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The progress of financial globalisation
Let me, for good order, start by defining what I mean by financial globalisation. I take it to mean cross-border financial integration that is reasonably spread around the globe. Financial integration, in turn, is the process by which financial markets and institutions become more tightly interlinked and move closer towards a fully integrated financial market, where economic agents in different locations face a single set of rules, have equal access to financial assets and services and are treated equally. By implication, the law of one price would hold in such a fully integrated market, that is risk-adjusted real returns on assets with the same maturity and other characteristics would be equal.
The benefits of cross-border financial integration in terms of financial sector development, potential for risk-sharing and promotion of economic integration and growth are widely appreciated and so are the associated risks of surges and sudden stops in capital flows, contagion and vulnerability to financial crises. Almost everybody is trying to find the Holy Grail of reaping the benefits and mitigating the risks.
What is probably less well understood are the implications of the fact that financial globalisation is a process rather than a state of nature. This is maybe partly because macroeconomic textbooks jump from totally controlled capital movements to full global interest rate arbitrage from one page to the next. It is important to bear in mind that this process is only partly driven by government action. In addition, we have a market-driven process of financial innovation and evolving financial structures that will work to gradually increase cross-border financial integration.
Financial globalisation being a process has at least two implications. First, we would like to be able to measure where we are in the process. Second, different countries and regions will at any point in time be at a different stage.
Financial globalisation should manifest itself in stronger co-movement of risk-adjusted real asset returns across countries, a reduction in home bias in domestic portfolios, a higher level of gross cross-border capital flows and stocks of cross-border assets and liabilities, and an increase in cross-border banking and foreign direct investment in the financial industry. Theory also suggests an increase in the scope for international risk-sharing, which would be reflected in a lower correlation of domestic consumption and GDP.
Many of these manifestations lend themselves to some kind of measurement. Using the BIS international banking statistics and other sources, we see that the trend of financial globalisation is unmistakable. Let me mention a few stylised facts:
First, countries: from 1995 to 2005 there was a doubling of gross external positions of a representative sample of 29 countries, measured by the sum of foreign assets and liabilities as a percentage of GDP.
Second, banks: international claims of banks located in mature economies have increased fivefold as a percentage of GDP since 1980 to reach 50% last year.
Third, asset returns: international co-movements of asset returns have increased significantly, as demonstrated in numerous studies. Furthermore, as predicted by theory, these co-movements are stronger further along the maturity spectrum. However, it is possible that they are, at least partly, due to other factors than financial globalisation, such as common shocks.
But it is a mixed bag. Although home bias has fallen, it remains substantial, even among countries that have operated open capital accounts for decades. Consumption remains more correlated with domestic output than predicted by theory. The global integration of financial markets has therefore so far provided less insurance against idiosyncratic shocks than expected. This could be because capital flows have effectively been more constrained than appears on paper, and financial integration has thus been less advanced. Alternatively, capital flows may be inherently volatile due to information problems and herding, thus becoming a source of shocks as much as smoothing.
Internationalisation of banking and prudential policies
Let me now turn to the internationalisation of banking and the challenges it creates for prudential policies. This is a big subject and my exposé will of necessity be sketchy. However, you might be interested to know that this will be treated in greater depth in the forthcoming Annual Report of the BIS.
As you are better aware than most others, internationalisation of banking is not a uniform process. There are cycles in the overall pace and uneven patterns of development in terms of whether banks engage in cross-border banking from their home base or have a local presence in host countries through branches or subsidiaries.
In recent years it seems that direct presence in host countries has become more prevalent. However, cross-border lending still dominates in the euro area and emerging Europe, while local presence is more usual in the United States and Latin America.
The pace of development has been diverse across countries and regions. According to the IMF’s latest Global Financial Stability Report, the share of foreign controlled bank assets in total bank assets increased globally by 8 percentage points between 1995 and 2005, to reach 23%. However, this share grew much more strongly in eastern Europe and Latin America, and it is currently significantly higher in these two regions than in other parts of the world.
A similarly strong regional variation emerges when seen from the standpoint of home countries. Cross-border activities, measured by the unweighted average shares of assets, revenues and employees, accounted for 45% of the total activity of 50 major European banks, but only 23% of the activity of 20 such banks in North America, and 14% of 20 major banks in Asia and the Pacific.
The drivers of the internationalisation of banking are partly the same as for globalisation in general, a reduction in transaction costs, progress in communication, economies of scale and scope, and liberalisation of trade and capital flows. Globalisation, in turn, gives a strong impetus to further internationalisation of banking. Thus following important domestic clients in international ventures is often an important motive for bank’s cross-border activities. However, there are also drivers more specific to the financial industry and the same applies to the domestic regulatory and competitive environment in which banks operate. Advances in computing and communication, in measurement and management of financial risk and financial innovation have increased the returns from expanded scope and scale, thus facilitating international expansion. Limits to domestic growth and a reduction of oligopolistic rents as competition increased then helped to provide incentives for expansion.
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