GLOBAL
FINANCIAL SYSTEM
Lecturer – Oleg Deev
oleg@mail.muni.cz
Contents
• Concept of the global financial system
• Evolution of the global financial system
• International reserve currency
• Post-Bretton Woods global financial system
• Institutions of global financial system
• Financialization
• Globalization of finance
Essential readings
1. Mishkin, F. S., and Eakins, S. G. (2009). Financial
Markets and Institutions, 6th edition. Pearson. –
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]
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
When the global financial system has
emerged?
• Birth of the global financial system is directly connected to
the growth of international economic relations
• International trade in a global scale started in the late 19th
century
• International trade is complicated by the fact that most
nations have their own currency, and that the rules and
regulations governing financial transactions vary widely
between countries
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
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
International monetary systems
Date 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 USA, UK, France
1924 - 1933 Gold standard Gold, dollar, pound USA, UK, France
1933 - 1971 Anchored dollar standard Gold, dollar US, G-10
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
Source: IMF
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
• Un-cashed cheque at everyone else’s expense
• Permits deficit financing (Vietnam and Iraq wars, current US bank
bailout)
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)
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 de-coupled, but connected, to US crisis
• Flight to quality is thus benefiting dollar
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
GDP share of US financial industry
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
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
Institutions of 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, etc.
• Private participants
• Commercial banks, pension funds, hedge funds, etc.
• Regional institutions
• Eurozone, NAFTA, CIS, Mercosur
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)
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
The era of financialization
• Developed countries’ financial systems exploded
relative to other parts of economy, particularly the
role of banks
• 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
Bank assets, $ billions
0
5000
10000
15000
20000
25000
30000
35000
40000
45000
Dec.77 Sep.81 Jun.85 Mar.89 Dec.92 Sep.96 Jun.00 Mar.04 Dec.07
Financialization
• Speculative price bubbles
• Debt being used to inflate value of assets against which more debt
is raised to re-start the cycle
• Financial innovation
• Also used to evade legislative oversight, e.g. 1999 Amendment to
US Community Reinvestment Act which excluded banks’ mortgage
investment in securities from scrutiny – then sub-prime lending
doubled from 2001 to 2006
• Policy mistakes
• Ignored bubbles and stoked consumer spending via indebtedness
Key features of international financialization
• Liberalisation of capital account
• Capital flows increasingly taking form of FDI and
portfolio investment
• Inflation targeting priority over growth, jobs,
health or other social outcomes to protect value
of investment capital
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?
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.