Western Financial System Versus The East Asian Financial System - Research Paper Example

Western Financial System versus the East Asian Financial System Introduction The development of economies worldwide is based on specific criteria;these criteria can be differentiated in accordance with the local ethics and culture, the position of a country in the international community and the resources available – funds and skilled employees – for the realization of the relevant projects. The financial crisis of 2007 onwards proved that the potentials of countries worldwide to face the pressures of the market couldn’t be precisely identified in advance. It should be noted that a similar crisis occurred, rather recently, in Asia; the crisis of the 1997 was used by many people in order to prove that eastern financial systems is not as strong as initially estimated by researchers. Current paper focuses on the examination of the merits of the Eastern Financial system towards its Western rival. The studies of Goodhart and Johnson – referring to the above systems – are critically discussed. It is proved that the Eastern financial system offers higher security – compared to the Western financial system. In this context, the views included in the study of Goodhart - that is supportive towards the Eastern financial system – are verified; the views of Johnson are important – in terms of the issue under discussion – and they are critically discussed in order to have more chances to highlight all aspects of these study’s issues. Assumptions are made in regard to the merits of both these systems but also the potential superiority of one of them – reference is made to the Asian Financial system; the views published in the literature in regard to the specific subject are also used – at the level that have been considered as important for supporting the arguments stated in the paper. 2. Western and Eastern financial model in the study of Goodhart The views of Goodhart on the Western and Asian financial system are based on the critical examination of certain aspects of these systems; particular attention has been paid on the responses of these systems to the crisis of 1997-98 but also to the recession of the period 2007-2009 – a recession that is still in progress. Goodhart notes that the ability of the Western (called also Anglo-Saxon) financial system and the Eastern financial system to respond to the crisis need to be evaluated by referring primarily to the structure of these systems; at the next level, the effects of these systems on the national economy can be identified. It is proved that the differences in these system’s potentials against financial crises can be explained based on these systems’ elements and role in the context of a particular social, political and economic environment. In accordance with Goodhart the main weakness of the Anglo-Saxon model is the fact that ‘stability carries within itself the seeds of future instability’ (Goodhart, p.9); in the context of the Western financial system, the above fact has led to the high exposure of banks to risk by expanding leverage (Goodhart, p.9). Of course, the activities of all financial institutions of the Western financial system are regulated by the rules of the Basel II – however, the existence of the above legislative framework had not the result expected; because of the above text, potential investors in the Western financial system are more likely to avoid appropriate check of their investment schemes – based on the fact that all relevant activities are based on specific laws; in this way, there would be no need for verification of the investment schemes developed in the context of a Western financial system. The above problem is highlighted by Goodhart who notes that ‘the adoption of the pro-cyclical combination of Basel II and mark to market accounting served to hide the fragility of the over-extended financial and banking positions both from the regulators and from the regulated’ (Goodhart, p.9). Furthermore, existing regulation of firms that operate in the financial services sector – referring to the Western financial system – is not appropriately developed – in terms of the priorities set by its rules; in this way, the non-compliance with the capital requirements can lead even to the cancellation of a firm’s documentation – referring to the documents that are used for proving the firm’s existence – because of the lack of validity; however, if severe failures are identified in this firm’s strategic decisions – meaning the decisions on investment schemes for the customers’ funds – then the measures taken by the state against the firm can be limited – even non-existent. In the study of Goodhart it is made clear that the responses of the Western financial system to a financial crisis can be explained by referring also to this system’s macroeconomic structure; the regulation of this system has been also regarded as being responsible for this system’s failure to face the crises of 1997-1998 and 2007-2009. The macroeconomic structure of the Western financial system is characterized by the key role of the executives – the power of these individuals is extended at such level that their decisions can be differentiated from the view of the government or the public on a specific issue referring to their firms’ activities. In the context of the US market, the high level of independency of banks’ executives led to the limitation – even to the elimination in certain cases – of these persons’ responsibility in regard to their investment choices – referring to the investments made in the name of the firms’ investors. Goodhart uses the weaknesses of the Western Financial system – as described above – in order to explain the potential superiority of the Eastern