WEEK 10 - Financial Globalisation: Opportunity and Crisis

Question 1

What do International Assets markets trade in?

Answer 1

• Financial and Physical assets including:
  1. stocks
  2. bonds (government and private sector)
  3. deposits denominated in different currencies
  4. commodities (like petroleum, wheat, bauxite, gold)
  5. forward contracts, futures contracts, swaps, options contracts
  6. real estate and land
  7. factories and equipment

Question 2

How have international capital markets increased the gains from trade?

Answer 2

buyer and a seller engage in a voluntary transaction, both receive something that they want and both can be made better off

A buyer and seller can trade:
goods or services for other goods or services
goods or services for assets
assets for assets

Question 3

What are the 3 types of international transactions?

Answer 3

SEE GRAPH IN NOTES

Question 4

What is the theory of comparative advantage?

Answer 4

Describes the gains from trade of goods and services for other goods and services:
->With a infinite amount of resources and time, use those resources and
time to produce what you are most productive at (compared to alternatives),
->then trade those products for goods and services that you want.

Be a specialist in production, while enjoying many goods and services
as a consumer through trade.

Question 5

What does the theory of intertemporal trade argue?

Answer 5

describes the gains from trade of
goods and services for assets, of goods and services today for claims
to goods and services in the future (today’s assets).

Question 6

How are borrowers and savers made better off through financial globalisation?

Answer 6

Savers:

• Want to buy assets (claims to future goods/services)
• Earn a rate of return on their assets

Borrowers:

• Want to use assets to consumer or invest in more goods and services than their current income allows them
• Able to use goods and services when they want to use them

Both of them made better off

Question 7

What does the theory of Portfolio Diversification argue?

Answer 7

describes the gains from
trade of assets for assets, of assets with one type of risk for assets with another type of risk

=> MORE DIVERSE LESS RISK

Question 8

EXPLANATION OF PORTFOLIO DIVERSIFICATION

Answer 8

SEE VERY USEFUL EXAMPLE OF PORTFOLIO DIVERSIFICATION IN NOTES

Question 9

What are the differing classifications of assets?

Answer 9

1. Debt Instruments
   
   • > Examples include bonds and deposits
   • > Specifies that issuer must repay fixed amount regardless of econ conditions
2. Equity Instruments
   - >Examples include stocks or title to real estate
   - > Specifies ownership or variable profits, vary to econ conditions

Question 10

Who are the participants in international capital mkts?

Answer 10

1. Commercial Banks and other depository institutions
2. Nonbank Financial Institutions -> Securities Firms, Pension Funds, Insurance Companies, Mutual Funds
3. Private Firms
4. Central banks and government agencies

Question 11

What are the elements of Commercial Banks?

Answer 11

Accept deposits.
- Lend to commercial businesses, other banks, governments, and/or
individuals.
- Buy and sell bonds and other assets.
- Some commercial banks underwrite new stocks and bonds by agreeing to find buyers for those assets at a specified price.

Question 12

What are the elements of Nonbank financial institutions?

Answer 12

Securities firms specialize in underwriting stocks and bonds (securities) and in making various investments.
- Pension funds accept funds from workers and invest them until the
workers retire.
- Insurance companies accept premiums from policy holders and invest
them until an accident or another unexpected event occurs.
- Mutual funds accept funds from investors and invest them in a diversified portfolio of stocks

Question 13

What does Offshore banking refer to?

Answer 13

Banking outside the boundaries of a country

Question 14

What are the 3 types of Offshore Banking Institutions?

Answer 14

1. An agency office in a foreign country makes loans and transfers, but
   does not accept deposits, and is therefore not subject to depository regulations in either the domestic or foreign country.
   2 A subsidiary bank in a foreign country follows the regulations of the foreign country, not the domestic regulations of the domestic parent.
   3 A foreign branch of a domestic bank is often subject to both domestic
   and foreign regulations, but sometimes may choose the more lenient regulations of the two.

Question 15

What are some of the elements of an offshore currency deposit?

Answer 15

1. Bank deposit denominated in a currency other than the currency that circulates where the bank resides.
2. An offshore currency deposit may be deposited in a subsidiary bank, a foreign branch, a foreign bank, or another depository institution located in a foreign country
3. sometimes (confusingly) referred to as eurocurrency deposits, because these deposits were historically made in European banks.

