TOPIC: Globalization continues to impact the nature and scope of financial

markets. Will deposit insurance remain relevant in its role in maintaining market discipline and bank stability? Discuss.

1st place winning essay by Patrina Pink, Wolmer’s Girls’ School

“We are not speaking of countries in crisis, but of a system in crisis,”

IMF chairman, Michel Camdessus (1998)

As the United States attempted to gather the crumbled remains of an economy left wasted by

one the world’s largest economic crises, policy makers took the changes necessary to ensure

that a crisis of such magnitude would never be repeated. One of the policy changes

mentioned was the implementation of a Deposit Insurance Scheme and the establishment of

the Federal Deposit Insurance Corporation (FDIC).

The purpose of Deposit Insurance is to protect individual deposits from loss in the case of

bank insolvency. Coverage may be either explicit or implicit and may not cover the entire

deposit. The aim is to stabilize the banking sector by thwarting fire-sale losses on assets that

may have contagion effects and extend to other banks. This may possibly disrupt financial

markets and the payments system as a whole. The banking sector is the cornerstone of every

economy and a troubled economy is a mere reflection of a troubled payments sector and

banking system.

With that said, this essay aims to provide the linkage between bank stability, market

discipline and Deposit Insurance in a Globalized Setting. Is Deposit Insurance worth the

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hassle? Or are markets too complex and entangled for such a scheme to make a difference?

Globalization or financial globalization in particular, refers to the increasing integration of

economies around the world. It entails the emergence of knowledge intensive production

technologies, the reduction in barriers for goods and services and the removal of capital

movement restrictions. This has signalled the dawn of economic interlocking. As a result, it

is necessary for states to rethink their traditional approaches towards microeconomic policy

making and the role of their financial institutions.

The increased competition has led banks and non bank financial organizations to expand

their market shares into new financial markets and the trade liberalization of some regulatory

systems in developing countries has facilitated investment from international firms. The

result is an unprecedented amount of North-South Capital flows which are flows from

developed or Industrial countries to the developing world. While these North –South Capital

flows have had a positive effect on growth in some developing or ‘Third World’ countries,

they also have resulted in collapses in growth rate and financial crises. These crises have

demanded a serious fee in terms of economic and social costs. As a result these factors are

taken into account when analyzing the overall effect of financial globalization on economic

growth in developing countries: Table 1 shows the various results of different studies over

the last 30 years.

It is of utmost importance to note that only two (2) of the fourteen studies have shown that

financial integration has had a positive effect on the growth rate of developing countries.

While, seven studies (half the number) have shown that financial integration has had no

effect on the growth rate of developing countries. This therefore dispels the myth that

financial integration is a prerequisite to economic stability and with it banking stability, the

two of which cannot be estranged.

TABLE 1: Summary of recent research on financial integration and economic growth Study Number of Countries Years Covered Effect on Growth

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Alesina, Grilli, (1994) 20 1950-89 No effect and Milesi-Ferretti Grilli and Milesi-Ferretti (1995) 61 1966-89 No effect Quinn (1997) 58 1975-89 Positive Kraay (1998) 117 1985-97 No effect / mixed Rodrik (1998) 95 1975-89 No effect Klein and Olivei (2000) Up to 92 1986-95 Positive Chanda (2001) 116 1976-95 Mixed Arteta, Eichengreen, and Wyplosz (2001) 51-59 1973-92 Mixed Bekaert, Harvey, and Lundblad (2001) 30 1981-97 Positive Edwards (2001) 62 1980s No effect for poor countries O'Donnell (2001) 94 1971-94 No effect, or at best mixed Reisen and Soto (2001) 44 1986-1997 Mixed Edison, Klein, Ricci, and Sløk (2002) Up to 89 1973-1995 Mixed Edison, Levine, Ricci, and Sløk (2002) 57 1980-2000 No effect Source: Extended by WEO, October 2001 and Edison, Klein, Ricci, and Sløk (2002).

Globalization exposes the economy of countries to the risks of the economic

environment. This therefore poses the question, what factors have led to the rising

vulnerability of developing economies to financial crises?

As mentioned before, the banking sector is the cornerstone of every economy.

Macroeconomic causes of banking instability can best be defined as the negative effects

of globalization on the banking sector. Macroeconomic stability and bank stability are

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therefore inexorably linked. A good banking sector can be endangered by a poor

macroeconomic environment.

The risk of sudden stops or reversals of global capital flows to developing countries is an

economic heartache for many developing countries. They are solely dependent on foreign

banks and portfolio investments or foreign direct investment. These North–South capital

flows are susceptible not just to domestic conditions in the home country but also to

macroeconomic conditions in developed or host countries.

