In the decade since the financial crisis began in August 2007, the contours of global finance have shifted dramatically. The total value of cross-border capital flows has shrunk by 65% over the last ten years, a decline that reflects, in particular, the sharp reduction in international banking activities.
The question for us is what figures like these can tell us about the health of global finance today. Are they evidence that “financial globalization” – the international movement of capital – has lurched into reverse? And if it has, would that be such a bad thing?
The current retrenchment reflects greater risk aversion and awareness since the bubble began to burst in late 2007. But, according to new research from the McKinsey Global Institute, what is emerging is a more resilient version of global financial integration.
Before the crisis, cross-border banking surged as many of the world’s largest banks expanded internationally, lending more to one another and investing in other foreign assets. After the creation of the euro, for example, eurozone banks expanded significantly. Foreign claims held by eurozone banks (and their subsidiaries) soared from $6.6 trillion in 2000 to $23.4 trillion in 2007. Most important, a majority of that growth was within the eurozone itself, where an integrated European banking market was emerging, leading some to believe that a common currency and shared rules meant country risk had almost disappeared.
What is clear today is that many institutions were simply engaging in herd mentality, rather than executing prudent business strategies. Then, stung by the financial meltdown in the United States, and subsequently by the eurozone’s own crisis, the major global banks reduced their foreign presence, selling off some businesses, exiting others, and allowing maturing loans to expire. Since 2007, global banks have sold at least $2 trillion of assets.
Swiss, British, and American banks have all been part of the retreat, but eurozone banks are at its epicenter. Since the crisis began, eurozone banks have reduced foreign claims by $7.3 trillion, or 45%. Nearly half of that is a shrinking portfolio among eurozone borrowers, particularly banks. The perception that lending within the currency area was quasi-domestic has fallen apart.
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As the financial crisis evolved, private-sector involvement – through “haircuts” and “bailing in” – became a threatening option. From a risk perspective, domestic markets – where banks had the advantage of scale and market knowledge – became comparatively more attractive. In Germany, for example, the ratio of foreign to total assets at the three largest banks flipped, from 65% in 2007 to 33% in 2016. This was not simply a matter of shrinking the overall balance sheet; domestic assets grew by 70% during the same period.
What has emerged in the eurozone and beyond is a potentially more stable financial system, at least where banking is concerned. Banks have been required to rebuild their capital, and new rules on liquidity have reduced leverage and vulnerability. Stress testing and resolution preparedness – the sector’s so-called living wills – have created significant disincentives to complexity. All of this has made foreign operations less attractive as well.
A more diverse mix of cross-border capital flows also indicates greater stability. While total annual flows of cross-border lending have fallen by two thirds, foreign direct investment has held up better. FDI is by far the most stable type of capital flow, reflecting long-term strategic decisions by companies. Equity-related positions (FDI plus portfolio investments) now account for 69% of cross-border capital flows, up from 36% in 2007.
One final measure of stability is that global imbalances, including aggregate capital- and financial-account balances, are shrinking. In 2016, these imbalances had fallen to 1.7% of global GDP, from 2.5% in 2007. Moreover, the remaining deficits and surpluses are spread over a larger number of countries than before the crisis. In 2005, the US absorbed 67% of global net capital flows. By 2016, that share had fallen by half. China, meanwhile, accounted for 16% of the world’s net capital surplus in 2005; last year it was only 1%. And, with only a few exceptions, like Germany and the Netherlands, imbalances have also declined within the eurozone. Today, developing countries have become capital importers once more.
None of this should invite complacency. A more tightly woven global financial system inevitably comes with a higher risk of contagion. Excesses can always return; indeed, equity and real-estate markets in some advanced economies are rising to new highs, despite mediocre growth prospects. Volatility in gross capital flows also remains a concern. Since 2010, one third of developing countries and two thirds of advanced economies have faced large fluctuations in total capital inflows. Lending flows are particularly unstable; more than 60% of countries have experienced some degree of annual fluctuation, with the median shift equal to 7.7% of GDP for advanced economies, and 3% of GDP for developing countries.
Some observers argue that more should be done to contain risk in the system; to the extent that risk has simply shifted from banks to shadow banks, they may be right. But, overall, signs of greater resilience and increased stability are everywhere. Actions taken over the last ten years therefore imply less fragility when the next crisis hits, as it surely will.