financial system especially regarding its potentials to face the pressures of a financial crisis. The Asian Financial system is considered by Goodhart to be more stable – compared to the Western Financial system; Goodhart has tried to identify the value of the Asian Financial system by examining this system’s structure but also its practical implications – as they could be identified through studying the operational practices of the banks of 4 Asian countries – Japan, China, India and Indonesia. It was revealed that the Asian Financial system should be preferred as it has two critical advantages – compared to its Western rival: a) a high percentage of the local banking system is owned and controlled by the state and b) the terms of lending to individuals and firms are closely monitored by the relevant authorities – a fact leading to the increase of the credibility of Asian Financial System (Goodhart, p.6); the comparison of the two systems, the Western and the Asian ones by Goodhart leads to the assumption that both these systems have their benefits and disadvantages; in any case, the Asian Financial system seems to be suggested by Goodhart as a financial system of increased safety. However, the radical change of both these systems is required in order to improve their quality and their safety; because the cost of such an initiative would be extremely high, it is suggested by Goodhart that a new – unified – system could be introduced meeting the requirements of both systems (the Western and the Asia ones). 3. The view of Simon Johnson on Western and Eastern financial model – critical analysis of the article ‘Quite Coup’ In the same context with Goodhart, Johnson has tried to identify the advantages and the weaknesses of the Western and the Eastern financial systems; his study aims to explain the terms under which countries worldwide have to ask for the support of the IMF; it is at this point that the term ‘Eastern’ takes a different meaning – compared to the one used by Goodhart. More specifically, in accordance with Johnson, the governments in Eastern countries tend to use a specific practice: to develop expensive projects which are based exclusively on loans; in this way, a huge amount of loans is developed; after a specific period of time and taking into consideration the fact that the global market is not stable, the repayment of these loans is quite difficult. The above practice is not related exclusively with the countries of the Islamic banking system; the term can also refer to countries of the East that use the Western system of banking, like in the case of Japan. Johnson refers to the case of Russia to show that the failures in using the capital borrowed can lead to severe turbulences; in the case of Russia it is noted that the country’s entrepreneurs borrowed a significant amount of money the last 5 years aiming to increase their commercial activities; however, the recession led to severe delays in all industrial sectors; the reduction of profits led to severe pressures for the repayment of the loans; and in this way, the borrowed capital has worked as a trap for the local investors. It is implied that the terms of borrowing need to be carefully examined each time that the external funding is required for the achievement of specific business plans. Another example of the factors that can led to a financial crisis is the one of US; in the specific case Johnson notes that ‘elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government’ (Johnson, 2009); again the crisis is not related with a specific financial system; USA which is based on a Western financial model was proved unable to confront the crisis; at the next level, the expansion of the crisis has been quite rapid indicating the lack of mechanisms for protect the market from such threats. Despite the crisis, the support of Johnson towards the Western financial model is clear; it is noted that the radical development of the financial services sector in USA has been related with a series of factors including ‘the monetary policy and relevant interest rates, the invention of securitization and credit-default swaps’ (Johnson, 2009); the above policies were appropriately structured and promoted; the financial development of the country was carefully planned – the failures related with financial products promoted by a specific team of individuals cannot be considered, in accordance to Johnson, as a key indicator regarding the potentials of the USA economy; on the contrary, in the case of eastern financial system – Johnson refers to the example of Russia – no similar basis for the development of the country’s economy seems to exist. Of course the financial policies of the two countries cannot be the same during to the geo-political and cultural differences of the above regions; however, even under these terms, Johnson clearly supports the superiority of the Western financial system towards the Eastern financial system. At this point, Johnson is differentiated from Goodhart who emphasizes on the important characteristics of Asian financial system. 