Financial Crisis On The International Scale: Causes And Institutional Mechanisms

Introduction

The continuous strengthening international tendency of economic and financial integration not only expands the international market but also makes various countries’ economies have great correlation and strong similarity. This has greatly advanced the global financial system’s vulnerability together with a regional or global financial crisis probability. Supposing that there occurs a crisis in a country’s economy, a small-scale limited crisis rapidly escalates into a large-scale regional or international financial crisis by dint of the international financial system.

In other words, the gradual deepening accompaniment of economic globalization and financial integration will further to its scale, as well as diffusion rate. To effectively prevent its outbreak and reduce its cost, it is necessary to analyse the financial crisis international infection mechanism. The paper studies the world financial system part in its epidemic from the point of view of the worldwide proliferation mechanism and the institutional mechanism.

The Financial Crisis Occurrence and Worldwide Diffusion Mechanism

The financial crisis contagion, as well as diffusion, means that in virtue of the financial system complexity together with fragility itself, one country’s occurring or appearing financial crises will spread to other countries and regions and ultimately have an inestimable negative impact on the world economy. That is to say, any regions or countries’ financial system imbalance can jeopardize that of other countries. Its international contagion and diffusion path analysis are as follows from three aspects: liquidity shock, financial network interconnection and crisis symbiosis mechanism.

1) Liquidity Shock

Because of highly close and complex links between various economies around the world, in the event of the liquidity problem in one country’s financial market, the safety of liquidity in other countries or regions may be jeopardized, inducing a wide-ranging financial crisis. Theoretically, bank deposit channels play an important role in the transmission of liquidity shocks (Chouchène, Ftiti & Khiari, 2017). The banking system may face liquidity shocks at any time owing to the uncertainty of depositors’ liquidity needs.

Relying on the close ties of banks, together with the imperfect interbank markets’ existence, the banking issues in one country may raise the global banking system’s volatility (Allen & Gale, 2000). The increased volatility creates conditions for its inter-regional and international proliferation (Eross, Urquhart & Wolfe, 2019). What’s more, liquidity shortage and credit crunch caused by banking crises outbreaks in a country will further exacerbate their worldwide dissemination, causing the global economic systems collapse (Diamond & Rajan, 2000). The foreign banks’ existence in some measure can appropriately alleviate the liquidity crunch caused by the crisis (Liu, Shao & Gu, 2017).

Based on information asymmetry and “collective risk transfer”, banks choose to hold highly similar investments to circumvent the negative effects of bankruptcies in other banks (Acharya, 2009). Assuming that banks deal with liquidity problems by holding deposits against each other, the creditor’s bank deposits value depends on whether the debtor’s bank is bankrupt (Dasgupta, 2004). This ‘spill-over effect’ spreads a single bank’s crisis to other banks, thereby exceedingly increasing the probability that they fail concurrently (Acharya, 2009).

2) Financial Network Interconnection

Due to financial network interconnection, financial institutions hold generous homogeneous assets, and their inherent correlation has been strengthened. Through the global financial network, any small shocks are highly likely to be amplified, threatening the stability of the whole system (Aswani, 2017). Even a non-systematic or non-diffuse shock, through the international interconnected financial network, can cause the entire system value to decline (Eisenberg & Noe, 2001). Its propagation effect depends in large measure on financial instruments or economic sectors where original shocks occurred as well as the basic economic network structure (Castrén & Rancan, 2014).

As the international network interconnection deepens, the system’s stability has shown a tendency which first declines and then rises (Cifuentes, Ferrucci & Shin, 2005). For banks, the best way to avoid liquidity shocks in a relatively stable financial system is to be fully connected; but in a relatively unstable financial system, the better option is not fully connected (Dasgupta, 2004). When the foreign exchange market is a sporadic clustering network, its crisis propagation mainly depends on external linkages among clusters rather than internal linkages (Naylor, Rose & Moyle, 2008).

The key to the outbreak of the subprime mortgage crisis in 2008 is the interconnection of the international financial network. First, structured financial products intensify the risk exposures’ links among financial institutions in various countries, prompting the systemic risk’s formation (Brunnermeier, 2009). Furthermore, the linkages between assets and liabilities, as well as the financial network interconnection, amplify and disseminate sub-prime mortgage market losses throughout the global financial market, leading to a global crisis (Razin & Rosefielde, 2011).

