R= ∗ ( E e
t + 1 − Et )
+ ρt
t −R t
Et
– Interest rate differentials are associated with exchange
rate changes and with risk premiums that change over
time.
– Changes in risk premiums may drive changes in
exchange rates rather than interest rate differentials.
Information Transmission – Exchange
Rates

R= ∗ ( E e t + 1 − Et )+ρ
t −R t t
Et
• Since both expected changes in exchange rates and risk
premiums are functions of expectations and since
expectations are unobservable,
– it is difficult to test if international capital markets are
able to process and transmit information about interest
rates.
Exchange Rate Predictability
• In fact, it is hard to predict exchange rate changes over
short horizons based on actual money supply growth,
government spending growth, GDP growth, and other
“fundamental” economic variables.
– The best prediction for tomorrow’s exchange rate
appears to be today’s exchange rate, regardless of
economic variables (a so-called “random walk”).
– But over long time horizons (more than 1 year),
economic variables do better at predicting actual
exchange rates.
Bottom Line
• The current evidence on the performance of international
capital markets is mixed
• If one interprets findings as favorable, this supports a
continuation of the present trend toward increased global
financial integration
• If one interprets findings as showing market failures, this
might imply a need for increased government oversight
and central bank intervention (and perhaps even a reversal
of the global trend towards financial liberalization)
• More research is clearly needed!
Summary
1. Gains from trade of goods and services for other goods
and services are described by the theory of comparative
advantage.
2. Gains from trade of goods and services for assets are
described by the theory of intertemporal trade.
3. Gains from trade of assets for assets are described by
the theory of portfolio diversification.
Summary
4. Several types of offshore banks deal in offshore currency
trading, which developed as international trade grew and
as banks tried to avoid domestic regulations.
5. Domestic banks are regulated by deposit insurance,
reserve requirements, capital requirements, restrictions
on assets, and bank examinations. The central bank also
acts as a lender of last resort.
6. International banking is generally not regulated in the
same manner as domestic banking, and there is no
international lender of last resort.
Summary
7. As international capital markets have developed,
diversification of assets across countries has grown and
differences between interests rates on offshore currency
deposits and domestic currency deposits within a country
have shrunk.
8. If foreign and domestic assets are perfect substitutes,
then interest rates in international capital markets do not
predict exchange rate changes well.
9. Even economic variables do not predict exchange rate
changes well in the short run.