Rapid changes in global financial system spell new risks
| Author | Ceyla Pazarbasioglu/Mangal Goswami |
| Position | IMF Monetary and Capital Markets Department |
| Pages | 129-135 |
Page 129
With unprecedented capital flows across borders and new asset classes and investors, the world's financial system needs to be alert to new risks on the horizon, particularly as investors put money in unfamiliar areas, according to the IMF's recent Global Financial Stability Report. A key policy challenge is encouraging effective cross-border coordination between home country and host country regulators.
Page 135
As a result of the globalization of today's world financial markets, global capital flows are increasing rapidly, and asset classes and investor types are becoming more diverse. Many of these developments have been driven by a broadening investor base, financial liberalization, and technological innovations, enabling investors to diversify into new markets and new instruments, according to the IMF's most recent Global Financial Stability Report.
The diversity of assets, source countries, and investor types suggests that this form of globalization should support financial stability by distributing risk more widely. Long time horizons and lower leverage of institutional investors such as pension funds imply a greater capacity to ride out market volatility. That said, the speed at which these changes are taking place and the sheer size of capital flows may temporarily distort prices in financial markets and create pockets of vulnerability.
Indeed, cross-border capital flows have tripled over the past decade, to $6.4 trillion in 2005.
In some emerging market countries, increased demand has outpaced the availability of domestic financial assets, leading to a sharp increase in asset prices, rapid credit growth, and currency appreciation. Also, some investors have been venturing down the "credit ladder," investing in riskier areas where they have little experience. With the growing role of leveraged investors such as hedge funds, asset prices have greater potential to overshoot during good times, increasing the probability of downside risks when financial conditions worsen.
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Implementing structural policies to capitalize on the globalization of the investor base while fostering financial stability is the key challenge for many countries. The focus of prudential regulation and supervision needs to...
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