4. Western versus Eastern financial model – identification and evaluation of merits using the studies of Goodhart and Johnson and the literature In accordance with the studies of Goodhart and Johnson, the Western Financial System has the following merits: a) development of the financial system in a free market; this an advantage of the Western financial system highlighted by Johnson; in this market the development of commercial and financial activities is free – not controlled by an oligarch – a political system which is often identified in eastern countries in accordance with Johnson; the existence of a free market in the Western Financial system has been proved as related with risks; in fact, it was in this free market that the expansion of faulty financial products was permitted; the result was the crisis of the 2007 onwards – an extremely powerful crisis the effects of which are extremely strong compared to the effects of the crisis of 1997-1998 in Asia which did not negatively affect the global market at this level, b) regulation by specific rules the application of which can be controlled by relevant international authorities – referring to the Basel rules on the banking regulation; on the contrary in the eastern financial system no common regulatory framework can be identified among the countries that are based on the eastern (Asian) financial model; this merit of the Western Financial system is highlighted by Goodhart. However, the Basel rules and the rest of the rules regulating the financial services activities in the Western financial system are not used strictly by the individuals and firms that work on the financial services industry; in this context the existence of specific regulation cannot be actually considered as a merit of the Western Financial system – a fact also noted by Goodhart who supports the superiority of the Eastern financial model as having less chances to lead to crises like the one of 2007-2009. As for the Asian Financial system, its merits were highlighted in the study of Goodhart; no comments on the potential positive aspects of the Eastern Financial system were made by Johnson; using the study of Goodhart the following merits of the Eastern financial system can be identified: a) the market is not depended on the initiatives of individuals – executives; rather the state has the control of the market; this means that initiatives that could threaten the national economy are likely to be avoided in the Eastern Financial model; b) lending is not approachable by all; criteria are set ensuring the protection of the system by severe turbulences – a risk that was not avoided in the US market which was heavily depended on faulty financial products – referring mostly to the the subprime products; as the repayment of loans in the US market started to present delays the pressures on the local market became extremely strong; in the Eastern financial system this risk is limited since the level of lending is closely monitored; a potential delay in the repayment of loans cannot threaten the global economy – like in the case of crisis that first appeared in the US market which is based on the Western Financial System. It is concluded that the Eastern Financial System has more advantages compared to the Western Financial System; the risks involved in the Eastern Financial System are low – compared to the risks involved in the Western Financial System. This fact is also highlighted in the literature; in accordance with Noble et al. (2000) two are the most important merits of the Eastern Financial system: ‘the security and the community’ (Noble et al., 2000, p.14); on the other hand, Henke et al. (2000, p.158) emphasize on the importance of the control of the state on the activities developed in the context of the Eastern Financial market. Another significant advantage of the Eastern Financial model seems to be its dependency ‘on bank loans than on securities markets’ (Caprio, 1998, p.4); on the other hand, the successful ‘transition to a market economy model’ (Ariff et al., 2000, p.5) seems to be a significant advantage for the countries that are based on the Eastern Financial System; an example of such country is China which managed to effectively respond to the transition of its economy into a market-economy mode. On the other hand, Gup (2000, p.85) notes that the countries based on the Eastern Financial system are able to stabilize the performance of their economy – even against to severe turbulences in the international market – when they introduce the necessary regulatory reforms (Mishkin, 2007, p.63). The risk for corruption and the moral hazards in the Eastern Financial system should not be regarded as exclusive disadvantages of this system – as noted by Lee (1998, p.14); in the Western financial system also such phenomena are common – as proved through the current crisis. In fact, the Eastern financial system can lead to the increase of the stability of the local economy – only under the terms that measures are taken for the limitation of corruption and the introduction of appropriate regulatory rules (Hassan et al., 2004, p.40). 5. Conclusion The crisis of the period 2007-2009 and the previous crisis of the period 1997-1998 have been used as events indicating the failures of financial systems worldwide; the first crisis started in a market based on the Western financial system; the second crisis is related with the Eastern Financial system. It seems that both these systems have strengths and weaknesses; in the context of the modern market, the comparison of these systems – using the studies of Goodhart and Johnson and the literature – has led to the assumption that the Eastern Financial system should be preferred – instead of its Western rival; the reasons on which this suggestion is based are analyzed in the previous section. The Eastern financial system is offered for higher security – due to the intervention of the state – and higher stability – due to the limitation in the loans available in the market (Siddiqui, 2008, p.57, Lastra, 2004, p.225); it has been proved that the appropriate reform of the regulatory framework of the Eastern Financial system would increase the superiority of this system towards the Western Financial system which is highly regulated but no effective mechanism exists for the control of the alignment of the investment and banking activities with the terms set by the relevant laws. 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