Introduction The advent of globalization has led to high international capital mobility, which have repeatedly led to international banking crises. One example of the case is what happened in the 1990s (Kutlay and Kutlay, 2009). Globalization as seen by many scholars has become one of the most heated topic in recent years. Currently, it is not possible to conclude a debate without touching one aspect of globalization. Furthermore, it has become difficult to define the term without overselling it (Dauphine University Paris, 2010). Although there is no consensus on the definition of economic globalization, most of the definition, given by a number of scholars defines economic globalization as the abolition of customs, as well as trade barriers, the surge of technology development, as well as knowledge, increased liberalization and integration of financial markets, and the movement of labor (Dauphine University Paris, 2010). However, as a number of scholars indicate the most dynamic and unstable part of economic globalization is the financial system. Therefore, this essay focuses on the implication of globalization and financial liberalization for the banking system that are outside developed countries. This involves identification of these implications and strategies that banks can employ to meet the challenges posed by the evolving global market in trade and finance. To identify the theories, the essay uses theories and case studies from different banks systems in several nations in the developing countries. Agents of Globalization of Financial Market According to Shehzad and De Haan (2009), there are four main players in the globalization of financial market. These players include the government, borrowers, investors, as well as financial institutions. Every player in the list is helping in the integration of the financial market. The government is one of the main agents in the integration of financial market. It is the main agent because it allows the liberalization of restrictions on the domestic financial sector. Dauphine University Paris (2010) indicates that, in the past the government controlled the financial market through restricting the allocation of credit, and through control of prices. The government also controlled the movement of capital from one country to the other (Kutlay and
Kutlay, 2009). Some of the strategies the government used include the use restriction on foreign exchange rate, lending and borrowing of banks, restriction of foreign investors’ participation in the local economy. However, as Kenan (2007) indicates, although there were many restrictions in the past, the governments of different nations have lifted off these restrictions. Currently, borrowers, as well as investors have become a major agent of financial globalization. According to Kenan (2007), firms are currently raising funds through the selling of bonds and equity issues in the international markets. This results to the firms increasing their investor base, and at the same time reducing their cost of capital, as well as increasing their liquidity (Kaminsky and Schmukler, 2003). The prevalence of foreign investors provides an opportunity in which firms can avoid direct and indirect financial barrier. In addition, Kutlay and Kutlay (2009) argue that international investors have taken this advantage to ensure they diversify their risks. Financial institutions are also agent of the globalization of the financial market. As Kenan (2007) indicates, they do this through the internalization of financial services. The changes that are taking place in the developed and developing country explain the importance of the financial institution in globalization of financial market. The increase of competition in the developed nations has led to the companies to look for other markets in the emerging, as well as developing nations. Globalization and Liberalization Globalization has led to increasing market liberalization in a different nation around the world, especially from developing under that notion that financial liberalization increases financial development of the country (Dauphine University Paris, 2010). Therefore, this will lead to sustained economic growth.
Indeed, this has been shown in the literature that financial liberalization, which involves that removal of restrictions, as well as operation of domestic financial system, and removal of restrictions on financial and capital transaction, can lead to financial development. However, as Dauphine University Paris (2010) indicates, most of this theory works perfectly in the developed nations, as well as emerging marketing, and some country in Latin America. Furthermore, Schmukler (2004) claims that financial liberation in the emerging, as well as developing nations, have both the positive, as well as negative outcomes. The economic and the financial system of a given country are interrelated. This is according to Schumpeter’s theory that indicates the banking system encourage growth in a given country because innovations can be financed. Studies by Kenan (2007) go further to illustrate that
the more complex financial system is the more growth it can bring to the economy. These work support proposition by liberal economists such as McKinnon or Shaw who indicates that financial repression, as case in the developing nation, should end, as such, the two authors advocate for financial market liberalization (Kenan, 2007). Liberal economists argue that a country needs to increase a financial sphere in order to increase growth. Financial repression implies that there are series constraints in the financial market that, necessities banks need to have remunerated reserves in the central banks that have little interests (Dauphine University Paris, 2010). According to Liberal economists, the prevalence of financial repression in a given country, encourage domestic agent of that country to have unproductive asset or no monetary assets. As a result, there is little money in the economy for lending. Therefore, the repercussions for this are lack of investment and future growth (Kenan, 2007). As a result, the only option for this problem is a free market that can provide saving allocations. On the other hand, current studies indicate that globalization and liberalization of financial market only work for the developed nation, but not for the developing nations. For example, Kutlay