3) Crisis Symbiosis Mechanism

The interconnection that prevails among markets means that crises among different markets may occur simultaneously. Whether they occur or not depends on the fundamentals of the global macroeconomy, and the time of their occurrence lies in the self-fulfilling expectations (Burnside, Eichenbaum & Rebelo, 2001). Rising real interest rates, falling exports, credit expansion together with the stock markets’ slumps have largely led to a symbiotic crisis eruption (Kaminsky & Reinhart, 1999). Games between national and external investors as well as the unexpected shocks caused by negative productivity shocks have also increased the probability of a symbiotic crisis (Simon, 2003; Nakatani, 2016).

There is a notable symbiosis between banking crises and currency crises. In most cases, currency crises tend to lead to banking crises and vice versa (Jing, 2015). The key to outbreaks turns on its relationships between foreign currency assets and liabilities as well as the government’s foreign reserves. When foreign liabilities are higher than assets besides the government has exhausted reserves, the banking crisis, as well as the currency crisis, will simultaneously erupt (Dooley, 2000). Banking crises can be observed through indicators such as the net interest margins of the bank, the yield curves and economic development. Nevertheless, the currency crisis is mainly observed by short-term interest rates and currency estimations (Joy et al., 2017).

Another cause of the banking and currency symbiosis crisis is the banking system’s fragility. Because of its inherent fragility, central banks’ rescues of liquidity injection are enough to jeopardize monetary stability (Borio & Lowe, 2002). For the relatively unstable banking system, the government’s act of raising interest rates to ease the pressure on the foreign exchange market against a background of a currency crisis may also trigger banking crises (Obstfeld, 1997). Second, changes in international interest rates, as well as capital flows, can also lead to a symbiosis crisis’ emergence (Baig & Goldfajn, 1999).

Financial Crises’ Institutional Mechanism

In view of the diversity of factors affecting the spread of international crises, it is indispensable for establishing a multidimensional perspective to re-examine its international spreading path. In addition to the above-mentioned content, different institutional mechanism choices have different effects on the financial system’s stability and the financial crisis’s occurrence probability. That is to say, the institutional mechanism plays a pivotal role in the crisis of international transmission. The following analyses relationships between the institutional mechanism and the crisis of international propagation including exchange rate regime, financial liberalization as well as government regulation.

1) Exchange Rate Regime

In the crisis of international dissemination, the exchange rate system has played a particularly important role in boosting. Usually, different exchange rate regimes have different effects on the international financial system’s fragility. From the GDP perspective, the financial crisis has a negative impact on economic growth regardless of each country’s income levels (Morales-Zumaquero & Sosvilla-Rivero, 2016). A study has shown that against the financial crises background in low-income and low-and-middle-income countries, the exchange rate regime only has a vital influence on short-term growth rates, yet the impact on long-term growth rates is not significant (Morales-Zumaquero & Sosvilla-Rivero, 2015).

Although the exchange rate stability plan’s implementation temporarily improves macroeconomic fundamentals, the subsequent real exchange rates sharp appreciation and the private reserve rates decline will bring about the current account deficit and excessive borrowing. Therefore, in response to currency attacks, the government should choose a currency depreciation policy (Calvo, Reinhart & Végh, 1995). It should be noted that this stability plan is not conducive to solving the hyperinflation problems (Cinquetti, 2000).

Consider the international development path of the banking crisis under two different exchange rate regimes. When the bank run occurs in a country, under the fixed exchange rate system, the central bank would implement intervention and provide liquidity support. The huge demand pressure on the national central bank’s international reserves will be transmitted to the international foreign exchange market and have an impact on its liquidity. Conversely, if the country implements a floating exchange rate regime, it can avoid the expected self-fulfilment of bank runs. Generally, the exchange rate system raises the banking crisis’ eruption eventuality by net foreign borrowing and currency crises (Angkinand & Willett, 2011).

Exchange rate devaluation, financial institutions’ currency mismatches and credit expansion are all likely to trigger banking crises (Angkinand & Willett, 2011). The systemic banking crisis, in turn, has a negative impact on trade flows among countries (Santana-Gallego & Pérez-Rodríguez, 2019). In developing countries, the fixed exchange rate system’s implementation can effectively lessen the chance of a banking crisis’ occurrences chance. However, when a banking crisis occurs, its actual cost will be even higher (Domaç & Martinez Peria, 2003).

2) Financial Liberalization

Since the 1970s, financial deepening and liberalization have gradually become a global trend. Although financial liberalization contributes to the global economy’s growth and prosperity (Rachdi, Hakimi & Hamdi, 2018), it also in large part leads to the international financial system’s instability (Botta, 2018). Financial liberalization has a significant negative influence on banking crises and currency crises occurrence (Lee, Lin & Zeng, 2016). In the context of financial liberalization, a poorly designed banking system often creates a crisis. However, in the face of fierce worldwide competition, even a well-designed system has the potential to erupt banking crises (Daniel & Jones, 2007).

