Banking Globalization and Global Imbalances - Essay Example

Banking Globalization and Global Imbalances Introduction Over the years, banks have continuously diversified internationally. This has greatly been because of the comparison of the costs and benefits of the decision. Like any other kinds of investments, banks face uncertainty about the expected costs and the expected gains of such a decision (Cetorelli & Goldberg, 2011). On the cost side, there is an accepted notion that the foreign banks face more cost disadvantages when they are compared with the local competition. The additional costs may be because of legal barriers, increased control problems, cultural differences among others. As such, in order for a bank to operate profitably in the foreign market, it must be able to gain or realize gains that are not available to local competitors. These gains to be realized when a bank is operating in foreign financial sector usually stem from; geographical risk diversification, competitive and comparative advantage factors and efficiencies that are not attained when operating exclusively in the local markets. On comparative advantages, better intermediation technologies, superior management quality, and innovative products are among the factors frequently cited by both the internalization theory and the electric theory of multinational corporations (De Haas & Lelyveld 2010). However, these factors are not permanent in the case of banks diversifying internationally based on the assumption that financial firms usually have intangible assets that cannot be imitated and management quality is easily transferable. Information is a crucial comparative advantage for a bank to operate in abroad markets. Organizations prefer doing business with a less number of banks to ensure that their sensitive financial information is not revealed to too many financial firms. As such, once a bank establishes a relationship with an organization, it has competitive advantage in serving the firm’s operations in the foreign markets. The increased importance of information in the banking sector has resulted to the shift from cross-border borrowing and lending towards the foreign banks’ local operations in the emerging countries (Mariotti & Piscitello, 2010). One of the best ways of exploiting comparative advantages arising from the private information in foreign markets is following the client. This means that banks usually expand in the countries where their client choose to invest so that they can be able to offer them services that they need. Additionally, a financial institution has clear interests in keeping other financial institutions away from establishing a relationship with its clients as this can lead in the loss of its market quota in the home market (Curry, Fung & Harper, 2003). Bank’s decision to move overseas is sometimes a defensive reaction taken to avoid losing of corporate clients at home. Regarding efficiency, the factors that are mainly involved are degree of internationalization, product and distribution channels, and the size of the bank. First, the large size of a bank enables it to translate its scale of efficiencies to the foreign markets at relatively low costs and to compete with the local institutions regardless of the extra costs that are usually faced by foreign competitors. Importance of size heavily depends on the kind of operation and activity developed by foreign firms in the host market (Committee on the Global Financial System, 2009). If a firm’s business model implies the duplication of costs, attaining scale efficiencies would be difficult. It is argued that a business model that is based on subsidiaries with a retail focus is unlikely to gain from large benefits in efficiency while branch model would if directed to investment banking or wholesale markets (Curry, Fung & Harper, 2003). This is a key factor that has led to the increase of banks starting their branches in foreign markets. The degree of internalization is also a crucial factor in ensuring efficiency. This is because banks with a huge and geographically diversified client base are able to reduce the transaction costs. Banks aim to achieve this by establishing their branches in the different foreign countries. In addition, the use of bank’s own distribution channels may lead to large gains in efficiency especially in the developing countries where supply of some banking services is poorer or nonexistent. In this case, subsidiaries aimed towards retail banking could greatly profit from the product efficiencies. It is even more the case where foreign banks usually share the same language and culture with the host country since no change is required in the services and products offered. Risk diversification is a great motivation for the banks to diversify internationally. Banks usually diversify their client and income base by operating in foreign countries obtaining the benefits in form of their risk-return profile (Schularick & Taylor, 2012). The importance of these benefits is closely related with the extent of the financial market imperfections that often render diversification of banks’ local operations more worthy than diversification by a final investor. In the case of financial foreign direct investment to the emerging countries, legal and informational problems for individual investors explain why the banks prefer to locally operate in the foreign country. The existence of such barriers to the mobility of capital constitutes an