What is the global financial system?

The global financial system is the worldwide framework of legal agreements, institutions,
and both formal and informal economic actor that together facilitate international flows of
financial capital for purposes of investment and trade financing since emerging in the late 19th
century during the first modern wave of economic globalization its evolution is marked by the
establishment of central banks ,multilateral treaties and intergovernmental organizations aimed at
improving the transparency regulation and effectiveness of international markets . It also a
system that enable leaders and borrowers to exchange funds ,the global financial system is
basically a broader system that encompasses of all financial institution that borrowers and
lenders within the global economy .The global financial system comprised of the international
monetary fund, central bank ,monetary authorizes ,world bank ,government treasuries ,major and
private international banks .In the late 1800s, world migration and communication technology
facilitated unprecedented growth in international trade and investment. At the onset of World
War I trade contracted as foreign exchange markets became paralyzed by money market
illiquidity. Countries sought to defend against external shocks with protectionist policies and
trade virtually halted by 1933, worsening the effects of the global Great Depression until a series
of reciprocal trade agreements slowly reduced tariffs worldwide. Efforts to revamp the
international monetary system after World War II improved exchange rate stability, fostering
record growth in global finance.

A series of currency devaluations and oil crises in the 1970s led most countries to float their
currencies. The world economy became increasingly financially integrated in the 1980s and
1990s due to capital account liberalization and financial deregulation. A series of financial crises
in Europe, Asia, and Latin America followed with contagious effects due to greater exposure to
volatile capital flows. The global financial crisis which originated in the United States in 2007,
quickly propagated among other nations and is recognized as the catalyst for the worldwide
Great Recession .A market adjustment to Greece's noncompliance with its monetary union in
2009 ignited a sovereign debt crisis among European nations known as the Eurozone crisis .

While the global financial system is edging toward greater stability, governments must deal
with differing regional or national needs. Some nations are trying to systematically discontinue
unconventional monetary policies installed to cultivate recovery, while others are expanding
their scope and scale. Emerging market policymakers face a challenge of precision as they must
carefully institute sustainable macroeconomic policies during extraordinary market sensitivity
without provoking investors to retreat their capital to stronger markets. Nations' inability to align
interests and achieve international consensus on matters such as banking regulation has
perpetuated the risk of future global financial catastrophes.
 THE GLOBAL FINANCIAL CRISIS.

The global financial crisis (GFC) refers to the period of extreme stress in global financial
markets and banking systems between mid 2007 and early 2009. During the GFC, a downturn in
the US housing market was a catalyst for a financial crisis that spread from the United States to
the rest of the world through linkages in the global financial system. Many banks around the
world incurred large losses and relied on government support to avoid bankruptcy. Millions of
people lost their jobs as the major advanced economies experienced their deepest recessions
since the Great Depression in the 1930s. Recovery from the crisis was also much slower than
past recessions that were not associated with a financial crisis.

MAIN CAUSES OF THE GFC.

As for all financial crises, a range of factors explain the GFC and its severity, and people are
still debating the relative importance of each factor. Some of the key aspects include:

1. Excessive risk-taking in a favorable macroeconomic environment

In the years leading up to the GFC, economic conditions in the United States and other
countries were favorable. Economic growth was strong and stable, and rates of inflation,
unemployment and interest were relatively low. In this environment, house prices grew strongly.
Expectations that house prices would continue to rise led households, in the United States
especially, to borrow imprudently to purchase and build houses. A similar expectation on house
prices also led property developers and households in European countries (such as Iceland,
Ireland, Spain and some countries in Eastern Europe) to borrow excessively. Many of the
mortgage loans, especially in the United States, were for amounts close to (or even above) the
purchase price of a house. A large share of such risky borrowing was done by investors seeking
to make short-term profits by ‘flipping’ houses and by ‘subprime’ borrowers (who have higher
default risks, mainly because their income and wealth are relatively low and/or they have missed
loan repayments in the past).