Question 16

Why has Offshore Currency trading grown?

Answer 16

1. growth in international trade and international business
2. avoidance of domestic regulations and taxes
3. political factors

Question 17

What are some of the Govt Safeguards against financial instability (PT1)

Answer 17

1. Deposit Insurance
2. Reserve Requirements
3. Capital Requirements and Asset Restrictions
4. Bank Examination
5. Lender of Last Resort
6. Bailouts

Question 18

What is a Moral Hazard?

Answer 18

a hazard that a party in a transaction will engage in
activities that would be considered inappropriate (ex., too risky)
according to another party who is not fully informed about those
activities

Question 19

What are the elements of Deposit Insurance

Answer 19

• > Insures depositors against losses up to $100,000 in the U.S. when banks fail.
• > Prevents bank panics due to a lack of information: because depositors cannot determine the financial health of a bank, they may quickly withdraw their funds if they are not sure that a bank is financially healthy enough to pay for them.
• > Creates a moral hazard for banks to take excessive risk because they are no longer fully responsible for failure.

Question 20

What are the elements of Reserve Requirements?

Answer 20

• Banks required to maintain some deposits on reserve at the central
  bank in case they need cash.

Question 21

What are the elements of Capital Requirements and Asset Restrictions?

Answer 21

->Higher bank capital (net worth) means banks have more funds available to cover the cost of failed assets.
->Asset restrictions reduce risky investments by preventing a bank from
holding too many risky assets and encourage diversification by
preventing a bank from holding too much of one asset.

Question 22

What are the elements of Bank Examination?

Answer 22

Regular examination prevents banks from engaging in risky activities.

Question 23

What are the elements of Lender of Last Resort?

Answer 23

• Central banks may lend to banks with inadequate reserves (cash).
• Prevents bank panics.
• Acts as insurance for depositors and banks, in addition to deposit
  insurance.
• Creates a moral hazard for banks to take excessive risk because they are not fully responsible for the risk.

Question 24

What are the elements of Govt Organised Bailouts?

Answer 24

Failing all else, the central bank or fiscal authorities may organize the
purchase of a failing bank by healthier institutions, sometimes throwing their own money into the deal as a sweetener.
- In this case, bankruptcy is avoided thanks to the government’s intervention as a crisis manager, but perhaps at public expense

Safeguards not nearly as sufficient to prevent fin crisis of 2007-09

Question 25

What are some of the difficulties in Regulating International Banking? (PT 1)

Answer 25

1 Deposit insurance in the U.S. covers losses up to $100,000, but since
the size of deposits in international banking is often much larger, the
amount of insurance is often minimal.
2 Reserve requirements also act as a form of insurance for depositors,
but countries cannot impose reserve requirements on foreign currency deposits in agency offices, foreign branches, or subsidiary banks of domestic banks.
3 Bank examination, capital requirements, and asset restrictions are more difficult internationally.

Question 26

What are some of the difficulties in Regulating International Banking? (PT 2)

Answer 26

4. No international lender of last resort for banks exists.
   - The IMF sometimes acts a ìlender of last resortî for governments
   with balance of payments problems.
5. The activities of nonbank financial institutions are growing in international banking, but they lack the regulation and supervision that banks have.
6. Derivatives and securitized assets make it harder to assess financial
   stability and risk because these assets are not accounted for on the
   traditional balance sheet.

Question 27

What is a Securitised Asset?

Answer 27

A securitized asset is a combination of different illiquid assets like loans that is sold as a security.

Question 28

What are some of the difficulties in Bank Examinations, Capital Requirement and Asset Restrictions?

Answer 28

• Distance and language barriers make monitoring difficult.
• Different assets with different characteristics (ex., risk) exist in different countries, making judgment difficult.
• Jurisdiction is not clear in the case of subsidiary banks: for ex., if a
  subsidiary of an Italian bank is located in London but primarily has
  offshore U.S. dollar deposits, which regulators have jurisdiction?

Question 29

What is the Financial Trilemma?

