Global Finance Resets Finance & Development, December 2017, Vol. 54, No. 4
Susan Lund and Philipp Härle
The decline of cross-border capital flows signals a stronger global financial system
A decade after the global financial crisis began, the landscape of global finance is much altered. Gross cross-border capital flows (foreign direct investment, purchases of bonds and equities, and lending and other investment) have fallen substantially since the precrisis era and, relative to world GDP, are back to the level of the late 1990s (see Chart 1). While all types of capital flows have shrunk, cross-border lending accounts for more than half of the overall decline. This phenomenon reflects a broad retreat from overseas business and a shift away from cross-border wholesale funding by major European and some US banks.
Does this mean that financial globalization has lurched into reverse gear? Our new research finds the answer is no. The global financial system remains deeply interconnected when measured by the stock of foreign investment assets and liabilities. What is emerging from the rubble appears to be a more risk-sensitive, rational, and potentially more stable and resilient version of global financial integration—an ultimately beneficial outcome.
Shift in the landscape Before the crisis, many of the largest European, UK, and US banks launched bold global expansions, pursuing every avenue for international growth. They built banking businesses for retail and corporate customers in new regions, amassed large portfolios of foreign assets, such as subprime mortgage securitizations and commercial real estate, and increasingly relied on short-term cross-border interbank funding.
But horns are now drawn in and capital is being conserved. Risk is out, and conservative banking—even “boring” banking, as former Bank of England Governor Mervyn King put it—is in. The largest Swiss, UK, and some US banks have all been part of the broad retreat, but nowhere has the reversal been more dramatic than among euro area banks (see Chart 2).
After the introduction of the euro on January 1, 1999, euro area banks expanded beyond their national borders into all corners of the single currency area. Given the common currency and a largely common rule book, country risk was downplayed or ignored. The stock of their foreign claims (including loans by their foreign subsidiaries) grew from $4.3 trillion in 2000 to $15.9 trillion in 2007. Most of that growth came from lending and purchases of other foreign assets within the euro area. But also important were the growing financial ties—and particularly...