The Global Capital Market

Hill, Chapter 11

Review: Basic EconomicsEconomists 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

BanksCommercial banks – take deposits from

savers, pay interest, and lend money to borrowersat slightly higher interest Can grow very largeMost employees make <$150,000/year

Investment banks – create securities (stocks, bonds, derivatives) for companies and sell themAlso arrange mergersMany 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 moneyReal 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 disagreementFree enterprise banking – let people create and

run banks freelyAdvocates believe most problems of banking are

caused by government mistakesThey 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 bankingTraditionally, governments regulated banking

tightly

In 19th century in US and UK, much freedom of banking was introducedHelped cause rapid economic growthAlso 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 growthMuch 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 CrashesUnfortunately, 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

maniaDeregulation

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 countriesU.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 bondsBanks said the mortgages underlying the bonds

wouldn’t all default at onceRating agencies (firms resembling Consumer Reports) agreed

Developing country & Japan investors bought

Eventually the pile got so bad people saw the problems

The Crash of 2008Many banks have so many hard-to-evaluate

investments that no one knows if their assets are worth more than their liabilitiesWould 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?