Global Financial System
Transformation of the financial system
Oleg Deev
Department of Finance, Masaryk University
spring 2015
Contents
1 Evolution of the global financial system
2 International reserve currency
3 Post-Bretton Woods global financial system
4 Growth of finance
Oleg Deev (Department of Finance) Global Financial System spring 2015 2 / 30
Essential readings
1 Mishkin, F. S., and Eakins, S. G. (2009). Financial Markets and
Institutions, 7th edition. – Chapters 14, 17-18.
2 Judis, J.B. (2009). Debt Man Walking. US Department of State
eJournal, vol.14, 5, pp. 9-12.
3 Vedder, R. (2009). The Evolving Global Financial System. US
Department of State eJournal, vol.14, 5, pp. 27-30.
4 Wyman. O. (2009). The Future of the Global Financial System.
World Economic Forum’s World Scenarios Series. [EXCERPT]
Oleg Deev (Department of Finance) Global Financial System spring 2015 3 / 30
What is the global financial system?
The Global Financial System refers to those financial institutions and
regulations that act on the international level, as opposed to those
that act on a national or regional level
This is the interplay of financial companies, regulators and institutions
operating on a supranational level
The global financial system can be divided into regulated entities
(international banks and insurance companies), regulators, supervisors
and institutions
Oleg Deev (Department of Finance) Global Financial System spring 2015 4 / 30
Evolution of the global financial system
Evolution of the global financial system (1)
Late 19th – early 20th centuries – little coordination of international
finances
Gold standard – financial obligations were settled in currencies
redeemable in gold
World War I involved vastly larger international capital flows than
ever before
European nations such as Britain and Germany went deeply in debt,
borrowing heavily from other nations, especially the United States
The Great Depression of the 1930s resulted partially from sharply
declining international trade caused, in part, by high tariffs
World War II disrupted world trade and led to international cooperative
arrangements to facilitate economic stability and growth
Oleg Deev (Department of Finance) Global Financial System spring 2015 5 / 30
Evolution of the global financial system
Evolution of the global financial system (2)
1944 – Bretton Woods Conference
John Maynard Keynes and Harry Dexter White successfully proposed a
new international financial order
The International Monetary Fund (IMF) and the International Bank for
Reconstruction and Development (World Bank) were created
Dollar was established as a main reserve currency (Keynes had argued
against the dollar having such a central role in the monetary system,
and suggested an international currency called Bancor used instead)
1947 – General Agreement on Tariffs and Trade (GATT - WTO)
Dramatic reductions in barriers to international trade
Led to the creation of a system of international financial arrangements
and deeper economic / financial integration (especially EU, NAFTA)
1971 – Dollar’s convertibility into gold was suspended
1973 – Abandonment of fixed exchange rates
Oleg Deev (Department of Finance) Global Financial System spring 2015 6 / 30
Evolution of the global financial system
International monetary systems
Years System Reserve assets Leaders
1803 - 1873 Bimetallism Gold, silver France, UK
1873 - 1914 Gold standard Gold, pound UK
1914 - 1924 Anchored dollar standard Gold, dollar US, UK, France
1924 - 1933 Gold standard Gold, dollar, pound US, UK, France
1933 - 1971 Anchored dollar standard Gold, dollar US, G10
1971 - 1973 Dollar standard Dollar US
1973 - 1985 Flexible exchange rates Dollar, mark, yen US, Germany, Japan
1985 - 1999 Managed exchange rates Dollar, mark, yen US, G7, IMF
1999 - ? Dollar, euro Dollar, euro US, Eurozone, IMF
Oleg Deev (Department of Finance) Global Financial System spring 2015 7 / 30
International reserve currency
International reserve currency
is a currency used as a reserve or store of wealth, as if it were an asset
itself
Source of wealth for whoever has the privilege to issue that currency
Uncashed check at everyone else’s expense
Permits deficit financing (Vietnam and Iraq wars, current US bank
bailout)
Oleg Deev (Department of Finance) Global Financial System spring 2015 8 / 30
International reserve currency
Historic role of reserve currencies
No reserve currency has ever been permanent
Reserve currencies reflects political power and authority
UK pound sterling is a reserve currency for more than 100 years
The exorbitant privilege refers to the benefit the country has in its
currency being the international reserve currency: this country would
not face a balance of payments crisis, because it purchased imports in
its own currency (concept created by Valerie Giscard d’Estaing)
Oleg Deev (Department of Finance) Global Financial System spring 2015 9 / 30
International reserve currency
The exorbitant privilege for euro?
