Discuss whether the globalisation of capital markets has given rise to the contagion effects of financial crisis

University Degree Business and Administrative studies

In this essay it has been asked to discuss whether the globalisation of capital markets has given a rise to the contagion effects of financial crisis. In order to do this we must first have an understanding of the factors leading to the globalisation of the capital markets, what capital markets are, how financial crises take place and the factors that cause it.

Globalisation of capital markets means the integration of capital markets throughout the world into a universal market. We can classify the factors leading to the globalisation of the financial markets as: deregulation or liberalisation of financial markets and activities of market participants, with respect to foreign transactions in key financial centres of the world; second, technological advances for monitoring world markets, executing orders and analysing financial opportunities and last of all increased institutionalisation of financial markets.

Deregulation of foreign exchange markets and global competitions have forced government to deregulate (or liberalise) various aspects of their financial markets so that financial orientated entities can compete effectively in global financial markets. Two sorts of deregulation, market deregulation and institutional deregulation have led to increased integration of global financial markets. Market deregulation refers to deregulation of the basic structure of the market; major national financial markets has taken the form of eliminating interest rate ceilings and fixed commissions on security transactions. Institutional deregulation measures to open up a country’s financial market to global market participants which includes eliminating foreign exchange controls, reducing or eliminating withholding taxes or transfers taxes imposed on foreign investors and relaxing restrictions on:

the purchase of domestic securities by foreign investors
the issuance of bonds by foreign borrowers and allowing the
foreign commercial banks’ to participate in local loan market.

This is followed by technological advances, which have increased the integration of the markets and the efficiency of it. Advances in the telecommunication systems link dealers throughout the world so that orders can be executed within seconds. Advances in the computer technology coupled with the telecommunication systems allow the transmission of real time information on security prices. Such key financial information will allows market participants to monitor global markets and simultaneously assess how information will impact the risk/return profile of their portfolios. Improved computing power allows the instant manipulation of real time market information so that arbitrage opportunities can be identified. The telecommunication systems permit the rapid execution of orders to capture any opportunities.

When it comes to institutionalisation, financial institutions have been more willing to transfer funds across national borders to improve portfolio diversification and/or exploit perceived mis-pricing of securities in foreign countries. The potential portfolio diversification benefits associated with global investing have been documented in numerous studies (* refer to bibliography). These studies have alerted investors to the virtues of global investing. The underlying theory for international diversification is that because international capital markets are less than perfectly correlated, including securities from other countries allows an increase of expected return without increasing risk.

There are many ways to classify financial ...

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There are many ways to classify financial markets. One way is by the maturity of the claims. The capital market exists to provide financing for long- term capital assets (original maturity of one year or greater). Households, often through investments in pension and mutual funds are the net investors in the capital markets. Firms and the federal and the local governments are net users of these funds. Three main capital market instruments are bonds, stocks and mortgages. Bonds represent borrowing by the issuing firm. Stock represents ownership in the issuing firm and mortgages are long term loans secured by real property. Only firms can issue the stock. Firms and governments can issue bonds. In any given year far more funds are raised with bonds than with stocks.

Financial crisis occur when there is a disruption in the financial system that causes such a sharp increase in adverse selection and moral hazard problems in financial markets that the markets are unable to channel funds through efficiently from savers to people with productive investment opportunities. As a result of this inability of financial markets to function efficiently, economic activity contracts sharply. Four categories of factors that can trigger this process are increases in interest rates, increases in uncertainty, asset market effects on balance sheets and bank panics.

With the interest rates, where the rates are driven up because of increased demand for credit or because of a decline in the money supply, good credit risks are less likely to want to borrow while bad credit risks are still willing to borrow. Because of the resulting increase in adverse selection, lenders will no longer want to make loans. The substantial decline in lending will lead to a decline in investment and aggregate economic activity.

A dramatic increase in uncertainty in financial markets, due to perhaps to the failure of a prominent financial or no financial institution, a recession or a market crash makes it harder for lenders to screen good from bad credit risks. The resulting inability of lenders to solve the adverse selection problems makes them less willing to lend, which leads to a decline in lending, investment and aggregate activity.

