Fixing Global Finance: Recent Trends in International Finance and Developmental Implications

by Climate Finance and Markets on .

Kavaljit Singh

The starting point in any discussion on global financial reforms should be an assessment of key developments that has shaped the global financial system (or rather “non system”) over the past few decades. These developments will help in understanding the nature and dynamics of rapidly changing landscape of global finance.

Since the 1980s, the global financial system has undergone tremendous changes. Financial liberalization in both developed and developing countries is one of most important factors behind increased capital mobility on a global scale.

Financial liberalization has two interrelated components – domestic and international. Domestic financial liberalization encourages market forces by reducing the role of the state in the financial sector. This is achieved by removing controls on interest rates and credit allocation as well as by diluting demarcation lines between banks, insurance and finance companies. International financial liberalization, on the other hand, demands removal of capital controls on inflows and outflows of capital. By allowing cross border movement of capital, it deepens global financial integration and free flow of capital across borders.

Other key developments such as the stagnation in the real economy due to overcapacity and over production, lower interest rates in the developed economies, and rapid technological changes in communications and IT have also enabled massive expansion of footloose finance capital across borders. In addition, new financial instruments and financial intermediaries have drastically changed the basic function of the financial sector.

It is a well acknowledged fact that financial sector exists to serve the real economy. But in the last two decades, the global financial sector has become so big that has led to a tail (financial sector) wagging the dog (real economy) kind of situation.


Financial Innovation, Deregulation and Globalization

Financial innovation played an important role in changing the dynamics between finance and real economy. It facilitated the introduction of new financial instruments (such as derivatives) and increased distance between financial instruments and productive assets. Certain kinds of innovation added to the complexity of the financial system.

The removal of regulatory measures led to the emergence of market- based financial system. In the US, the Banking Act of 1933 (popularly known as the Glass-Steagall Act) came into existence in the wake of Great Depression. The Glass-Steagall Act separated commercial banking from investment banking and also led to the establishment of the Federal Deposit Insurance Corporation (FDIC), a government agency which provides deposit insurance. Under the influence of free-market doctrine, the Glass- Steagall Act was repealed by the Gramm-Leach-Bliley Act in 1999. The repeal allowed investment banks, depository banks and insurance firms to consolidate and created the legal framework for the emergence of universal mega banks such as Citigroup.

Following a similar approach, the UK allowed banks to enter the securities business in 1986. In Europe, the introduction of single banking license in 1989 gave a boost to cross-border banking.

Since the mid-1980s, many developing countries also undertook steps to deregulate and open up domestic financial sector to international competition. The structural adjustment programs and trade agreements played a vital role in the removal of restrictions in banking and financial services. These developments led to the emergence of internationally active banks which fueled the large-scale mergers and acquisitions in the banking and financial services globally.

To a large extent, the implicit taxpayer guarantee drove banks to expand  nationally or internationally rather than achieving any economies of scale. Empirical studies have shown that that there are no significant economies of scale in banking. On the contrary, diseconomies of scale prevail when large banks undertake mergers and acquisitions.

Since the mid-1990s, financial conglomerates with significantly large balance sheets (and off-balance-sheet positions) have become an important part of the global financial landscape. In the US, for instance, the top ten financial conglomerates were holding more than 60 percent of financial assets in 2008, as compared to merely 10 percent in 1990. The financial conglomerates rapidly expanded their activities in wholesale markets, equity markets and derivatives. Simultaneously, shadow banking institutions emerged outside the traditional banking system. These institutions include hedge funds, SIVs, finance companies, asset-backed commercial paper (ABCP) conduits, money market mutual funds, monolines and investment banks. The shadow banking institutions grew in importance as they acted as intermediaries between investors and borrowers. Bear Stearns, Lehman Brothers, Fannie Mae and Freddie Mac are some of the prominent examples of shadow banking institutions.

In its heyday, the shadow banking system was considered as an integral part of the free-market economy. Since shadow institutions do not accept deposits like a depository bank, they are not subject to similar capital requirements and regulatory oversight. Usually, such institutions tend to use a very high level of leverage. Driven by excessive liquidity and light- touch regulation, shadow banking system expanded dramatically in the years leading up to the crisis. In 2008, shadow banking system had as much as $20 trillion worth of liabilities, significantly larger than the liabilities of the traditional banking system at about $13 trillion.

The shadow banking institutions played an important role in the sub-prime mortgage meltdown in 2008. Post-crisis, the activities of the shadow banking system have come under closer scrutiny and regulations.


