Financial integration and systemic crises 1980–present.docx

Financial integration and systemic crises: 1980–present

Financial integration among industrialized nations grew substantially during the 1980s and

1990s, as did liberalization of their capital accounts.[26]: 15 Integration among financial markets

and banks rendered benefits such as greater productivity and the broad sharing of risk in the

macroeconomy. The resulting interdependence also carried a substantive cost in terms of shared

vulnerabilities and increased exposure to systemic risks.[43]: 440–441 Accompanying financial

integration in recent decades was a succession of deregulation, in which countries increasingly

abandoned regulations over the behavior of financial intermediaries and simplified requirements

of disclosure to the public and to regulatory authorities.[16]: 36–37 As economies became more open,

nations became increasingly exposed to external shocks. Economists have argued greater

worldwide financial integration has resulted in more volatile capital flows, thereby increasing the

potential for financial market turbulence. Given greater integration among nations, a systemic

crisis in one can easily infect others.[34]: 136–137

The 1980s and 1990s saw a wave of currency crises and sovereign defaults, including the

1987 Black Monday stock market crashes, 1992 European Monetary System crisis, 1994

Mexican peso crisis, 1997 Asian financial crisis, 1998 Russian financial crisis, and the 1998–

2002 Argentine great depression.[2]: 254 [15]: 498 [20]: 50–58 [44]: 6–7 [45]: 26–28 These crises differed in terms of

their breadth, causes, and aggravations, among which were capital flights brought about by

speculative attacks on fixed exchange rate currencies perceived to be mispriced given a nation's

fiscal policy,[16]: 83 self-fulfilling speculative attacks by investors expecting other investors to

follow suit given doubts about a nation's currency peg,[44]: 7 lack of access to developed and

functioning domestic capital markets in emerging market countries,[32]: 87 and current account

reversals during conditions of limited capital mobility and dysfunctional banking systems.[35]: 99

Following research of systemic crises that plagued developing countries throughout the

1990s, economists have reached a consensus that liberalization of capital flows carries important

prerequisites if these countries are to observe the benefits offered by financial globalization.

Such conditions include stable macroeconomic policies, healthy fiscal policy, robust bank

regulations, and strong legal protection of property rights. Economists largely favor adherence to

an organized sequence of encouraging foreign direct investment, liberalizing domestic equity

capital, and embracing capital outflows and short-term capital mobility only once the country has

achieved functioning domestic capital markets and established a sound regulatory framework.[16]:

25 [26]: 113 An emerging market economy must develop a credible currency in the eyes of both

domestic and international investors to realize benefits of globalization such as greater liquidity,

greater savings at higher interest rates, and accelerated economic growth. If a country embraces

unrestrained access to foreign capital markets without maintaining a credible currency, it

becomes vulnerable to speculative capital flights and sudden stops, which carry serious

economic and social costs.[36]: xii

Countries sought to improve the sustainability and transparency of the global financial

system in response to crises in the 1980s and 1990s. The Basel Committee on Banking

Supervision was formed in 1974 by the G-10 members' central bank governors to facilitate

cooperation on the supervision and regulation of banking practices. It is headquartered at the

Bank for International Settlements in Basel, Switzerland. The committee has held several rounds

of deliberation known collectively as the Basel Accords. The first of these accords, known as

Basel I, took place in 1988 and emphasized credit risk and the assessment of different asset

classes. Basel I was motivated by concerns over whether large multinational banks were

appropriately regulated, stemming from observations during the 1980s Latin American debt

crisis. Following Basel I, the committee published recommendations on new capital

requirements for banks, which the G-10 nations implemented four years later. In 1999, the G-10

established the Financial Stability Forum (reconstituted by the G-20 in 2009 as the Financial

Stability Board) to facilitate cooperation among regulatory agencies and promote stability in the

global financial system. The Forum was charged with developing and codifying twelve

international standards and implementation thereof.[26]: 222–223 [32]: 12

The Basel II accord was set in 2004 and again emphasized capital requirements as a

safeguard against systemic risk as well as the need for global consistency in banking regulations

so as not to competitively disadvantage banks operating internationally. It was motivated by

what were seen as inadequacies of the first accord such as insufficient public disclosure of banks'

risk profiles and oversight by regulatory bodies. Members were slow to implement it, with major

efforts by the European Union and United States taking place as late as 2007 and 2008.[16]: 153 [17]:

486–488 [26]: 160–162 In 2010, the Basel Committee revised the capital requirements in a set of

enhancements to Basel II known as Basel III, which centered on a leverage ratio requirement

aimed at restricting excessive leveraging by banks. In addition to strengthening the ratio, Basel

III modified the formulas used to weight risk and compute the capital thresholds necessary to

mitigate the risks of bank holdings, concluding the capital threshold should be set at 7% of the

value of a bank's risk-weighted assets.[20]: 274 [46]

Birth of the European Economic and Monetary Union 1992

In February 1992, European Union countries signed the Maastricht Treaty which outlined a

three-stage plan to accelerate progress toward an Economic and Monetary Union (EMU). The

first stage centered on liberalizing capital mobility and aligning macroeconomic policies between

countries. The second stage established the European Monetary Institute which was ultimately

dissolved in tandem with the establishment in 1998 of the European Central Bank (ECB) and

European System of Central Banks. Key to the Maastricht Treaty was the outlining of

convergence criteria that EU members would need to satisfy before being permitted to proceed.

