Global Trends by Martin Khor

Monday 24 September 2007

Dangers of opening the financial sector     

Last week, a run on a bank in Britain showed the spread and seriousness of the financial crisis, while a UN agency warned developing countries of the risks of opening up their financial sector to foreign firms


The pictures of long queues of people withdrawing their savings from a bank in Britain last week demonstrated, more than anything else, how far-reaching is the present financial crisis sparked off initially by the giving of loans to less than credit-worthy house-buyers in the United States.

The “banking panic” in Britain, curbed only after Ministers gave a government guarantee to Northern Rock bank’s savers that their money would be paid back, shows how fragile is the level of confidence that the investing or saving public may now have in some countries whose institutions are hit, directly or indirectly by the United States’ sub-prime crisis.

The problem is not so much the bad debts in the sub-prime home-mortgage sector, but that these debts had been sold and re-sold many times over from the lending banks to other financial institutions and to investors through a web of entanglement which up to now has not been sorted out.

The U.S. recently reduced interest rates b y 0.5 percentage points, which gave a fillip to stock markets.  But if more bad news emerges on losses by banks or hedge funds or about the real economy, the market slide may resume.

In the end, it is the public that pays the costs of bail-outs. In a column in Fortune magazine, Allan Sloan, points out that in a financial crisis, the small fry are hit with no one to rescue them, like the thousands who are losing their homes because they can’t service their mortgages, or mortgage companies who made the loans.

However, the giant firms in Wall Street are “too big to fail”, and so they are bailed out through the injection of billions of dollars into the financial markets.  Yet, says Sloan, it is these Wall Street giants that “enabled the mess in the first place by sucking hundreds of billions of dollars’ worth of suspect mortgages from marginal U.S. borrowers and begging mortgage makers to create more of them.

“The Street sliced and diced this financial toxic waste into a variety of esoteric securities, making a nice mark-up when it sold them and generating a continuous stream of profits when it made markets out of them.”

Wall Street – the biggest financial institutions – did not care about the real world as it was too busy making profits.  “But the world’s central bankers aren’t letting the big guys fail,” continues Sloan. 

“Think of it as the Escape of the Enablers…It’s the ‘too big to fail’ syndrome…The Fed’s job is to protect the financial system.  That’s why it’s trying to rescue the gigantic sub-prime enablers while letting borrowers and mortgage companies go under.”

For us in developing countries, surely a key lesson is to be very cautious about allowing our financial institutions and system to be so liberalized that de-regulated that they too are  caught up in the web of international investment and speculation. 

Speculation and risky investment are tempting as the players make easy profits in good times, but it can end in financial disaster not only for the institutions concerned but also the system, the public and the tax-payers.

Last week, the UN Conference on Trade and Development (UNCTAD) held an expert meeting on development implications of financial services.

An UNCTAD paper for the meeting warned developing countries of the dangers of financial sector reforms and liberalization, which it says can have good results only if supported by good policies and regulations which are difficult to achieve due to rapid changes in the financial system.

In theory, there are many arguments for liberalizing financial services, but there are real concerns about the relative virtues of openness and protection in finance. 

The paper lists the following concerns about financial liberalization:

-- The role which foreign financial institutions would play in the domestic economy. Because of the strategic function of the financial sector, countries should avoid that the domestic financial services system is dominated by foreign firms, which could lead to abuse of market dominance.

-- The adverse effects that foreign firms can have on national firms. Entry of foreign firms can lead to a decline in profits of local firms and the lower profit margins create pressure to reduce costs, potentially leading to financial distress among individual domestic firms.

-- Foreign firms can also bid lucrative corporate business away from domestic banks. Case studies showed that foreign entry significantly reduced the profitability of domestic banks.

-- Some governments wish to maintain a certain national presence in the domestic market or to provide temporary support to national suppliers. In certain segments, domestic firms simply cannot compete with foreign firms and need time to adjust to new and unequal competition.

-- Concerns over the public’s access of services. Foreign firms may operate only in very profitable market segments and not serve those in need, for example, retail banking in rural areas.  Also, greater competition and pressure to cut costs can cause local firms to close branches and reduce their services to the poor.

--  Fears that opening to foreign financial firms may lead to capital flows abroad and that liberalization of financial services trade worsens a country’s balance-of-payments position.

Foreign firms are more likely to invest domestic savings abroad rather than in the local economy. Regarding portfolio–equity flows, openness to foreign providers increases the probability of capital flight and volatility.

-- The difficulty of properly managing the liberalization process, lack of experience in regulating international financial services markets and transactions and in monitoring more complex financial institutions.

The above concerns have caused developing countries to pursue a policy of “selective openness” for financial services liberalization, concludes UNCTAD.

Though the paper does not spell out the meaning of “selective opening”, it is normally taken to mean that countries are cautious and open up only over a long period, in stages, and only in areas in which they are confident there will be no adverse effects, in line with their capacity to regulate and the capacity of local firms to face the competition..

This advice, and the listing of concerns above, are very timely in view of the current global financial crisis which has shown up the follies and dangers of deregulation and liberalization when carried out too far.