and Kutlay (2009) provide a case of Mexico and South Korea during the recent financial crises. According to the authors, although the two countries have solid macroeconomic fundamentals, they suffered greatly during the time. The case also illustrates how the deterioration of the financial sector can be detrimental to the economy. Before the crisis, Mexico reduced inflation from 130 percent in 1987 to 9 percent in 1994 (Kenan, 2007). At the same time, the country’s economy was growing at a rate of 4.4 percent, and government budget was at -0.7percent. However, the only problem the country was experiencing was account deficit of 7.2 percent of GDP. However, after undertaking an uncontrolled and fast liberalization, the country has paved the way of full-fledged financial crisis (Kenan, 2007). This crisis plus another crisis brought an agenda of the world that there are risks associated with liberalization of capital market. Schmukler (2004) indicates that most of these risks affect mostly the developing countries. Benefits of Market Liberalization McKinnon indicates that saving is important for a given economy to grow. There is a lot of saving in the emerging markets, but these resources are poorly managed. The emerging markets are fragmented and, therefore, there is the likelihood of unproductive investment. In a time of high inflation, accumulation of capital is discouraged because the nominal interests are low and the real interest could be negative. At this time, banks have limited the supply of money, the banks only deals with specialize activities. Low supply of money implies that people need to finance their investment for themselves, or they have to go the informal sector where real interest rates are not stable. However, because of financial liberalization, Schmukler (2004) indicates that the financial market is unified and the best strategy to adopt is to allow the interest rates freely fluctuate. Therefore, the interest rates signify the scarcity of the market, as well as the information cost. Brownbridge et al. (2008) indicate that, at this time, the authorities need to limit their role so that there will be low inflation, as well as development of the financial sector. However, in a country, where there is fixed exchange rate, the market liberalization results to increased inflation than before. Shaw theory of financial market liberalization, although different from McKinnon, it also comes to the same conclusion. According to Shaw, liberalization of the Financial market allows centralization of resources, which is required in economic development. The author indicates that the financial repression has a number of negative effects (Mishkin, 2009). On the other hand, financial liberalization has benefits because there is the optimal allocation of resources, which signifies the scarcity of resources. Another positive aspect of financial market liberalization is that it leads to less unemployment than unliberalized (Schmukler, 2004). However, many studies conducted on the effect of financial market liberalization in developing nations show that this case only happens in developed nations. The reason behind this is that there are other factors that affect the interest rates. The business environment of the developed nations is much different from that of developing nations. For example, Mishkin (2009) indicate the major problem in the emerging markets is how to manage economic growth. Furthermore, Ahmed and Islam (2010) also indicate that although the emerging markets are saving a lot of capital, these saving are poorly managed. An empirical study evaluating the relationship between financial liberalization and banking crises indicate cases of bank crisis are more likely to be seen in liberalized financial systems (Elkins and Simmons, 2004). The study also indicates that the impact of liberalization on a fragile banking sector is less where the institutional environment is strong. Another study evaluated the relation between corruption and the probability of a financial crisis. The study found that cases of financial crises are higher in countries that have a low level of transparency. While focusing on the relation between currency and banking crises Elkins and Simmons (2004) analyzed 76 currencies and 36 bank crises and found that liberalization always precedes bank crisis. Some papers indicate that the market liberalization is a potential cause of bank crisis. Chinn and Ito (2006) indicate that banking concentration, banking regulation and national institution have an effect on bank crises in a given country. The author found that, crisis are less seen in countries that have a centralized banking system. Moreover, they also found that the prevalence of regulation that discourage competition contribute to the fragility of the sectors. Therefore, because of these differences, financial globalization and liberalization carry some risk to the developing nations Risk of Market Globalization and Liberalization According to Ahmed and Islam (2010), financial market globalization carries some risks, especially to the developing nations. However, these risks are likely to occur in the short-term once a country opens-up for integration (Kose et al.2009). One of the well-known risks is the financial crises, whereby some crises that have taken global interest include financial crises 1997-1998 in Asia and Russia crises, Brazil in 1999, Ecuador in 2000, Turkey in 2009 and Uruguay in 2002. Schmukler (2004) argues that there is a link between globalization and financial crises. The author indicates that if the right infrastructure is not in place during integration, and liberalization causes the inflow of capital, the health of the financial system of that country can be debilitated. Furthermore, if the market fundamental continue to deteriorate, the speculative attack will occur, and will cause capital outflows generated by both local and foreign investors. Schmukler (2004) argue that, for a good integration to take place, the market fundamental needs to remain intact. As a result, the author argues that there is a need to have a local mechanism that would regulate and supervise the operation of the financial market. Strong market fundamentals are an important element to ensure a perfect global integration. When other factors remain constant, financial globalization tends to intensify in a country that is sensitive to external shocks. Another risk that globalization of financial market can create is the separation of those able to access global financial system and those unable to access, which means they have to rely on the domestic market(McKinnon and Pill, 2007). Schmukler (2004) also argue that international market imperfections such as herding, boom-bust cycles, panics and the fluctuating nature of capital may affect countries that have maintained good market fundamentals. The neo-classical economic theory, which is the theory used by international Financial Institutions, assume “information in the market is perfect in the sense that each side of the financial transaction in question” (McKinnon and Pill, 2007, p. 45). Since the market uses the available information in the market, the funds will move to places with the best investment opportunities. There are three known channels that the contagion has been identified. They include real links — herding behavior, or unknown correlation — as well as financial risk. According to Chinn and Ito (2006), real links are usually associated with trade links. This occurs when two country trade within themselves, or there is competition with external markets. In this case, the devaluation of one country exchange rate deteriorates the competitive advantage of the other countries (McKinnon and Pill, 2007). As a result, the two countries will end up devaluating their currency in order to re-balance the external environment. Financial risk exists where there is a connection of two economies through a financial system. An example of financial risk is where there are two institutions that face margin calls. When one of the collaterals loses value