The third and final stage introduced a common currency for circulation known as the Euro,

adopted by eleven of then-fifteen members of the European Union in January 1999. In doing so,

they disaggregated their sovereignty in matters of monetary policy. These countries continued to

circulate their national legal tenders, exchangeable for euros at fixed rates, until 2002 when the

ECB began issuing official Euro coins and notes. As of 2011, the EMU comprises 17 nations

which have issued the Euro, and 11 non-Euro states.[17]: 473–474 [20]: 45–4 [23]: 7 [39]: 185–186

2007–2008 financial crisis

Following the market turbulence of the 1990s financial crises and September 11 attacks on

the U.S. in 2001, financial integration intensified among developed nations and emerging

markets, with substantial growth in capital flows among banks and in the trading of financial

derivatives and structured finance products. Worldwide international capital flows grew from $3

trillion to $11 trillion U.S. dollars from 2002 to 2007, primarily in the form of short-term money

market instruments. The United States experienced growth in the size and complexity of firms

engaged in a broad range of financial services across borders in the wake of the Gramm–Leach–

Bliley Act of 1999 which repealed the Glass–Steagall Act of 1933, ending limitations on

commercial banks' investment banking activity. Industrialized nations began relying more on

foreign capital to finance domestic investment opportunities, resulting in unprecedented capital

flows to advanced economies from developing countries, as reflected by global imbalances

which grew to 6% of gross world product in 2007 from 3% in 2001.[20]: 19 [26]: 129–130

The 2007–2008 financial crisis shared some of the key features exhibited by the wave of

international financial crises in the 1990s, including accelerated capital influxes, weak regulatory

frameworks, relaxed monetary policies, herd behavior during investment bubbles, collapsing

asset prices, and massive deleveraging. The systemic problems originated in the United States

and other advanced nations.[26]: 133–134 Similarly to the 1997 Asian crisis, the global crisis entailed

broad lending by banks undertaking unproductive real estate investments as well as poor

standards of corporate governance within financial intermediaries. Particularly in the United

States, the crisis was characterized by growing securitization of non-performing assets, large

fiscal deficits, and excessive financing in the housing sector.[20]: 18–20 [35]: 21–22 While the real estate

bubble in the U.S. triggered the 2007–2008 financial crisis, the bubble was financed by foreign

capital flowing from many countries. As its contagious effects began infecting other nations, the

crisis became a precursor for the Great Recession. In the wake of the crisis, total volume of

world trade in goods and services fell 10% from 2008 to 2009 and did not recover until 2011,

with an increased concentration in emerging market countries. The 2007–2008 financial crisis

demonstrated the negative effects of worldwide financial integration, sparking discourse on how

and whether some countries should decouple themselves from the system altogether.[47][48]: 3

Eurozone crisis

In 2009, a newly elected government in Greece revealed the falsification of its national

budget data, and that its fiscal deficit for the year was 12.7% of GDP as opposed to the 3.7%

espoused by the previous administration. This news alerted markets to the fact that Greece's

deficit exceeded the eurozone's maximum of 3% outlined in the Economic and Monetary Union's

Stability and Growth Pact. Investors concerned about a possible sovereign default rapidly sold

Greek bonds. Given Greece's prior decision to embrace the euro as its currency, it no longer held

monetary policy autonomy and could not intervene to depreciate a national currency to absorb

the shock and boost competitiveness, as was the traditional solution to sudden capital flight. The

crisis proved contagious when it spread to Portugal, Italy, and Spain (together with Greece these

are collectively referred to as the PIGS). Ratings agencies downgraded these countries' debt

instruments in 2010 which further increased the costliness of refinancing or repaying their

national debts. The crisis continued to spread and soon grew into a European sovereign debt

crisis which threatened economic recovery in the wake of the Great Recession. In tandem with

the IMF, the European Union members assembled a €750 billion bailout for Greece and other

afflicted nations. Additionally, the ECB pledged to purchase bonds from troubled eurozone

nations in an effort to mitigate the risk of a banking system panic. The crisis is recognized by

economists as highlighting the depth of financial integration in Europe, contrasted with the lack

of fiscal integration and political unification necessary to prevent or decisively respond to crises.

During the initial waves of the crisis, the public speculated that the turmoil could result in a

disintegration of the eurozone and an abandonment of the euro. German Federal Minister of

Finance Wolfgang Schäuble called for the expulsion of offending countries from the eurozone.

Now commonly referred to as the Eurozone crisis, it has been ongoing since 2009 and most

recently began encompassing the 2012–2013 Cypriot financial crisis.[20]: 12–14 [49]: 579–581