Answer 29

At most two goals from the following list of three are simultaneously
feasible:

1 Financial stability.
2 National control over financial safeguard policy.
3 Freedom of international capital movements.

Question 30

What are the Basel Accords (1988 and 2006)?(international Regulatory Co-op)

Answer 30

=>Provide standard regulations and accounting for international financial institutions.
=>1988 accords tried to make bank capital measurements standard across countries.
=>They developed risk-based capital requirements, where more risky assets require a higher amount of bank capital.

Question 31

What are the Core Principals of Effective Banking Supervision?(international Regulatory Co-op)

Answer 31

developed by
the Basel Committee in 1997 for countries without adequate banking
regulations and accounting standards.

Question 32

Why did they make a Basel III?

Answer 32

The Önancial crisis made obvious the inadequacies of the Basel II regulatory framework, so in 2010 the Basel Committee proposed a tougher set of capital standards and regulatory safeguards for
international banks

Question 33

What is the Financial Stability Forum (FSF)?

Answer 33

Delivers reports on how to deal with banks internationally

Question 34

Why did the FSF become the Financial Stability Board (FSB)?

Answer 34

with a broader membership (including a number of emerging market
economies) and a larger permanent staff

Question 35

What is the Macroprudential?

Answer 35

Form of analysis:
=>Ensuring that each individual financial institution is sound will not
ensure that the financial system as a whole is sound.
=>National financial regulators often face fierce lobbying from their
home financial institutions, which argue that stricter rules would put them at a disadvantage relative to foreign rivals.
=>The Basel multilateral process plays an essential role in allowing governments to overcome domestic political pressures against
adequate oversight and control of the financial sector

Question 36

What is some of the Macroprudential perspective using US data?

Answer 36

=>2008, U.S.-owned assets in foreign countries represented about46.6% of U.S. capital.
=>Foreign assets in the U.S. represented about 54.7% of U.S. capital (indicating that international capital markets have allowed
investors to diversify, in full diverse economy 80% if US Capital would be owned by foreigners)
=> Foreign Assets and Liabilities as a percent of GDP has grown for US and other countries

Question 37

What would be optimal in providing diversification?

Answer 37

would be optimal if investors diversified more by investing more in foreign assets, avoiding the
home bias of investment.

Question 38

What is the extent of International Intertemporal Trade and how does it impact in real life?

Answer 38

If some countries borrow for investment projects (for future production and consumption) while others lend to these countries,
then national saving and investment levels should not be highly correlated.
(National Saving -Invst = CA)

In reality National Saving and Invst lvls highly correlated

Question 39

When should interest rates on offshore currency deposits and those on domestic currency be the same?

Answer 39

If:
=>the two types of deposits are treated as perfect substitutes,
=>assets can flow freely across borders, and
international capital markets are able to quickly and easily transmit information about any differences in rates.

Question 40

How has better information processing helped with interest rate differential?

Answer 40

Differences in interest rates have approached zero as financial capital mobility has grown and information processing has become
faster and cheaper through computers and telecommunications.

Question 41

What is the interest parity if asset are treated as perfect substitutes?

Answer 41

Rt - Rt* = (Et+1 to the power of e - Et)/Et

Question 42

What happens if the interest parity holds?

Answer 42

=>the interest rate difference is the market’s forecast of expected changes in the exchange rate.
=>If we replace expected exchange rates with actual future exchange rates, we can test how well the market predicts exchange rate changes.
=>But interest rate differentials fail to predict large swings in actual exchange rates and even fail to predict in which direction actual exchange rates change

Question 43

What is the interest parity if assets are imperfect substitutes?

Answer 43

Rt - Rt* = (Et+1 to the power of E - Et)/Et + p t

=>Interest rate differentials are associated with exchange rate changes
and with risk premiums that change over time.
=>Changes in risk premiums may drive changes in exchange rates rather
than interest rate differentials

Question 44

Hard to predict Exchange rates changes based on what?

Answer 44

over short horizons
based on money supply growth, government spending growth, GDP
growth, and other fundamental economic variables.

The best prediction for tomorrows exchange rate appears to be todayís
exchange rate, regardless of economic variables.

But over long time horizons (more than 1 year), economic variables do better at predicting actual exchange rates