From the point of view of banking, the crisis is associated to a certain extent with financial liberalization and the credit scale expansion in this process (Bird & Rajan, 2001). The foreign capital influxes cause a surge in the domestic financial markets’ liquidity, fuelling the boom in domestic credit markets and creating asset price bubbles. While excessive credit expansion leads to an increase in banks’ risk loans and non-performing loans, which significantly increase the banking systems’ vulnerability. Therefore, domestic credit expansion and asset price booms can be seen as ex-ante signals of the banking crisis outbreak (Demirgüç-Kunt & Detragiache, 1998). Theoretically, when full financial liberalization is implemented, the flexible exchange rate regime’s impact on the banking crisis is positive and notable (Richey, 2018).

From a macroeconomic perspective, capital inflow countries appear investment overheating, exchange rate appreciation and current account deterioration in a short period of time, which have an impact on the stability of the macroeconomy. If speculative shocks occur at this time, there would be a reversal of foreign capital, which triggers a currency crisis (Calvo & Mendoza, 2000).

In the international context of financial liberalization, the credit expansion of the banking system will cause further financial crisis deterioration. High-interest rates, together with a lack of capital resources in developing countries attract constant foreign capital flows into the country. Because of the banking system’s credit expansion function, the influxes of a large amount of speculative capital have spawned the domestic credit expansion, which in turn leads to the emergence of asset price bubbles. In the long run, asset price volatility drives bank credit expansion (Borio & Lowe, 2002). This series of processes acting on the financial system as a whole exacerbate the domestic markets’ volatility, and thus increase the global financial system’s fragility.

3) Government Supervision

In the event of a financial crisis, timely government discovery can effectively prevent the spread and diffusion (Bakare, 2016). Thus, to maintain efficient and stable economic growth, the global economy should be placed under a prudential supervision system. This is because the government’s good macroeconomic policies are conducive to providing a transparent as well as efficient financial market, effectively preventing the major financial and capital markets illiquidity. The regulation quality and executive body are the crux of the matter (Haidar, 2012).

For example, the deposit insurance system under the regulatory system would induce banks to create moral hazards. Simply put, banks take on more risks proactively based on government guarantees. This greatly aggravates the global banking system’s instability and finally leads to the banking crisis outbreak. In reality, banks borrow foreign capital then lend to national corporate institutions. However, under the government guarantees, the banks’ moral hazards further induce external borrowing, over-investment as well as current account deficits.

As the fiscal deficits increase, once foreign creditors stop financing, the government is bound to turn to seigniorage to maintain solvency. The strong inflation expectation certainly will put enormous pressure on a country’s currency and banking system, eventually leading to the outbreak of a systemic banking crisis (Corsetti, Pesenti & Roubini, 1999). There is, therefore, a need for strict government regulation to maintain systemic stability and eliminate the damage to the global financial system caused by speculative financing (Ülgen, 2016).

In general, the financial crisis is rooted in poor regulation and government guarantees; furthermore, the government intervention timing is the direct cause of its outbreaks (Kletzer & Dekle, 2001). When the government lacks effective supervision of banks under the deposit insurance system, the accumulation of non-performing assets will ultimately be borne by the government. In this case, when the government intervenes would affect the future economic growth rates. If the government has not intervened within a certain period of time, even if there are no external shocks at this time, there would be a banking crisis (Kletzer & Dekle, 2001). Nevertheless, higher capital regulatory requirements for banks can reduce the banking system’s vulnerability and improve the bank’s development (Lee & Lu, 2015).

Conclusion

The trend of economic globalization and financial liberalization has increased the links and interactions among each country’s economies, which has greatly contributed to the global economy’s prosperity. But the increasing national financial system’s relevance and similarity also aggravate the international financial system’s volatility and vulnerability, which greatly increase the systemic risk probability and the global financial crisis outbreak.

From the financial crisis occurrence and international diffusion mechanism perspective, the system’s liquidity problem greatly raises the worldwide financial crisis outbreak probability. The financial network interconnections deepening degree exceedingly reduces the international financial system’s stability; so that a country’s economic problem is easily spread to other regions and countries. The symbiotic mechanism expands the financial crisis’ damage extent and influence scope. These, to some extent, reinforce its negative impact and also raise its occurrence costs.

From the financial crisis occurrence mechanism perspective, the floating exchange rate system as well as government supervision can diminish its occurrence probability and worldwide spread to a certain extent. Excessive financial liberalization is a key factor in exacerbating the worldwide crisis outbreak. This paper analyses and studies the financial crisis international transmission mechanism, and has a certain reference value for effectively preventing their occurrence in the future.