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December 16, 1983
International FinancialIntegration
Much of the currentdiscussion on the
international debt problem has concentrated on its immediate causes and possible
remedies. This Letter proposes that perhaps
both the diagnosis of the problem and the
prescription for its solution depend critically
on how one interprets the international
banking developments of the last twenty
years.
The conventional view with regard to international banking is that it is a mere extension
of domestic banking: banks lend a portion of
domestic deposits abroad in pursuit of
higher returns. As such, the regulatory and
supervisory approach that has been adequate for ensuring prudence in domestic
banking shou ld also be sufficient for protecting the banking system from the vagaries of
international activities-provided that
control over international banking is
tightened.
An alternative view puts the international
debt problem in the context of the international financial integration that has
occurred over the last two decades. Similar
to inter-regional financial integration within
a national economy, this pe(spective interprets the international-debt problem as one
of international financial management,
comparable to that of national financial
management.
This Letterwill attempt to establish that
international financial integration is a reality
that can be reversed only at great costs to
the world economy. Its implications for the
international-debt problem will be explored
in next week's Letter.
The concept
An "integrated financial system" is one in
which the savers and ultimate users of funds
residing in different regions are guided by
essentially the same set of market signals
(e.g., interest rates) in making their financial
decisions. In the U.S. financial system, for
example, competition and the efficient dissemination of information allow savers in .
different parts of the country to be given
essentially the same set of returns for
thei r savings, and borrowers the same set
of interest costs. Money-market mutual
funds, secondary mortgage markets, insurance companies, national finance companies and investment banks have all
helped to ensure that this condition prevails
nationwide.
The extent of international financial integration is, of course, far less than that within
a nation. In concept, one may recognize
three levels of integration. First, at the most
underdeveloped level, segregated national
markets exist. These may consist of national
financial markets effectively separated by
capital controls (examples being centrally
planned economies) orby prohibitively high
information costs (such as those prevailing
in poor nations in remote regions). The result
is that little if any international private
capital flows across national boundaries.
Each separate national financial market
allocates the national savings among
domestic borrowers at interest rates that are
completely unaffected by those in the rest of
the world, and domestic investment is confined to that wh ich can be financed out of
domestic savings.
Second, linked national markets exist where
the market participants in each nation have
little or no direct access to financial services
outside their nation's borders, but limited
international capital flows take place as permitted by national exchange-control authorities. Capital tends to flow from those cou ntries with a surplus and relatively low rates
of return to capital-deficient countries with
relatively high rates of return. Since these
flows are obstructed, interest rates are not
equalized internationally.
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The pace of the revival has been especially
rapid during the past decade_ The total
international banking assetsof fifteen major
industrial nations grew from roughly $300
billion althe end of 1 974 to almost $1.7
trillion at mid-19B3 -an average growth
rate of 23 percent a year. The bulk of these
assets were claims among banks, but as
much as $500 billion consisted of loans to
foreign governments and businesses. The
phenomenon has been worldwide in scope.
Banks located in the United States
accounted for about one-third of the total
assets at mid-19B3, and those in Europe
about 60 percent, with the rest divided
between banks in Japan and Canada.
Third, full international financial integration
exists where the market participants in different nations have access to the same
financial services for borrowing and for
placing funds at essentially the same set of
interest rates. These fin.ancial services are
provided by institutions that have acquired
expertise in international risk assessment
and that have free access to funds in national
or international markets. Because of economies of scale and market competition, they
can offer higher interest rates to savers and
lower rates to borrowers than those operating strictly in national markets.
In contrast to linked national markets, international capital flows in integrated markets
are characteristically two-way flows
between nationals in a country and financial
institutions located abroad. Since in this
case international banking is a service
industry based on financial expertise rather
than the relative abundance of national
capital, it can be conducted by banks of any
nationality that can more ably provide this
service, and in any country that enjoys a
comparative locational advantage with
respect to a given region. Thus, London, the
Bahamas, Panama, Hong Kong, and Singapore are international centers with extensive
two-way international flows, not because
of the relative abundance of their domestic
capital endowment, but because of the existence of a well-established international
banking service industry and thei r locational
advantage.
A necessary and sufficient condition for
financial integration is a two-way capital
flow between international financial centers
and residents outside such centers_ At mid19B3, total international banking assets
amounted to $1 .7 trillion and liabilities,
$1 .6 trillion. These were banking claims and
liabilities involving residents outside the
fifteen industrial countries and the offshore
financial centers where the banks were
located. Most of these two-way international claims and liabilities were in relation
to entities within the reporting area. With
respect to those outside that area, the banks
held a total of $530 billion claims and had
$330 billion liabilities.
A further breakdown indicates that this
international banking system had two-way
financial relations with all major individual
I'outside /l areas or countries. For instance/
The evidence
$79 billion of claims on the OPEC nations
and $1 20 billion of liabilities to them, $4B
billion of claims on Asia other than Japan
versus $36 billion of liabilities to the region,
and $60 billion of claims on Mexico
matched with $13 billion of liabilities to that
nation_ These data sketch out a profileof the
current status of international financial
integration in the world economy.