Operating reserve currency brings costs
Euro area lacks political will for unity and avoids promoting Euro as
reserve
Euro area not decoupled, but connected, to US crisis
Flight to quality is thus benefiting dollar
Oleg Deev (Department of Finance) Global Financial System spring 2015 10 / 30
International reserve currency
Global financial system based on US dollar
China’s dollar dependence (Not just China, but Brazil, India, Russia
and oil-exporting Gulf states all similarly attached to US situation)
Reserve accumulation over $1tn
Power to destabilise US financial system but only at huge cost to itself
US domestic economy transformed (like in 19th century in UK) to
financial services while neglecting exports, manufacture and jobs
Weaker dollar needed to stimulate US economy but counter-balanced
against damage it does to its partners
US lacks surpluses given its economic weakness to sustain strong
dollar as reserve
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International reserve currency
GDP share of US financial industry
Oleg Deev (Department of Finance) Global Financial System spring 2015 12 / 30
Post-Bretton Woods global financial system
Features of the post-BW system
Volatility drastically increased
Contradicting expectations and orthodox economic predictions
Volatility created need to hedge against fluctuating prices
New markets in volatility-management tools: derivatives
Created marketplace for speculative profits and amplified the use of
these tools
Assault on transparency
Vast majority of derivatives ‘OTC’ – over the counter and not traded
on exchanges
Created mechanism to avoid supervision or regulatory oversight
New markets in derivatives allowed huge profit opportunities via
speculation on price movements that were disconnected from real
economic activity
Oleg Deev (Department of Finance) Global Financial System spring 2015 13 / 30
Post-Bretton Woods global financial system
Post-BW global financial system
Financial crises have been more intense and have increased in
frequency by about 300%
All financial crises since 1971 have been preceded by large capital
inflows into affected regions
Investors have frequently achieved very high rates of return, with
salaries and bonuses in the financial sector reaching record levels
Oleg Deev (Department of Finance) Global Financial System spring 2015 14 / 30
Post-Bretton Woods global financial system
Institutions of the global financial system
International Institutions
IMF - keep account of international balance of payment of members
states, also acts as lender of last resort
World Bank - provide funding, take up credit risk and offer financial
favorable terms to development projects in developing countries
WTO - negotiate international trade agreements, settles trade disputes
Bank for International Settlements (BIS)
Institute of International Finance (IIF)
Government institutions
Financial ministries, tax authorities, central banks, securities and
exchange commissions, sovereign wealth funds, etc.
Private participants
Commercial banks, pension funds, hedge funds, etc.
Regional institutions
Eurozone, NAFTA, CIS, Mercosur
Oleg Deev (Department of Finance) Global Financial System spring 2015 15 / 30
Post-Bretton Woods global financial system
Bank for International Settlements
is an intergovernmental financial organization of central banks which
fosters international monetary and financial cooperation and serves as
bank for central banks
Regulates capital adequacy
Encourages reserve transparency
Leads the changes of banking regulation and supervision through the
Basel Committee on Banking Supervision passing global regulatory
standards (Basel II, Basel III)
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Post-Bretton Woods global financial system
Institute of International Finance
is the world’s only global association of financial institutions
Providing analysis and research to its members on emerging markets
and other central issues in global finance
Developing and advancing representative views and constructive
proposals that influence the public debate on particular policy
proposals, including those of multilateral agencies, and broad themes
of common interest to participants in global financial markets
Coordinating a network for members to exchange views and offer
opportunities for effective dialogue among policymakers, regulators,
and private sector financial institutions
Oleg Deev (Department of Finance) Global Financial System spring 2015 17 / 30
Growth of finance
The era of financialization
Developed countries’ financial systems exploded relative to other parts
of economy, particularly the role of banks
Financial markets now tend to dominate over traditional industrial
economy
Climate of greater general indebtedness and increased gearing (debt
to equity ratios)
Financial assets and debts become larger proportion of GDP
Banks strategically became focused upon commissions business and
speculative operation
Oleg Deev (Department of Finance) Global Financial System spring 2015 18 / 30
Growth of finance
The growth of financial services in US (share of
GDP)
4 Journal of Economic Perspectives
Figure 1
The Growth of Financial Services
(value added share of GDP)
Source: Authors’ calculations using data from National Income and Product Accounts (1947–2009) and
the National Economic Accounts (1929–1947).
Insurance
Securities
Credit
intermediation
9%
8%
7%
6%
5%
4%
3%
0%
1%
2%
1929
2004
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
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Growth of finance
The growth of financial services (share of GDP)
A: Increasing trend
.07
.06
.05
.04
.03
.08
United Kingdom
The Netherlands
United States
Japan
Canada
1970 1975 1980 1985 1990 1995 2000 2005
Figure 3
Value Added Shares of Finance in GDP
Oleg Deev (Department of Finance) Global Financial System spring 2015 20 / 30
Growth of finance
The growth of financial services (share of GDP)
B: Weak increasing or mixed trend
Belgium
Denmark
Austria
Germany
France
Sweden
Finland
.07
.06
.05
.04
.03
.02
1970 1975 1980 1985 1990 1995 2000 2005
.03
1970 1975 1980 1985 1990 1995 2000 2005
Source: Authors’ calculations using data from EU KLEMS.
Oleg Deev (Department of Finance) Global Financial System spring 2015 21 / 30
Growth of finance
The growth of US securities industry
Revenues as % of GDP
Robin Greenwood and David Scharfstein 9
Figure 2
The Growth of the Securities Industry, 1980–2007
(revenues from different activities as a percent of GDP)
Source: Data are compiled by authors and described further in the text.