The state of firms’ balance sheet has important implications for the severity of asymmetric information problems in the financial system. A sharp decline in the stock market is one factor that can cause a serious deterioration in firms’ balance sheets that can increase adverse selection and moral hazard problems in financial markets and provoke a financial crisis. A decline in the stock market means that the net worth of corporations has fallen because share prices are the valuation of a corporations’ net worth. This results in lenders being less willing to lend as the net worth of the firm plays a role similar role to that of collateral. When the value of collateral declines it provides less protection to lenders, meaning that losses on loans are likely to be more severe. As lenders are less protected against the consequences of adverse selection, they decrease their lending, which in turn causes investment and aggregate output to decline. In addition, the decline in corporate net worth as a result of a stock market decline increases moral hazard by providing incentives for borrowing firms to make risky investments, as they now have less to lose if their investment go sour. The resulting increase in moral hazard makes lending less attractive.

Economies in which inflation has been moderate (most industrialised countries), many debt contracts are typically of fairly long maturity with fixed interest rates. In this institutional environment, unanticipated declines in the aggregate price level also decreases the net worth of firms. As debt payments are normally fixed in nominal terms, an unanticipated decline in the price level raises the value of firms’ liabilities in real terms but does not raise the value of firm’s assets’. The result is that net worth in real terms declines. A sharp drop in price level therefore causes a substantial decline in real net worth and an increase in adverse selection and mo0ral hazard problems facing the lenders. An unanticipated decline in the aggregate price level leads to a drop in lending and economic activity.

Because of uncertainty about the future value of the domestic currency in developing countries and in some industrialised countries, many non-financial firms, banks and governments in these countries find it easier to issue debt denominated in foreign currencies. This can lead to a financial crisis in a fashion similar to the unanticipated decline in inflation. With debt contracts denominated in foreign currency, when there is an unanticipated depreciation or devaluation of the domestic currency the debt burden on domestic firms increases. Since assets are typically denominated in domestic currency, there is a resulting deterioration in firms’ balance sheets and a decline in net worth, which then increases adverse selection and moral hazard problems along the lines as described above. The increase in asymmetric information problems leads to a decline in investment and economic activity.

Banks play a major role in financial markets since they are well positioned to engage in information-producing activities that facilitate productive investment for the economy. If banks suffer deterioration in their balance sheet and so have a substantial contraction in their capital, they will have fewer resources to lend and bank lending will decline. This will lead to decline in investment spending which slows economic activity. If the deterioration is severe, banks will start to fail, and fear can spread from one bank to another, causing even healthy banks to go under. The multiple bank failures that result are known as a bank panic. In a panic, depositors, fearing the safety of their deposits and not knowing the quantity of banks’ loan portfolios, withdraw their deposits from other to the point that the banks fail. The disappearance of a large number of banks in a short period of time means that there is a loss of information production in the financial markets and hence a direct loss of financial intermediation by the banking sector. The decrease in bank lending during a financial crisis also decrease the supply of funds to borrowers, which leads to higher interest rates. The outcome is an increase in adverse selection and moral hazard problems in credit markets; this produces an even sharper decline in lending to facilitate productive investments and a strong contraction in economic activity.

Financial crisis can be described like the business cycle, where the economic activity of a particular country or the whole world itself fluctuates over time. You have your ups and downs, and every climb up the ladder is just making that country or the world stable and stronger financially. To answer the question set, I would say that the globalisation of the capital markets do have a contagion effect on the financial crisis. The capital market whether it is domestic or globalised work in the same way. The growth of the capital market throughout the world has been the result of a shift in lending and borrowing activities from traditional syndicated bank loans to some type of marketable security or securitised instrument. Coupled with fast and improving telecommunication systems, deregulations and institutinalisation the market is open to every one and everything is possible. People or organisation who behave in the right manner will always go through the right channels. But due to availability of nce of plenty of adverse selection and asymmetric information

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