Financialization of Economy

One of the recent developments is the excessive financialization of economy with greater importance to financial activity over non-financial economic activity. 

In the US, for instance, the financial sector has grown by leaps and bounds in the last three decades. As illustrated by Simon Johnson, former chief economist of the IMF, financial industry’s share in the total US corporate profit was 16 percent between 1973 and 1985.[1] In the 1990s, it ranged between 21 and 30 percent.[2] However, just before the crisis broke out, 41 percent of the profits of the entire US corporate sector went to the financial industry.[3] In the same vein, wages in the US financial sector reached 181 percent of average compensation in domestic private industries in 2007.[4]

In the case of UK, the share of financial services in GDP rose to 8.3 percent in 2007, from 5.3 percent in 2001. Such developments have led to a situation where the financial sector increasingly serves itself, exhibiting high growth and profits, while doing relatively little for the non financial sectors of the economy, which the financial sector exists to serve in principle. In the words of Robert Reich, the former US Labor Secretary, “Before 1980, Wall Street had been the handmaiden of industry, helping large oligopolies raise capital when necessary. After 1980, industry became the handmaiden of Wall Street.”


The Growing Domination of Speculative Finance Capital

The global financial markets have moved beyond their original function of facilitating cross border trade and investment. The financial markets are no longer a mechanism for making savings available for productive investments. Nowadays, global financial flows are less associated with the flows of real resources and financing long-term productive investments.

As the value of global foreign exchange trade is many times more than the value of annual world trade and output, much of global finance capital is moving in search of quick profits from speculative activities rather than contributing to the real economy.

Every day, trillions of dollars move in the world’s financial markets in search of profit making opportunities from speculative investments. These flows are largely liquid and are attracted by short-term speculative gains, and can leave the country as quickly as they come.

That is why, many analysts have described this phenomenon as “casino capitalism.”[5] In fact, it is “casino capitalism” that very often perpetuates economic disasters thereby adversely affecting the lives of millions of ordi- nary people. As Susan Strange puts it succinctly:

For the great difference between an ordinary casino which you can go into or stay away from, and the global casino of high finance, is that in the latter we are all involuntarily engaged in the day’s play. A currency change can halve the value of a farmer’s crop before he harvests it, or drive an exporter out of business. A rise in interest rates can fatally inflate the costs of holding stocks for the shopkeeper. A takeover dictated by financial considerations can rob the factory worker of his job. From school-leavers to pensioners, what goes on in the casino in the office blocks of the big financial centers is apt to have sudden, unpredictable and unavoidable consequences for individual lives. The financial casino has everyone playing the game of Snakes and Ladders.[6]

The growing presence of financial players (non-end users) in commodity and agricultural markets should be a matter of serious concern for global policymakers. Financial speculation is now well recognized as one of the major contributors in extreme price volatility in commodity and agricultural markets. A study by SOMO found the growing influence of “non-traditional” institutional investors (such as hedge funds) in agricultural markets.[7]

The sharp rise in global food prices during 2006-08 and subsequent food riots in many countries have alarmed the policymakers about the increasing interconnectedness of global finance and agricultural markets. The convergence of financial and food crises reveals that financial reforms are necessary to curb excessive speculation.

Excessive speculation by large players is a significant factor in market manipulation and unreasonable price movements and therefore has the potential to distort the normal functioning of a market.

There are numerous ways in which the domination of speculative finance capital negatively affects the real economy. Firstly, by providing economic incentives to gamble and speculate on financial instruments, the global finance capital diverts funds from long-term productive investments.

Secondly, it encourages banks and financial institutions in developing countries to maintain a regime of higher real interest rates which significantly reduces the ability of productive industries and enterprises in terms of access to credit. Lastly, finance capital (because of its speculative nature) brings uncertainty and volatility in interest and exchange rates, thereby affecting trade and other components of real economy.


Source: Fixing Global Finance: A Developing Country Perspective on Global Financial Reforms, Chapter 3.

[1] Simon Johnson, “The Quiet Coup,” The Atlantic, May 2009.

[2] Ibid.

[3] Ibid.

[4] Ibid.

[5] See, for instance, Susan Strange, Casino Capitalism, Blackwell, 1986.

[6] Ibid., p. 2.

[7] Thijs Kerckhoffs, Roos van Os and Myriam Vander Stichele, Financing Food:   Financialisation and Financial Actors in Agriculture Commodity Markets, SOMO  Paper, SOMO, April 2010 ( at_download/fullfile).