In a study by Mody and Taylor (2002), they discovered instances of what they termed as

“international capital crunch”. This is where capital flows to developing countries were

reduced by industrial country conditions. These financial linkages represent an additional

conduit through which shocks that hit developed or industrial countries can affect

developing countries. The explosion of financial and currency crises among developing

countries are often referred to as the “growing pains” of financial globalization.

The insensitivity of the international investor manifests itself in “Momentum Trading”

and “Herding”. Herding is defined as investors replicating each others’ actions,

oftentimes to the detriment of a society by ignoring socially valuable information. The

aim is to learn from the mistakes of others. Momentum Trading is defined as buying

assets with rising prices and selling assets with falling prices, this is to anticipate

immediate profit and this action can be destabilizing for a developing economy because

of the drastic impact it has on financial markets.

The governments of developing countries may also play a destabilizing role: this may

occur when they incur large debts as a result of over-borrowing. Difficulties may arise

from lending booms as a result of excessive capital inflows or changes in tax laws. It can

also be the result of a slow down in growth or exports and the loss of an export market.

Lower investment, rising fiscal or current account deficits, weak public debt

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sustainability and changes in the exchange rate are other factors and were precursors to

Jamaica’s banking crisis of the 1990s.

Dollarized economies are particularly susceptible to financial crisis. In cases of economic

hardship countries may accumulate large debt in foreign currency (the favored currency

of trade) and face illiquidity problems. The limited international reserves may be

inadequate to address excessive bank runs. With currency depreciating after flotation,

many firms may be unable to repay their debt and banks may accumulate vast amounts of

credit losses as witnessed by the Finnish catastrophe of the 1990s.

The microeconomic reasons for bank instability and crisis are extensive. They can be

defined as the poor financial and regulatory practices of the banking sector. Problems like

excessive risk-taking, bad banking operations, lack of internal regulatory controls and a

concentration on market share instead of profitability are the usual culprits. The situation

is worsened when owners have little capital investment and are insensitive to the effects

of international risk sharing. These tend to be more prevalent in the case of families and

Industrial groups. Poor banking persists in states of poor regulation and supervision and

inadequate market discipline.

The weak financial framework of banks may be triggered by macroeconomic volatility.

The Latin American experience is perhaps the finest prototype for this argument. In order

to prevent financial crisis, I believe in strengthening the legal and regulatory framework

of financial institutions. Establishing a comprehensive Deposit Insurance scheme and

organization is one way to improve the regulatory framework of the banking sector.

Working closely with the Central Bank to help regulate banking activities, it should assist

in the prevention of bank failure and the contagion effects. Deposit Insurance prevents

the exodus of deposits, which would otherwise leave banks in hordes because of payment

limitations. Argentina and Uruguay were forced to restrict withdrawals which led to

pandemonium. A properly executed Scheme would theoretically prevent such chaos.

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Deposit Insurance protects those incapable of accessing the riskiness of the institution

chosen. It restores confidence in deposit taking institutions by reducing the probability of

deposit runs on institutions that may cripple the financial system as a whole.

The role of Deposit Insurance in maintaining market discipline is a controversial one.

Market discipline can best be defined as the monitoring of bank activities by depositors

and other bank stakeholders. It is theorized that Deposit Insurance erodes the practice of

market discipline by providing a safety net to depositors in the case of financial crisis.

Once depositors are said to be “safe” they will take no interest in monitoring the activities

of the bank.

Without the risk of large scale deposit runs, banks have an incentive to engage in risky

investments, especially in the developing world. The dangers of subordinated debt

become insignificant and banks will risk for higher returns. The lender of last resort

(central bank) further insulates banks from the penalties of risky activities.

The risks to market discipline can be counteracted with a responsible approach to

Deposit Insurance. Excessive coverage is bound to erode market discipline but a

reasonable amount should be established that protects most, but does not encourage

negligence on the part of depositors. With the right scheme implemented, market

discipline would be encouraged and not endangered.

To conclude, risk management and supervisory practices must be a priority in the topsy

turvy macroeconomic environment that financial globalization encourages. Frameworks

like Deposit Insurance must be implemented before markets are liberalized. Deposit

Insurance contributes significantly to bank stability and as a result economic stability,

however measures ought to be applied to ensure that market discipline is protected.

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Bibliography

Internet sources

www.imf.org

www.law.havard.edu

www.frbf.org

www.fdic.com

www.mit.edu

www.independent.com

www.globalozation.com

www.jdic.org

www.boj.org.jm

www.worldbank.org

www.investorwords.com

www.neweconomist.blogs.com

www.ideas.repec.org

www.financialintegration.com

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www.frbsf.org

www.eu-financial-system.org

www.bis.org