due to the negative shock in one country, the necessity of increasing their reserves occurs and, therefore, the only solution is to sell one of their valuable to the other collateral on another country (McKinnon and Pill, 2007). This scenario may propagate shock to the other country. As such, financial markets may be an instrument of transmitting shock from one country to another due to herding behavior or panic. However, at the start of this behavior, there is a lack of information because information is costly and investors are not informed (Kutlay and Kutlay, 2009). As a result, the only choice investors have is to estimate future price by looking how other markets are behaving. For instance, a change of Thailand’s asset price may give information about the performance of Brazil or Indonesia asset price. In addition, through asymmetrical information, an investor may gain information of how other market participants are doing (McKinnon and Pill, 2007). As a result of this lead to herding behavior and panic, this automatically results to irrational decisions. Strategies that can be used to offset Management Risks A survey conducted by Chinese banks and PricewaterhouseCoopers shows that the market liberalization of financial market in China caught the market by surprise with only financial having to react to the financial market (Mingkang, 2013). Therefore, some of the strategies discussed here are some, which were used by the Chinese market. Therefore, one of the strategies the bank can use is enhancing innovative capacity and allocating more resources for the development of new businesses, as well as new products. According to Mingkang (2013), increased rate of interest rate liberalization require advance way of interest rates risk management. As a result, the commercial banks need to develop more products that target management of risk, which include interest rate derivatives aiming at hedging the bank risks. At the same time, banks use these strategies to provide diversified hedging services, as well as improving their own revenue. The survey found that 90.9 percent of the banks believed that they should enhance their innovation and expand their products portfolio and service range and also allocate more resources business innovation (Mingkang, 2013). To manage risk, the commercial banks also preferred strategies such a price differentiations, as well s adjusted product pricing. However, some of the hindrance to these strategies is the lack of essential information and flaws of quantitative models and the prevalence of the incomplete base rate, as well as market guidance, or rate transmission mechanism (Kutlay and Kutlay, 2009). However, there are measures that prevent banks from achieving this process. Although the Mingkang (2013) indicate setting prices one of the main strategy the bank can use to ensure it accomplish its goal. Furthermore, other strategy the commercial banks are using is the development of the base rate system, as well as financial infrastructure, which is important component in effective liberalization efforts. A survey done in China indicated that because there are not fully developed, it is not possible for them to establish a comprehensive transmission mechanism that balances the base rate, as well as the banks’ price setting. However, Kutlay and Kutlay (2009) indicates that these are the two limiting factors that a making the bank risk, and preventing the bank from risk-pricing. The survey also indicate that 73 percent of the banks reported that the lack of insufficient basic infrastructure such as financial regulation, as well as supervision, and insurance deposition, as well as other limitation do not provide insurance for bank to set their own price (Kutlay and Kutlay, 2009). However, additional to this is the lack of man power resulting from low education is another hindrance to banks to make to set risk-adjusted prices in professional way (Mingkang, 2013). In this regard, many external factors are preventing the banks from implementing their price-setting ability. Some of the banks surveyed indicated that some of the most important strategies to make a bank ready for marked liberalizations are optimizing the customer relationship, improving risk management, improve price-setting capacity, enhance liquidity management, provide an elaborate transformation strategy, redesign business, as well as operation process, and enhance the capital budget, as well as debt management (Mingkang, 2013). Conclusion The advent of globalization has led to high international capital mobility, which have repeatedly led to international banking crises. Globalization of financial market has different effects on the developed nation and developing nation. Developing nations can gain a lot for liberalization of financial market. These benefits include the development of financial market system and access to capital. On the other hand, some benefits realized in the developed nation cannot be realized in the developing nations because of the difference in the level of financial development. Some factors such as transparency, level of development of the financial system influence the benefits in a given country. Liberalization of the market also comes with risk to the developing nations. These risks include the financial crisis, market imperfections such as herding, and many others. However several strategies that can be used to ensure that these risk are mitigated they include management of financial risk and maintenance of strong market fundamentals and strong institutions References Ahmed, A. D., & Islam, S. M. N. (2010). Financial liberalization in developing countries: Issues, time series analyses, and policy implications. 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