Global Banking Regroups

• Author: Stijn Claessens and Juan A. Marchetti
• Position: Assistant Director of the IMF's Research Department, and is Counsellor in the Trade in Services Division of the World Trade Organization.

The global financial crisis led to a reevaluation of the benefits and risks of finance—including international financial services—which many observers believe had grown too big and too complicated and whose products, such as complex securitization and derivatives, seemed to offer little added value but generated many risks.

Nowhere can this reevaluation be observed more clearly than in international banking. After two decades of rapid expansion across borders, global banking is retreating. After peaking in the first three months of 2008 aggregate foreign bank lending dropped sharply. The decline was especially large in direct cross-border loans; lending through foreign affiliates has been more stable. This retrenchment was driven largely by market forces, as undercapitalized banks reduced their balance sheets. But some domestic regulatory changes have added to the desire to retreat to their home base.

The retrenchment reflects in part shortcomings in the global financial architecture—those mechanisms that facilitate global financial stability and the smooth flow of financial services and capital across countries. The crisis showed how the problems in one nation can be transmitted extensively to others, and how limited coordination among financial regulators complicates crisis management and the resolution of failing banking groups that do business in more than one country. Moreover, incentives to monitor and support banks and their foreign affiliates can differ between home and host country authorities. In many central, eastern, and southeastern European countries, for example, affiliates of western European banks were of systemic importance to the host country, but small relative to the parent bank’s global operations. Only close international coordination—through the so-called Vienna Initiative—prevented major problems for host countries when foreign banks were hit by shocks at home or in their global operations. In some other cases, when a bank’s activities were large relative to the home country’s economy, that country was not always in a position, or willing, to support the parent bank, let alone its affiliates.

Growth in globalization

During the two decades before the global financial crisis, financial globalization increased considerably, reflecting mainly

• a large rise in direct cross-border bank lending, foreign direct investment, and other forms of capital flows, such as equity and bond portfolio investments; and

• foreign-owned financial institutions, in particular banks, setting up shop in other countries and doing business there.

The sharp rise in bank and other debt-creating financial flows occurred across a broad range of countries. Between 2002 and 2007, gross capital flows rose from about 8Â percent to almost 25 percent of the GDP of advanced economies and from about 2.5Â percent to more than 12 percent of the GDP of emerging market economies. While financial globalization helped spread risk among countries, it also increased the likelihood that an adverse shock in one major financial center would be transmitted across countries. And that is what happened. After peaking in early 2008, global gross capital flows plummeted to 1.3 percent of global GDP in 2009, affecting advanced economies as much as emerging market economies. Flows recovered somewhat in 2010, but fell again as the European sovereign debt crisis intensified. In 2012, flows were only 3.6 percent of global GDP.

Similarly there was a large increase in the local presence of foreign banks and other financial institutions prior to the crisis. In the preceding two decades, banks enlarged their global footprint by establishing operations in many countries through branches (direct extensions of the bank) and subsidiaries (which are locally chartered and capitalized). Over the period 1995â2009, some 560 foreign bank investments took place...