Going to pieces
The global financial system is becoming more national. Three years after Western taxpayers were forced into a mass bailout of banks, Western lenders are in full retreat, encouraged by regulators and governments.
In the two decades leading up to the financial crisis, national borders became steadily less important in finance. The crisis made it clear that nationality does matter, because domestic taxpayers ended up supporting banks, including their far-flung operations. The crisis also showed that banks had too much leverage.
European banks are now leading a backwards charge. According to Barclays Capital, euro zone lenders had $1.2 trillion of assets in emerging markets in mid-2011 – double the amount just seven years earlier. A significant chunk of those assets are supported by the parent bank’s capital and funding. With capital scarce and funding costs high, retreat is the only option.
Europe’s banks are also pulling back on the business of lending in dollars, which were often borrowed from U.S. money market funds. After U.S. investors fled from Europe last year, that business looks too risky. Though the funds may be returning to the euro zone, banks are likely to remain wary.
Post-crisis regulation is contributing to de-globalisation. Capital-short banks in Europe and elsewhere have sold foreign businesses. And the UK government has accepted the recommendation of its Independent Commission on Banking to ringfence domestic retail banking operations, making foreign and investment banking units less appealing. The U.S. Federal Reserve’s latest stress tests effectively punished big U.S. lenders with extensive European operations by requiring them to be able to withstand a euro zone meltdown. And Canada and Japan fear the U.S. Volcker rule, which bans proprietary trading, will force lenders out of foreign sovereign debt markets.
At least the Basel Committee’s new bank capital regulations are designed to be implemented on a global basis. But other financial rules are less universal. For example, Europe is pushing ahead with the Solvency II framework for insurers, even though the United States is showing no sign of following suit.
Governments also want financial institutions to concentrate their efforts at home. Politicians no longer see any advantage in hosting global financial champions, but stress the value of lending to local small businesses and consumers. Commerzbank declared last year that it would stop lending outside Germany and Poland. Austrian banks are under orders to limit their exposure to central and eastern Europe. Some European lenders are also under pressure to buy their home governments’ bonds.
Does this de-globalisation matter? The adjustment is clearly painful for countries that had come to rely on cheap capital from the West. The Institute for International Finance predicts that net capital flows to emerging markets this year will drop by almost a fifth to $746 billion – only slightly above the post-credit crunch low of $643 billion. This will make credit more expensive, perhaps hindering economic growth.
But the financial fragmentation of the past three years should not be exaggerated. Capital can still flow freely in and out of most developed countries. The world’s most ambitious cross-border financial experiment, the euro zone, is still just about intact. The only explicit national capital controls have been imposed by countries such as Brazil, which were worried about attracting too much hot foreign money – not losing it. And cross-border trade has resumed its upward trend, generating foreign exchange surpluses which China and others can still invest around the world.
In any case, some retreat was probably in order. The crisis showed the foundations of international finance were less solid than previously thought. And financial internationalisation does not always make sense. A recent study of seven western economies – the United States, Japan, Germany, UK, France, Italy and Spain – by the consultancy Oliver Wyman showed that each is roughly in financial balance, and does not necessarily need to either export capital or seek foreign financial support.
Nevertheless, the reversal is significant. For several decades, many Western governments embraced liberalisation and globalisation, in the belief that free markets would allocate resources efficiently and stimulate growth. That orthodoxy has been thoroughly discredited. But the cracks now appearing in the global financial system could lead to more undesirable fissures. A global outbreak of protectionism could be even more destructive than the financial crisis.