Examining Its Causes and Consequences in the Global Financial Services Industry - Literature review Example

Global Financial Crisis Name Institution Course Date Global Financial Crisis Introduction Financial contagion is the shock to the asset market of a country that results in changes of the prices in another country's financial market. Besides that, contagion can be defined as the process of transmitting market disturbances or changes from one country or region to another. It normally happens domestically and globally but has turned out to be more noticeable phenomena due to the growth of the global economy. Principally, contagion normally happens after the collapse of the international markets, but cross-border trade and investment could lead to quick crashes of regional currencies that are closely correlated as evidenced by the collapse of Thai baht in 1997 that spread quickly to the close by East Asian countries. This led to widespread market and currency crises in the East Asian region. The objective of this piece is to examine the causes and consequences of contagion in the global financial services industry and also to determine the extent of this risk as well as the methods of managing it both on an individual (institutional level) and an international level Discussion Examining Its Causes and Consequences in the Global Financial Services Industry Contagion has been defined by Kilic, Chelikani, and Coe (2014) as the diffusion of market disturbances from one economy to another. It can happen for various reasons such as local shocks and international macro-economic shocks disseminated through financial ties, competitive devaluations as well as commercial connections. Contagion can also be caused by gaps and imperfect information between the expectations of the investors. The majority of investors are normally poorly informed with regard to the countries’ real attribute; for that reason, they normally make decisions rooted in numerous indicators that can or cannot depict the state of vulnerability in the respective country. Some investors utilise information based on actions of the other investors; thus, demonstrating the information asymmetry effects. Contagion can be classified into a pure or psychological contagion, which is caused by the behaviour of the investors and mechanical contagion attributed to the economies’ financial connections. According to Armeanu, Pascal, and Cioaca (2014), a financial crisis can be diffused swiftly by psychological contagion together with commercial and financial international flows as well as information asymmetry. All of these factors combined can induce a high contagion effect. Besides that, regional models, commercial ties, as well as macro-economic similarities increase the countries’ vulnerability to volatility. Actions of the investors and lenders operating in the global financial service industry can pass volatility can from one country to another. When a country is strongly integrated into the global financial market the economic variables such as prices of assets would likely experience an evolution pattern. When the level of integration is higher, the country’s contagion effects increases tremendously (Armeanu, Pascal, & Cioaca, 2014). That is to say, countries which are not financially integrated, as a result of not being able to access international funding are immune to contagion. As mentioned by Walker (1998), contagion is caused by trade links as evidenced by Thai devaluation. The collapse of Thai baht benefited the foreign buyers because the Thailand exports became cheaper. However, countries like Indonesia which compete with Thailand in export markets experienced a decline in foreign demand since importers had switched to cheap Thai goods. Indonesia’s current account deficit increased because of the lower exports; therefore, Indonesia had to borrow more money overseas to make up for the financing gap created by the collapse of Thai baht. Indonesia reserves reduced leaving the country with fewer dollars that could not protect the rupiah; thus, the currency’s confidence reduced and Indonesia became an easier target for currency traders taking a gamble on the devaluation of rupiah. Besides that, the devaluation of Thai baht increased the amount of money Thailand paid for imports; thus, Thai imports reduced. Contagion can also happen through financial channels through liquidity effects, bandwagon effects, financial volatility (Walker, 1998). OECD (2012) posits that strong financial contagion can lead to global financial crisis since the localised issues in particular financial markets’ segments diffuse rapidly into a crisis of global magnitude. Furthermore, the shocks caused by financial contagion could affectedly exacerbate the countries' risk of experiencing a financial crisis. OECD (2012) further mentions that financial instability could spread to other countries through financial intermediaries’ balance sheets. When the financial institutions’ balance sheet is hit, the banks can be pushed to recall cross-country loans or sell external assets. This could lead to the spreads of financial instability to countries where banks have major asset holdings or those that have been loaned some money. As pointed out by Dungey and Gajurel (2015), contagion can affect many countries as evidenced by 2007 to 2009 financial crisis that affected all the banking sectors worldwide. Approximately 60 per cent of banking markets were exposed to idiosyncratic contagion and the global systematic risk that originated from the U.S. banking market (Dungey & Gajurel, 2015). This crisis also led to the collapse of Lehman Brothers, which had been in operation for 15 decades. This systemic risk increased the fears the US financial sector collapsing completely because of financial contagion and fears that the international financial markets would be disturbed significantly (Dumontaux & Pop, 2012). The Extent of Contagion and the Methods of Managing It Both On an Individual (Institutional Level) and an International Level Roy and Roy (2015), financial contagion could affect any asset market because the current world is financially globalised, and this effect could be transmitted to countries’ asset markets. Financial contagion can also lead to internal shocks by means of inter-linkages that diffuse to other asset markets at domestic level. When a market is hit by financial