International financial integration is not
a new phenomenon. It prevailed to a large
extent in the 1 9th century, when London
was the international financial center of the
world. The system fell apart during World
War I and disintegrated as a result of the
Great Depression. It is only in the last twenty
years, with the removal of capital controls
by major industrial nations and the rise of
the Euro-currency markets, that international financial integration has revived.
Through the international banking system,
the fifteen industrial countries and the off2
---
twenty years. To the extent that trade benefits all nations, international banking has
also benefitted the world economy by
making trade growth possible.
shore centers together constitute a highly
integrated core, on which is anchored a farflung two-way financial network covering
various parts of the world, with varying
degrees of financial integration.
However, international financial integration
cuts both ways. Increased interdependence
also means increased exposure to risks for
both the banks and their customers. In addition to ordinary credit risk, international
lending exposes banks to political and
economic risks in debtor nations overwhich
they have little control. ( However, international portfolio diversification reduces total
risk.) Moreover, because extensive and massive inter-bank claims closely link the major
international banks, a crisis that hits one
could also shake up the rest. ( On the other
hand, the inter-bank market has been a
major source of support for banks in temporary liquidity shortages.)
Its significance
The significance of international financial
integration can be assessedby examining its
benefits and costs. First, international
integration increases the efficiency of
capital allocation among nations. Instead
of confining the investment horizon to the
national or regional market, an integrated
system allows savers to seek the highest and
safest return worldwide, as offered by financial institutions whose business is to know
the optimal investment opportunities. Borrowers also benefit by being released from
the confines of the national market to seek
the lowest cost fi nanci ng offered in the
world market. The result is not only higher
returns to savers and lower costs to borrowers, but also greater real income for both
the lender and borrower nations than is
possible under either segregated or linked
national markets. More efficient capital
allocation means larger world output of
goods and services for distribution to the
lender and borrower nations.
Debtor nations that tie themselves to the
world capital market expose themselves to
the risks of disrupted flows of funds and large
interest-rate fluctuations. When times are
good, bankers swarm around, fighting to
offer funds, but when conditions sour and
financing is desperately needed, funds
become scarce quickly. The unwary
borrower would then be left in the lurch and
be forced to undergo painful deflationary
adjustments to make ends meet.
Second, an internationally integrated financial system cushions the world economy
from unexpected shocks and facilitates the
financing of world output and trade expansions. For instance, the world banking
systemdid a remarkably good job in recycling the OPEC surplus dollars follo Wing
the two large oil-price increases in the
1970s. This gave the importing nations
time to adjust their production and consumption structures to the price changes,
and thus avert abrupt disruptions to their
economies. (A possible adverse effect is that
the access to financing may have induced
some countries to forego or unduly postpone
necessary adjustment,,) In addition, the rise
of international banking has also been
instrumental in financing the tremendous
growth in world trade and output in the last
From the viewpoint of an individual nation,
are the benefits of international financial
integration worth the costs?The question is
as irrelevant to a nation as it is to a region
within a national economy, for financial
integration, international or inter-regional,
cannot be reversed without wreaking havoc
on the economy. The world tried it in the
early 1930s and suffered from a severe
world recession that was in part attributable
to international financial disintegration. The
only relevant question is, therefore, how to
manage a partially integrated world financial system to maximize the benefits and
minimize the risks.
Hang-Sheng Cheng
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BANKINGDATA-TWELFTHFEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
SelectedAssetsandliabilities
Large Commercial Banks
Loans (gross, adjusted) and investments*
loans (gross,adjusted)- total#
Commercialand industrial
Realestate
Loansto individuals
Securities loans
U.s. Treasury securities*
Other securities*
Demanddeposits- total#
Demanddeposits- adjusted
Savingsdeposits- totalt
Timedeposits- total#
IndiViduals,part.& corp.
(Large negotiable CD's)
Weekly Averages
of Daily Figures
Member Bank Reserve Position
ExcessReserves(+ )/Deflciency (-)
Borrowings
•
Net free reserves(+ )/Net borrowed( -)
Amount
Outstanding
11/30/83
163,462
143,476
43,981
57,511
25,250
2,723
7,678
12,306
44,023
29,532
66,122
70,175
64,478
17,372
Change
Change from
year ago
Dollar
Percent
from
11/23/83
350
500
393
11
154
- 107
22
- 127
-
1,443
474
369
33,326
2,472
1,232
91
- 115
- 117
- 112
- 27,441
- 23,203
- 16,876
Weekended
Weekended
11/30/83
11/23/83
92
17
75
763
1,330
1,553
257
1,610
378
876
0.5
0.9
- 3.4
0.4
6.8
16.1
12.9
- 10.5
1.1
1.3
101.6
- 28.1
- 26.5
- 49.3
Comparable
period
38
139
5
43
33
96
* Excludes trading account securities.
# Includes items not shown separately.
t Includes Money Market Deposit Accounts,
accounts, and N OW accounts.
Editorial comments may beaddressedto the editor (Gregory Tong)or to the author .... Freecopies of
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Information Section, Federal ReserveBank of San Francisco, P.O. Box 7702, SanFrancisco 94120.
Phone(415) 974-2246.
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