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First, countries: from 1995 to 2005 there was a doubling of gross external positions of a representative sample of 29 countries, measured by the sum of foreign assets and liabilities as a percentage of GDP.
Second, banks: international claims of banks located in mature economies have increased fivefold as a percentage of GDP since 1980 to reach 50% last year.
Third, asset returns: international co-movements of asset returns have increased significantly, as demonstrated in numerous studies. Furthermore, as predicted by theory, these co-movements are stronger further along the maturity spectrum. However, it is possible that they are, at least partly, due to other factors than financial globalisation, such as common shocks.
But it is a mixed bag. Although home bias has fallen, it remains substantial, even among countries that have operated open capital accounts for decades. Consumption remains more correlated with domestic output than predicted by theory. The global integration of financial markets has therefore so far provided less insurance against idiosyncratic shocks than expected. This could be because capital flows have effectively been more constrained than appears on paper, and financial integration has thus been less advanced. Alternatively, capital flows may be inherently volatile due to information problems and herding, thus becoming a source of shocks as much as smoothing.
Internationalisation of banking and prudential policies
Let me now turn to the internationalisation of banking and the challenges it creates for prudential policies. This is a big subject and my exposé will of necessity be sketchy. However, you might be interested to know that this will be treated in greater depth in the forthcoming Annual Report of the BIS.
As you are better aware than most others, internationalisation of banking is not a uniform process. There are cycles in the overall pace and uneven patterns of development in terms of whether banks engage in cross-border banking from their home base or have a local presence in host countries through branches or subsidiaries.
In recent years it seems that direct presence in host countries has become more prevalent. However, cross-border lending still dominates in the euro area and emerging Europe, while local presence is more usual in the United States and Latin America.
The pace of development has been diverse across countries and regions. According to the IMF’s latest Global Financial Stability Report, the share of foreign controlled bank assets in total bank assets increased globally by 8 percentage points between 1995 and 2005, to reach 23%. However, this share grew much more strongly in eastern Europe and Latin America, and it is currently significantly higher in these two regions than in other parts of the world.
A similarly strong regional variation emerges when seen from the standpoint of home countries. Cross-border activities, measured by the unweighted average shares of assets, revenues and employees, accounted for 45% of the total activity of 50 major European banks, but only 23% of the activity of 20 such banks in North America, and 14% of 20 major banks in Asia and the Pacific.
The drivers of the internationalisation of banking are partly the same as for globalisation in general, a reduction in transaction costs, progress in communication, economies of scale and scope, and liberalisation of trade and capital flows. Globalisation, in turn, gives a strong impetus to further internationalisation of banking. Thus following important domestic clients in international ventures is often an important motive for bank’s cross-border activities. However, there are also drivers more specific to the financial industry and the same applies to the domestic regulatory and competitive environment in which banks operate. Advances in computing and communication, in measurement and management of financial risk and financial innovation have increased the returns from expanded scope and scale, thus facilitating international expansion. Limits to domestic growth and a reduction of oligopolistic rents as competition increased then helped to provide incentives for expansion.
In many ways, Iceland fits this bill. Membership in the European Economic Area in 1994 provided access to EU markets and a level playing field. Privatisation of the banking system in the late 1990s and early this decade created the incentives and the dynamism. Then, the country’s banks embarked on an international expansion that was partly designed to follow Icelandic firms in their own outreach. This has now created a situation where three-quarters of the total lending of the largest commercial bank groups is to non-residents. This episode raises an interesting question that has to my knowledge not been given a satisfactory answer: what determines which countries become predominantly home countries and which become predominantly host countries? Why is Iceland a home country but New Zealand and the Baltic countries, to name a few examples, host countries? I leave the question with you, but I suspect that accidents of history might have as much to do with it as current assessment of economic efficiency.
The challenges for prudential authorities created by the internationalisation of banking are many. First, internationally active banks are more complex, as you know better than most, requiring more sophisticated resources from supervisory authorities. Second, in the absence of global or regional supervisors, internationalisation of banking requires information, views and local knowledge to be shared between supervisors in different jurisdictions, in particular between home and host authorities. Third, crisis management and resolution will necessarily involve several jurisdictions, with all the complexities and tensions over burden-sharing that this implies. Fourth, emergency liquidity assistance will be complicated or even impossible for central banks to deliver when internationally active banks face liquidity problems in currencies other than that of their home country. Iceland is a case in point.
The fundamental problem is of course that there is a mismatch between the international scope of banking institutions and the national scope of the frameworks for banking supervision and crisis management. The home-host principle is designed to meet these challenges, at least partly. However, it is currently being strained in several respects. Let me mention three examples:
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