Causes of the Contagion - Australian Banking System - Case Study Example

Contagion Student’s Name Institutional Affiliation Contagion The Australian financial sector is also involved in international financial markets through the Bank of International Settlements which is an international monetary authority. A financial contagion in the banking industry is defined as a crisis or a shock within one bank that causes harmful changes to other systems. The spillover and spreads to other organizations in the financial market. The Contagion occurs due to the complex interrelationships between institutions and the nature of the exchange settlement systems. According to Ong, Mitra & Chan-Lau (2007), the shocks of a contagion in one financial institution or market can be transmitted locally or internationally due to the increased interconnections among the domestic and international financial systems. The high volumes of financial transactions can also result to a spill over that would affect the Australian market. Causes of the Contagion The main cause of the Contagion is the inter-linkages of the banks with other segments of the financial sector both locally and internationally. Banks provide various services to other industries such as giving insurers letters of credit, providing investors with services such as hedge funds, and so on. Recently, there are a lot of cross-border lending activities and the transactions and the connections in the Australian banking system represent a probable tool for financial contagion. There are a wide range of potential conduits for contagion from various banking systems to Australia and vice-versa. The external connections could arise from direct and indirect exposure of the domestic banks in international banks or through shareholding by foreign banks. Most Australian-owned banks have significant global positions that expose them to the developments in the other countries. The reserve Bank of Australia can also be a potential source of contagion during times of substantial stress. The RBA is a major source and key controller of liquidity held by banks in the financial system. The RBA is continually expanding in size and major banks in Australia set their references for short-term interest rates locally and internationally based on the RBA policies. The Reserve Banks control the cash rate, thus influencing the whole interest rate structure in the Australian market. The expanding links between the financial institutions indicate that a crisis in one financial institution is detrimental across the whole financial system leading to a systemic liquidity challenge. Consequences The risk of contagion is enhanced by financial integration through banking debts. However, the definite impact is dependent on the banking sector structure of the borrowing state. According to Kilic, Chelikani and Coe, (2014), direct borrowing through international banks are more risky than lending conducted through subsidiaries or branches of the global banks. The reason is that direct borrowing is substantially affected during periods of financial crises. When the global liquidity is low and the interest rates high, there is a possibility that a bank or country with direct borrowing debt will suffer a systematic financial crisis. Therefore, the Reserve Bank of Australia must ensure there is a strong international liquidity during periods of financial havoc to reduce the effects of contagion. A contagion affects both emerging markets and developed economies with robust structures such as Australia. According to Lhost (2015), the effects of a contagion depend on the information available in the market. Emerging markets are more significantly affected by contagion because there is less accessibility to the fundamental information for the investors in those countries than in developed markets. Thereby, the financial contagion is exacerbated. Additionally, the developed markets can transmit the contagion to different emerging markets. In particular, the developed markets can act as a channel for the transmission of shocks between the emerging markets, and thus, worsening the financial crisis in those markets. A contagion has a negative effect on the perception of the investors in regards to productivity of the foreign market. The contagion shocks the economy to a sudden stop. The foreign investors view it as a risk lending to entrepreneurs in markets with a contagion due to the rise in risk premiums. The shock lowers the value of investments and reduces output in the foreign economy. Thus, the decrease in the supply of capital has greater negative consequences for the local markets. The Extent of the Contagion Risk and the Methods of Managing It on All Levels When determining the risk of the contagion, the IMF addresses the crisis depending on its origin. Where the crisis or shock is of domestic origin, the local economy is likely to benefit from the depreciated currency rates, but the rest of the world suffers from the unfavorable financial upheavals. The consequential contraction in productivity in the foreign economy is conveyed to the local economy through a decrease in the demand for exports. Consequently, the fall in export demand aggravates the crises and increases the period of the shock. Thus, all the countries involved suffer the severity of the shock. The financial and trade interrelationships have apparent repercussion to the extent of integration between trade and the financial systems of domestic and global economies. If the contagion is lower in the international economy, the lesser the implications for the domestic market. A lower contagion from the global shock ensures that the domestic economy has a chance of recovery (Ozkan & Unsal, 2012). The interconnectedness of the financial systems across the world means that there is a fear of financial contagion. Therefore, governments and investors are highly motivated to provide bailouts as well as other interventions to countries or markets experiencing financial shock. To manage contagion, most governments, including Australia have put policies in place that prevent the possibility of financial contagion. In Europe, there has been a development in the framework for modeling contagion to avoid spill over. The model applies to the credit risk of sovereign debt in Europe because credit markets are perceived to bear less risk of contagion and spillover effects (Lim, 2012). A sound risk management plan is essential for the banking industry across the globe. Governments must ensure the responsibility to mitigate risk is shared between the private and public sectors in the financial system. A joint risk management plan is essential in the domestic level to avoid disruptions that overflow to the other sector. Banks are also encouraged to adopt risk-management policies that identify precarious areas such as managing liquidity and so on (Ong, Mitra & Chan-Lau, 2007). On the international level, there is a significant importance is being positioned on enhancing cross-border cooperation to avoid international shocks. For example, the IMF has listed the FSA in the UK, European regulatory counterparts and the European Commission as some organizations that encourage and support resourceful and risk-based global collaboration. Therefore, to avoid contagion, there must be international coordination and sharing of information between different authorities so as to enhance the stability of the financial systems (Ozkan & Unsal, 2012). In brief, financial globalization is a new phenomenon rapidly gaining popularity across the world. There are various forces in the market that push towards globalized financial institutions such as governments, lenders, and investors. Various governments in the developed countries have eased up their restrictions thus liberalizing their local financial sector. The gradual move is meant to increase the participation of financial globalization and enhancing international consumption and investment. Contagion has posed a challenge to cross-border financial stability. Thus, trade organizations and governments are looking to establish policies that manage the shock of contagion globally. References Kilic, O., Chelikani, S., and Coe, T. (2014). Financial Crisis and Contagion: The Effects of the 2008 Financial Crisis on the Turkish Financial Sector. International Journal of Applied Economics, 11(2). Lhost, J. (2015). Future Implications of Financial Contagion. ThoughtCo. Retrieved 10 July 2017, from https://www.thoughtco.com/cause-effects-and-implications-of-financial-contagion-1146263 Lim, K. G. (2012). Global financial risks, CVaR and contagion management. Journal of Business and Policy Research, 7(1), 115. O’connor, A. (2010). Government policy, banks' strategies and the financial crisis: Contagion through interconnectedness. Vie & sciences de l'entreprise, (3), 59-75. Ong, L., Mitra, S., & Chan-Lau, J. A. (2007). Contagion risk in the international banking system and implications for London as a global financial center. International Monetary Fund. Ozkan, F. G., & Unsal, D. F. (2012). Global financial crisis, financial contagion, and emerging markets. Read More