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Cross-Border Capital Flows And The Risks of Financial Crises

Financial Crisis Risks from Globalization

Globalization cannot be progressing without cross-border capital flows. These capital flows can exist in the form of foreign direct investment, stock and bond purchases, and lending. Although there are many benefits that cross-border capital flows bring to globalization, there are still disadvantages. One of the most outstanding disadvantages is that during the time of a global financial crisis, capital flows can spread the crisis from one country to another. This post aims at clarifying the risks of the occurrence of global financial crises as well as how multinational corporations can limit those risks when raising funds to meet their short-term financial obligations and long-term investment needs.

Reasons for 2007-2008 Financial Crisis to Occur Again

There are three main reasons why the 2007-2008 crisis can occur again. First, big banks are getting even bigger nowadays. Ten biggest banks in the U.S. possess more than half of the assets of the top one hundred banks. Among the ten biggest banks, JPMorgan Chase has increased its total asset more than 100 percent over the past decade. The problem with giant banks is that if they failed, the whole financial system would collapse. In 2008, the growth of a variety of financial instruments, such as credit default swaps, removed the blockade between investment and commercial banks. This removal gave banks an incentive to take excessive risks when lending money. Those extreme risk-takers ultimately caused a global financial crisis. If the biggest banks were to retake unreasonable risks in the future, the chances that they would fail and drag the whole economy with them were notable.

The second reason that may cause financial crises to happen again is the devaluation of the dollar (and other stable currencies). The U.S. economy was in recession at the beginning of 2001. To combat the recession, the Federal Reserve started to devaluate the dollar to help exports and stimulate the economy. However, by weakening the dollar, the Federal Reserve accidentally discouraged people from keeping money. Instead, they turned to hard assets, such as the housing market, as a safer channel. Besides, a weaker dollar made everything more expensive and higher inflation. Combining these two factors, devaluating the dollar led to the housing market bubble, which then caused a financial crisis. If the U.S. government decides to devalue the dollar again to fight against recession in the future, the chance that it may cause another crisis is highly possible.

The third possible cause of the next financial crisis is the U.S. budget deficit and national debt. The budget deficit is projected to reach approximately 900 billion dollars at the end of 2019 and more than 1 trillion dollars in 2021. The national debt has reached around 80% of GDP in 2018 and will be increasing to 100 percent in 2017. When American and foreign creditors are aware of the government debt and deficit situations in the U.S., they are more likely to increase their interest rates on U.S. debt. Every time the creditors increase the interest rate by 1 percent, the U.S. deficit will increase by more than 1 percent. It can lead to a slower economic growth rate and eventually create a recession and financial crisis.

Minimizing the Risks of Occurrence of Global Financial Crises

With the reasons mentioned above, there are several ways to mitigate the risks of a global financial crisis happening again at some points in the future. The first way to reduce such risks is to tighten the regulations on mortgage brokers who made terrible loans without worrying about the creditworthiness of borrowers. In the 2007-2008 global financial crisis, banks did not care about the credits of the borrowers. They simply resold those loans on the secondary mortgage market. In addition, a large number of homeowners took out loans with high-interest rates. When the housing market burst and the housing prices fell sharply, homeowners could not sell their houses for a profit to repay their debt. Consequently, they defaulted. The government had only one choice to buy bad loans to rescue the market. Therefore, to reduce the risks of a future financial crisis, regulations should be tightened to force commercial banks to focus on borrowers’ creditworthiness and only lend money to those with strong credit scores. These strict regulations can help reduce bad loans and, thus, mitigate the risk of a crisis.

The second way to reduce the risks of another financial crisis is to require banks to increase their equity capital. At the time of the 2008 crisis, banks relied heavily on debt to finance their operations. At the moment, when the economy is relatively stable, banks should be required to raise their equity so that when the economy is in recession, the risk of a financial crisis is mitigated. The third way to reduce the risks is to ensure that financial institutions are not too big. If one troubled bank is too big and deeply interconnected with other banks, when that bank fails, it will drag the whole financial system down with it. This risk would be significantly reduced if the troubled bank is not so influential on the entire system.

Ways That Multinational Firms Can Limit the Impact of Future Global Financial Crises

One of the popular ways that multinational companies to meet their short-term debts is issuing commercial papers. International firms always look for buyers who want to buy mortgages. Those buyers do not wish to purchase obligations from banks or the government because of low-interest rates. Instead, they are willing to buy debts from big multinational companies due to higher rates of return. Typically, commercial papers are considered a safe investment channel for investors because they have short maturities, and companies who issue the papers have good credit ratings. Multinational companies mainly issue commercial papers to meet their short-term debts, such as payroll obligations or paying vendors. During the 2008 crisis, the commercial paper market nearly collapsed. As a result, Federal Reserve had to intervene by directly buying as many commercial papers as it could support both investors and the corporations that issued the papers.

As can be seen, investors are less willing to buy commercial papers in the course of a financial crisis because the risks are higher. To limit the impact of future global financial crises on their ability to raise capital to meet short-term obligations, multinational firms can issue asset-backed commercial papers instead of regular commercial papers. Asset-backed commercial papers are safer because those papers are backed by real assets in case firms fail to pay. Because demand for commercial papers decreases during financial crises, it is harder for multinational firms to raise capital. By issuing asset-backed commercial papers, firms can guarantee investors of their ability to pay back their debt and, hence, can raise money more efficiently.

To fund their long-term investments, multinational corporations can issue either stocks or bonds. During economic booming, when investor’s confidence is high, it is easy for big corporations to raise funds through stocks. They can sell their shares at a high price. However, trading stocks is not a good option. During the 2007-2008 global financial crisis, the cross-border stock market crashed due to the panic of the investors. They aggressively sold their stocks, resulting in dramatic price drops. Therefore, companies could not rely on selling shares to raise capital funds throughout a financial crisis. When stock market crashes, issuing bonds is a better option for multinational firms. Generally, bonds are a safer investing channel than stocks, especially in the time of economic crises and downturns. Compared to stocks, bonds have a fixed interest rate. Investors know the interest rates before they invest. Through financial crises, while the rate of return from stocks significantly decreased, the profit from bonds stayed the same (if investors bought the bonds before the crisis).

Moreover, bondholders are promised to be paid back while stockholders may get nothing in return. Because businesses did not do well in financial crises, they paid fewer dividends if at all to stockholders. Bondholders, on the other hand, were still got paid regardless of the business situations. For these reasons, multinational firms should raise their long-term capital funds through bonds to limit the impact of a future financial crisis.

Summary and Conclusions

To mitigate the risks of occurrence of a future global financial crisis, governments should pass more laws and regulations to put mortgage brokers under control. Mortgage brokers should concentrate more on the creditworthiness of borrowers. Furthermore, banks should be required to hold more equity instead of debts. A low debt-equity ratio will make banks and other financial institutions more stable throughout the time of an economic crisis. With respect to international firms, to limit the impact of financial crises on the ability to raise capital, they should utilize asset-backed commercial papers to meet their short-term obligations and issue bonds to meet their long-term investment needs.

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