Banks and other lenders were willing to make increasingly large volumes of risky loans for a
range of reasons:

Competition increased between individual lenders to extend ever-larger amounts of housing

Many lenders providing housing loans did not closely assess borrowers’ abilities to make loan
repayments. This also reflected the widespread presumption that favorable conditions would
continue. Additionally, lenders had little incentive to take care in their lending decisions because
they did not expect to bear any losses. Instead, they sold large amounts of loans to investors,
usually in the form of loan packages called ‘mortgage-backed securities’ (MBS), which
consisted of thousands of individual mortgage loans of varying quality. Over time, MBS
products became increasingly complex and opaque, but continued to be rated by external
agencies as if they were very safe.

Investors who purchased MBS products mistakenly thought that they were buying a very low
risk asset: even if some mortgage loans in the package were not repaid, it was assumed that most
loans would continue to be repaid. These investors included large US banks, as well as foreign
banks from Europe and other economies that sought higher returns than could be achieved in
their local markets.

In the lead up to the GFC, banks and other investors in the United States and abroad borrowed
increasing amounts to expand their lending and purchase MBS products. Borrowing money to
purchase an asset (known as an increase in leverage) magnifies potential profits but also
magnifies potential losses. As a result, when house prices began to fall, banks and investors
incurred large losses because they had borrowed so much.

2. Increased borrowing by banks and investors

In the lead up to the GFC, banks and other investors in the United States and abroad borrowed
increasing amounts to expand their lending and purchase MBS products. Borrowing money to
purchase an asset (known as an increase in leverage) magnifies potential profits but also
magnifies potential losses. As a result, when house prices began to fall, banks d investors , banks
and some investors increasingly borrowed money for very short periods, including overnight, to
purchase assets that could not be sold quickly. Consequently, they became increasingly reliant on
lenders – which included other banks – extending new loans as existing short-term loans were
repaid.

3. Regulation and policy errors

Regulation of subprime lending and MBS products was too lax. In particular, there was
insufficient regulation of the institutions that created and sold the complex and opaque MBS to
investors. Not only were many individual borrowers provided with loans so large that they were
unlikely to be able to repay them, but fraud was increasingly common – such as overstating a
borrower's income and over-promising investors on the safety of the MBS products they were
being sold.

In addition, as the crisis unfolded, many central banks and governments did not fully recognize
the extent to which bad loans had been extended during the boom and the many ways in which
mortgage losses were spreading through the financial system.
 HOW THE GFC UNFOLDED.

US house prices fell, borrowers missed repayments.

The catalysts for the GFC were falling US house prices and a rising number of borrowers
unable to repay their loans. House prices in the United States peaked around mid 2006,
coinciding with a rapidly rising supply of newly built houses in some areas. As house prices
began to fall, the share of borrowers that failed to make their loan repayments began to rise.
Loan repayments were particularly sensitive to house prices in the United States because the
proportion of US households (both owner-occupiers and investors) with large debts had risen a
lot during the boom and was higher than in other countries

Stresses in the financial system.

Stresses in the financial system first emerged clearly around mid 2007. Some lenders and
investors began to incur large losses because many of the houses they repossessed after the
borrowers missed repayments could only be sold at prices below the loan balance. Relatedly,
investors became less willing to purchase MBS products and were actively trying to sell their
holdings. As a result, MBS prices declined, which reduced the value of MBS and thus the net
worth of MBS investors. In turn, investors who had purchased MBS with short-term loans found
it much more difficult to roll over these loans, which further exacerbated MBS selling and
declines in MBS prices.

Spillovers to other countries

As noted above, foreign banks were active participants in the US housing market during the
boom, including purchasing MBS (with short-term US dollar funding). US banks also had
substantial operations in other countries. These interconnections provided a channel for the
problems in the US housing market to spill over to financial systems and economies in other
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)

971 – Dollar’s convertibility into gold was suspended

1973 – Abandonment of fixed exchange rates

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)
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 reserv

Euro area not decoupled, but connected, to US crisis

Flight to quality is thus benefiting dollar

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

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

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 the global financial system

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

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

Bank for International Settlements

Is an intergovernmental financial organization of central banks which fosters international

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

Financial markets now tend to dominate over traditional industrial economy

Climate of greater general indebtedness and increased gearing (debt to equity ratios)

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

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

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
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

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

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Trachtman, J.P. (2009). Global Financial Trouble: Causes, Cures, Responses. US Department of
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Shahrokhi, M. (2011). The Global Financial Crrisis of 2007-2010 and sthe future of capitalism.
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