The Global Capital Market Hill, Chapter 11

Review: Basic Economics Economists teach that the most efficient use of resources can be achieved by free competition “ Every individual seeks the most advantageous employment for his capital …. “ Study of his own advantage necessarily leads him to prefer that employment most advantageous to society ” - Adam Smith, 1776

Banks Commercial banks – take deposits from savers, pay interest, and lend money to borrowers at slightly higher interest Can grow very large Most employees make <$150,000/year Investment banks – create securities (stocks, bonds, derivatives) for companies and sell them Also arrange mergers Many employees make $1 million or more a year

How do you know when you’ve made money… at a commercial bank? There are many businesses where it takes a long time to know if you’ve made money Real estate Cattle breeding But banking is probably the biggest and most important

Does this create any dangers?

What to do about the dangers of banking? For centuries there has been disagreement Free enterprise banking – let people create and run banks freely Advocates believe most problems of banking are caused by government mistakes They fear regulation will reduce efficiency Government-regulated banking – government sets rules about who can start a bank and how they can run it Advocates believe government can reduce the dangers without greatly reducing efficiency

A brief history of banking Traditionally, governments regulated banking tightly In 19 th century in US and UK, much freedom of banking was introduced Helped cause rapid economic growth Also contributed to many ‘panics’ Banking scandals were believed to have contributed to Great Depression of 1930s When free trade was promoted in 1940s, 50s, banking was tightly regulated

In 1970s, tight regulations in many industries (banking, trucking, airlines) were believed to be preventing economic innovation and growth Much deregulation in late 70s, 80s, 90s, 2000s

Functions Of A Generic Capital Market Figure 11.1: The Main Players in a Generic Capital Market

Attractions Of The Global Capital Market Borrowers benefit from: the additional supply of funds global capital markets provide the associated lower cost of capital (the price of borrowing money or the rate of return that borrowers pay investors) The cost of capital is lower in international markets because the pool of investors is much larger than in the domestic capital market

Attractions Of The Global Capital Market Figure 11.3: Risk Reduction through Portfolio Diversification

Growth Of The Global Capital Market Global capital markets have been growing at a rapid pace In 1990, the stock of cross-border bank loans was just $3,600 billion By 2006, the stock of cross border bank loans was $17,875 billion The international bond market shows a similar pattern with $3,515 billion in outstanding international bonds in 1997, and $17, 561 billion in 2006 International equity offerings were $18 billion in 1997 and $377 billion in 2006

Manias and Crashes Unfortunately, the world economy since the time of the Holy Roman Empire (800 years ago!!!) has been plagued by Manias – periods when everyone believes they can make money doing something that turns out not to be so great after all Example – the dotcom boom of the early 2000s. Crashes – periods when the economy has huge problems as the problems of the mania period unravel Kindelberger, Manias, Panics, and Crashes, 1998

Mid 2000s: The world had a lending & investing mania Deregulation Excess savings in developing countries (China, Taiwan) and Japan It’s hard to spend money in a fast-growing economy “Easy money” in the developed countries U.S. government allowed money supply to grow

Banks, most of all in U.S., issued ‘sub-prime’ mortgages Banks did not want to own them, but packaged pieces of many mortgages into bonds Banks said the mortgages underlying the bonds wouldn’t all default at once Rating agencies (firms resembling Consumer Reports) agreed Developing country & Japan investors bought Eventually the pile got so bad people saw the problems

The Crash of 2008 Many banks have so many hard-to-evaluate investments that no one knows if their assets are worth more than their liabilities Would you invest in your bank if your deposits weren’t government guaranteed?

Governments… Lent huge amounts of money to banks Took over dying banks Launched huge stimulus packages (deficit spending)

So what do we do? Do we increase regulation? If so, how? What do we do about dying banks?