incentive for foreign direct investments if the international banks have the ability to build a geographically diversified portfolio at lower costs than the individual investor could (Ostry, Ghosh & Habermeier, 2011). A number of factors that determine what extent banks’ diversify their income base when they are operating in foreign country are mostly macroeconomic in nature such as the interest rate structure, the exchange rate, and the business cycle. Banks mainly prefer opening branches in the relatively riskier countries that have generous deposit guarantee schemes. The role of strategic behavior has also been termed as a motivating factor for banks’ international diversification by the microeconomic/behavioral theories of financial foreign direct investment. They introduce the notion that globalization and internationalization decisions could be conditioned by competitive structure of the bank’s home market (Lane & Milesi-Ferretti, 2007). It is assumed that once a certain bank has initiated the internationalization process, its home markets competitors may follow because of oligopolistic reaction. This competitor response is a key motivator to most banks to diversify internationally to gain competitive advantage over their rivals. Other motivating factors to banks’ diversifying internationally are the macroeconomic determinants of foreign direct investment, which are classified in push and pull factors (Pissarides, 2008). Among the push factors, home country’s economic cycle greatly influence the investment decisions of many banks. Growth in the home country economy increases the organization’s wealth and reduces the financial constraint faced by financial direct investment. Conversely, the extent that the home productivity of its capital is positively related to the growth, expansions should go in hand with relative increase in the expected home returns reducing the need and attractiveness of foreign direct investments. Interest rates in the home country are another important push factor. It is generally accepted that high interest rates hinders foreign direct investment. Low interest rates at home country leads to lower costs of capital and narrow interest margins which are among the reasons why banks operate abroad especially in emerging countries where the margins tend be larger (Hume & Sentance, 2009). Financial conditions in the home country greatly influence a bank’s decision to invest abroad (Reinhart & Reinhart, 2009). Wealth factors because of the exchange rate in a country greatly affect the foreign direct investment. For example, appreciation in the dollar usually postpones the foreign investment by the U.S companies and banks. Higher stock market value of banks in the home country greatly favors their investment abroad. Pull factors have been highly associated to the foreign financial investments. They usually refer to the host country related factors. The host country’s economic growth is a key factor to international banking. Development of the financial system in the host country is an important pull factor. Foreign banks prefer to operate in countries that have a relatively developed and less concentrated financial system. The economic integration between the host and home countries is also a driving force of banks’ foreign investment (Obstfeld & Rogoff, 2010). Another pull factor is macroeconomic volatility, which appears to hinder the financial foreign direct investment. A number of institutional factors appear to be determinants of a banks’ international diversification (Hryckiewicz & Kowalewski, 2010). These factors are in the categories of either push or pull factors. For instance, among the push factors, a crucial one is the existence of the domestic restrictions that limits banks’ operations at home. In regard to the pull factors, openness of a host country to the establishment of foreign subsidiaries and branches is a key factor as well as the tax incentives. Banks usually prefer acquiring equity interests in the countries where the market is less concentrated or where the banking activities regulatory restrictions are low. Another pull factor that is important to banks’ foreign investment is the legal system particularly the bankruptcy procedures and the protection of the creditor rights. High per capita income in a host country enhances financial foreign direct investment since it is a major determinant of the profit opportunities. Banks are highly attracted to the markets with low taxes as well as high profitability. Risks of banking globalization The 2007 – 2009 global financial crises are the worst crisis that the world economy has ever experienced since the 1930s’ great depression. It started in the U.S. as a credit crunch and then it spread to most countries and threating the survival of many financial institutions. As mortgage related investments of billions of dollars went sour, banks disappeared and the Federal Reserve of the U.S and other central banks took steps to contain the situation (McGuire & Peter, 2009). The steps included additional lending systems such as term securities lending facility, term auction facility, and commercial paper lending facility among others. U.S Treasury also launched the troubled Asset Relief Plan where it committed to purchase the risky securities to offset them from the balance sheets of the banks. As a result, U.S and other countries came up with systems aimed at reviving the sector and limiting future financial crisis. Despite the fact