crisis, all markets across the globe could be affected, because the negative shock could be transmitted by foreign investors. A negative shock could spread from an overseas source to the domestic asset markets; thus, affecting other asset markets. The most recent global financial crisis at first affected the advanced economies’ asset markets before spreading out to other asset markets in developing countries and emerging economies by means of financial contagion. According to Chiwira and Tadu (2013), globalisation has resulted in the idea of financial integration, whereby the financial systems are interconnected to bring forth financial openness. Financial integration normally leads to the formation of the financial market where assets are considered as possessing similar returns and risks. In this case, the returns are identically priced irrespective of where the transaction happens. Therefore, financial integration is the process through which markets are unified to allow for the conjunction of risk adjusted returns across the markets on the assets having the same maturity. The financial integration process has to involve unconstrained access of participants to different segments of the financial market. Therefore, a complete financial integration must eventually lead to the development of an efficient market with no entry barriers or informational asymmetries for participants of the financial market. Financial integration can be beneficial because it leads to consumption smoothing because of risks’ international diversification and it also improves the financial system efficiency. It also increases the financial market agents’ prudence and allows for the alignment of high financial stability level. However, it comes with a number of challenges such as inadequate access to funding during financial instability, poor capital flows allocation and financial contagion. The financial contagion risk increases when the banking sectors are interconnected and also through financial linkages. Many financial institutions are transacting across borders so as to diversify their risk and revenue streams; thus, resulting in the development of financial integration. The financial institutions’ interactions can generate an international financial system that is resilient and can survive financial shocks. But still, these financial market interactions by means of financial institutions and interdependent banks in various economies are related to ‘contagion’ effects. As mentioned by Chiwira and Tadu (2013), the financial institutions’ interdependence could transmit a financial crisis because of the direct financial linkages. Therefore, financial integration is a double edged sword because it can improve financial stability and at the same time transmit a financial crisis by means of contagion effects. At the institutional level, financial companies can solve the contagion problem by improving their financial integration and abandoning the traditional financial system considering that the financial market is dominated by cross- border institutions (Burda, 2013). Furthermore, the nondepository financial intermediation can allow for debt instruments’ institutional dependencies, which are not protected by the prevailing depository guarantee. As mentioned by Jenkins (2011), guaranteeing short-term financial debt can help address the contagion problem; thus, enabling the financial institutions to fail and become insolvent devoid of triggering a panic. More importantly, financial integration is crucial because it facilitates investment and trade and it is highly beneficial to countries since it allows for efficient resources allocation in the economy. Financial integration also insures countries from the external shocks’ effects. Countries would have to enhance their own economy and make sure all the available financial sources are controlled so that the financial market is liberalised and international cooperation is supported to avoid contagion effect. Conclusion In conclusion, this piece has examined the causes and consequences of contagion in the global financial services industry and has also determined the extent of this risk as well as the methods of managing it both on an individual (institutional level) and an international level. As mentioned in the essay, contagion is mainly indicative of interdependence in the global market. It is normally related to the financial crisis and can manifest itself as negative externalities originating from a collapsed market. Contagion can happen domestically when a big financial service company sells the majority of its assets quickly leading to the confidence drop in the other large banks. Financial contagions are more likely in cross-border trade and global investment, particularly amongst the emerging markets or developing countries.  In such markets, asymmetric information exacerbates the contagion effect; thus, leading to both reactionary market downturns and unsustainable investments because of the nearby correlated markets that are collapsing.   The best way to manage contagion is through financial integration. References Armeanu, D. S., Pascal, C. E., & Cioaca, S.-I. (2014). Managing Contagion Risk During Economic, Financial and Political Shocks. Proceedings of the 8th International Strategic Management Conference, (pp. 1148-1157). Bucharest, Romania . Burda, M. C. (2013). How to Avoid Contagion and Spillover Effects in the Euro Zone? In A. R. Dombret, & O. Lucius, Stability of the Financial System: Illusion Or Feasible Concept? (pp. 440-456). Cheltenham, United Kingdom: Edward Elgar Publishing. Chiwira, O., & Tadu, R. (2013). Financial integration and the risk of financial contagion in Africa: Empirical Review. Journal of Research in International Business and Management, 3(4), 128-138. Dumontaux, N., & Pop, A. (2012). Contagion Effects in the Aftermath of Lehman’s Collapse: Measuring the Collateral Damage. Working Paper, Laboratoire d’Economie et de Management Nantes-Atlantique, Nantes. Dungey, M., & Gajurel, D. (2015). Contagion and banking crisis – International evidence for 2007–2009. Journal of Banking & Finance, 60, 271–283. Jenkins, A. M. (2011). Committee on Capital Market Regulation: Financial Regulation, Systemic Risk, and the Audit of Financial Contagion. Research Report, Harvard Law School, Cambridge, Massachusetts. 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