Notes: “Other broker-dealer activities” include revenues from derivatives and commodities trading, as well
Alternative asset
management
Other brokerdealer
activities
Commissions
Pension fund
administration
Traditional asset
management
Underwriting
Trading
0%
1%
2%
3%
4%
5%
2007
1980
1982
1984
1986
1988
1990
1992
1994
1996
2006
1998
2000
2002
2004
Securities industry output
Oleg Deev (Department of Finance) Global Financial System spring 2015 22 / 30
Growth of finance
Credit intermediation output in the USFigure 4
Credit Intermediation Output 1980–2007
Uncounted
output
from
securitization
Mortgage
origination
and “other”–
mostly
consumerrelated
fees
Traditional
bank-based
credit
intermediation
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
0%
1%
2%
3.%
4%
5%
6%
7%
8%
OutputasapercentofGDP
Imputed output loans
Imputed output deposits
Other fees on residential loans
Credit card fees
Oleg Deev (Department of Finance) Global Financial System spring 2015 23 / 30
Growth of finance
Short-term funding of the US financial sector
Figure 5
Short-term Funding of the Financial Sector
Source: Author using data from the Flow of Funds Accounts of the United States.
Note: Insured deposits and uninsured deposits are only available starting in 1984.
Money market
mutual fund assets
Financial
commercial paper
Repo (gross)
Uninsured
deposits
Insured deposits
100%
PercentofGDP
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
20062007
Oleg Deev (Department of Finance) Global Financial System spring 2015 24 / 30
Growth of finance
Credit intermediation index
the ratio of gross credit to net credit to end users (government,
households, and non-financial firms)
24 Journal of Economic Perspectives
Figure 6
Credit Intermediation Index
Source: Flow of Funds and author’s calculations.
Notes: The Credit Intermediation Index (CII) is equal to the ratio of gross credit to net credit to end users
20%
30%
40%
50%
60%
70%
80%
90%
100%
110%
1.7
1.8
1.9
2.0
2.1
2.2
2.3
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
20062007
ShareofGDP
Creditintermediationindex
CII (left axis)
Household credit/GDP (right axis)
Corporate credit/GDP (right axis)
Oleg Deev (Department of Finance) Global Financial System spring 2015 25 / 30
Growth of finance
Results of financialization
Capital flows increasingly taking form of FDI and portfolio investment
Speculative price bubbles
Debt being used to inflate value of assets against which more debt is
raised to re-start the cycle
Financial innovation
Policy mistakes
ignored bubbles and increase of consumer spending via indebtedness
inflation targeting priority over growth, jobs, health or other social
outcomes to protect value of investment capital
Oleg Deev (Department of Finance) Global Financial System spring 2015 26 / 30
Growth of finance
Globalization of finance
Financial institutions are forced to cultivate strategic partnerships that
allow them to be competitive and offer diverse services to customers
Reasons for globalization in financial services:
Economic integration
Deregulation of financial intermediation
Augmentation of domestic savings
Lower cost of capital due to better risk allocation
Transfer of technology
Enhancement of capital inflows by signaling better policies
What are advantages and disadvantages of globalization?
Oleg Deev (Department of Finance) Global Financial System spring 2015 27 / 30
Growth of finance
Financial integration
Financial markets became closely linked together
information sharing
cross-border capital flows
foreign participation in the domestic financial markets
sharing of technologies
firms borrow and raise funds directly in the international capital markets
investors directly invest in the international capital markets
newly engineered financial products are domestically innovated and
originated then sold and bought in the international capital markets
rapid adaptionof newly engineered financial products among financial
institutions
Oleg Deev (Department of Finance) Global Financial System spring 2015 28 / 30
Growth of finance
Financial integration: benefits and costs
Benefits
more opportunities for risk sharing and risk diversification
better allocation of capital among investment opportunities
better corporate governance due to increased competition
potential for higher growth
Costs
financial contagion - vulnerability to external macroeconomic shocks
and financial crises
high degree of concentration of capital flows and lack of access to
financing for small countries
loss of macroeconomic stability
risks associated with foreign bank penetration
Oleg Deev (Department of Finance) Global Financial System spring 2015 29 / 30
Homework
Readings for the next topic
1 Geisst, C.R. (2009). Globalization and the US Financial System. US
Department of State eJournal, vol.14, 5, pp. 13-16.
2 Levine, R. (2010). An autopsy of the US Financial System: accident,
suicide, or negligent homicide. Journal of Financial Economic Policy,
vol.2, 3, pp. 196-213.
3 Trachtman, J.P. (2009). Global Financial Trouble: Causes, Cures,
Responses. US Department of State eJournal, vol.14, 5, pp. 23-26.
4 Shahrokhi, M. (2011). The Global Financial Crrisis of 2007-2010 and
the future of capitalism. Global Financial Journal, vol.22, pp.
193-210.
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