that financial globalization has some potential benefits, it also carries some risks. Banks often run the risks associated with lending abroad. Country risk is a term that is used to refer to the potential political, economic, and legal sources of losses common to a jurisdiction (Giavazzi & Spaventa, 2010). The recent occurrence of financial contagion and crises after countries liberalized financial systems and were integrated with the world financing markets proves that financial globalization can generate financial crises and volatility. Although domestic factors are said to be the major determinants of crises, various channels can be used to relate financial globalization to crises. For instance, when a country adopts the world financial system or liberalizes its system, it becomes subject to the market discipline practiced by domestic and foreign investors (Baba & Packer, 2009). In a closed economy, the monitoring of the economy and the reactions or measures to unsound fundamentals is only attributed to the domestic investors. In the open economies, a joint force of the foreign and domestic investors could generate a crisis when the fundamentals deteriorate (Acharya & Schnabl, 2010). The investors can overreact by being over-pessimistic in bad times and over-optimistic in good times, which may not be favorable to a country. Thus, small changes in news or fundamentals may cause sharp changes in the investors’ attitude and appetite for risk. Banking globalization may also lead to crises especially when imperfections are present in the international financial markets. These imperfections in the financial markets may be the cause of bubbles, crashes, herding behavior and speculate attacks (McCauley & Zukunft, 2008). Imperfections in the international capital markets may generate crises even in the countries that have sound fundamentals. For instance, when the investors believe the exchange rate is not sustainable, they could speculate against the currency, which may lead to self-fulfilling crisis of balance of payments regardless of the market fundamentals. Imperfections are also associated with the deterioration of fundamentals. For example, over borrowing syndromes can result from moral hazard when the financial economies are liberalized and there is the presence of implicit government guarantees and this increases the likelihood of crisis. Even in the countries with sound fundamentals as well as in the absence of imperfections in the capital markets, banking globalization may lead to crises because of the external factors. If a country tends to be highly dependent on the foreign capital, shifts in the foreign capital flows may create economic downturns and financing difficulties (McCauley, 2008). The shifts do not depend necessarily on the country fundamentals. External factors are key determinants of the capital flows to the developing countries. For instance, it is argued that world interest rates were a major determinant of the capital inflows into Latin America and Asia in the 1990s. Economic cyclical movements in the developed countries and the regional effects tend to be the other important global factors. Contagion may result from financial and banking globalization (OECD, 2012). These shocks are usually transmitted between countries and usually lead to financial crises. The channels of contagion have been grouped into three categories; financial links, herding behavior and the real links. Financial links usually exist when there is connection of two economies through financial international system. An example of financial risks occurs when leveraged institutions like the banks face margin calls. When value of their collateral reduces or falls during a negative shock in a country, the leveraged institutions need to raise and increase their reserves. Thus, they tend to sell some of their valuable holdings on the countries that are not affected by the initial shock. As a result, shock is propagated to the other economies. Real links have been associated with the trade links. When two countries compete for market in the same external markets, devaluation of exchange rates in a particular country leads to the deterioration of the competitive advantage of the other country. As a result, both countries are likely to end up devaluing their currencies in order re-balance their own external sectors. Financial markets may also propagate shocks across countries because of the herding behavior. The root of the herding behavior is the asymmetric information. The information is considered costly so the investors remain uninformed. They thus tend to infer the future price change based on the reaction of other markets (Lane & Milesi-Ferretti, 2007). For example, a change in Brazil’s asset prices may be useful information on the future changes in Indonesian asset prices. In this context of asymmetric information, market participants in one economy may convey information that other investor does not have and it may lead to panic or herding behavior. References Acharya, V.V. & Schnabl, P., 2010, ‘Do global banks spread global imbalances? Asset backed commercial paper during the financial crisis of 2007–09’, IMF Economic Review 58 (1), 37–73. Baba, N & F Packer 2009, ‘From turmoil to crisis: dislocation in the FX swap market before and after the failure of Lehman Brothers’, Journal of International Money and Finance, no 28(8), pp 1350–74. Cetorelli, N., & Goldberg, L. 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