Banking in Emerging Markets in the Aftermath of Global Financial Crisis - Literature review Example

Banking in Emerging markets in the aftermath of Global Financial Crisis Synopsis This paper discusses the performance of banks in in emerging market economies EMEs in the period after the Global financial Crisis (GFC) putting into consideration the factors that influenced their performance in reaction to the GFC. The paper examines the support banks in EMEs received from the central bank with respect to its role in managing the GFC.The performance of banks in the EMEs in comparison to that of the western economies throughout the periods during and after the Global Financial Crisis and the vulnerability of banks in the EMEs is presented. The paper proceeds with an insight into the manner in which economies in emerging countries were affected to and how they managed the effects of the GFC as well as the risks there in. Introduction The global financial crisis of 2007 - 2011 took a toll on advanced economies as well as emerging economies of the world. Whereas a bank’s failure may be attributed to factors ranging from meagre management, poor credit policy, insufficient credit scrutiny, errors in documentation, fake practices, biased and social pressure on the part of the bank’s operation, the global financial crisis made banks vulnerable to numerous financial risks. Key among these risks include; liquidity risk, operation risk, market risk and credit risk, all of which may result in grave consequences that are financial in nature placing the economy in vulnerability to crisis(Khan et al 2012). The global financial crisis has had far reaching implications for the emerging economies of the world, in the financial sector banks’ trading activities were affected at varied degrees with respect to bilateral borrowing between such economies. This essay refers to developed countries as those in the G7 and includes countries such as Japan, USA, France, Germany, Italy, and Canada while the emerging economies are the E7 that include China, India, Brazil, Russia, Indonesia, Mexico and Turkey. For purposes of this essay focus is directed to the financial dealings of theE7 countries with respect to the GFC shedding light into the financial implications that the GFC has had on emerging market economies. It also presents challenges and opportunities alike brought about by the GFC. The subsequent parts of the paper is organized as follows, the structure of banks is discussed with respect to their formation and ownership, an understanding into the role that each type plays in the economy is outlined especially the role of the central bank in relation to management of financial risks, followed by the main body of the text which explains the banking sector in emerging economies (E7) after the GFC and the final part gives summary remarks of issues discussed. Structure of Banks Banks are structured or formed on the basis of ownership and are broadly categorized as private, public or foreign banks. Commercial banks form a majority of private banks whereas a bank that lends to its subscribers abroad in different financial currencies is termed as a foreign bank. Mian (2003) categorises banks into foreign, private domestic and government banks. Government owned banks fall under the category of public banks. Government ownership of banks is widely seen to serve political interests rather than the limited legislator role they are supposed to play (Dinc 2005). Protagonist of government owned banks argue that funds that private commercial banks make are often available to finance individual rather than communal projects. On the other hand, antagonists argue that economies with government owned banks are prone to lower subsequent economic growth and are prone to abuse by politicians in attempts to further their political goals. Moreover, they argue that government owned banks are at a higher risks of financial crisis since politicians have the power to maintain or increase the control of financial resources more readily pausing unfair competition for non-government owned financial banks(Dinc 2005).Dinc (2005) acknowledges that government owned banks are uncommon in the USA but very common in the developing world especially in third world countries, a characteristic that has derailed the economic development of the third world over the last century. The central bank does not fall in either category mentioned above as its functions are distinct from the functions of these banks. Private Banks are local/domestic banks that are commonly termed as commercial banks. Their structure differs marginally from that of public banks since their management is structured such that there is a great distance between the regulator and ownership contrary to government banks where the owner and regulator are the same. The effect of this structure has been that private banks have higher cash-flow incentives compared to their government-owned counterparts (Milan 2003). Foreign banks are similar in management structure to private banks in terms of regulation and incentives with the only difference being that the board of directors of foreign banks sits in the bank’s home country and for this reason foreign banks assume a highly hierarchical organizational structure (Mian 2003). The central bank plays a major role in keeping inflation in check, in its capacity it carries out price controls depending on the prevailing market conditions to cushion the economy from instances of inflation. In responding to indeterminacy and or determinacy of prices the central bank has the sole mandate of ensuring stability by fixing the price or inflation level in the economy. Therefore the central bank’s response to inflation or its targeting of nominal money stock provides such an anchor, but many other rigidities and lags may serve to anchor inflation. The central bank also plays a major role in controlling activities of unscrupulous business people who may take advantage of anticipated increase in demand to hoard in anticipation of selling at exaggerated prices (Goyal&Tripathi 2012). The central bank therefore plays an important role to cushion the economy from both internal and external financial risk effects paused by crises such as the Global Financial Crisis. Banks and the GFC Hawks worth (2006) stipulate that lending patterns of banks in western countries to those in the EME countries in the period during and immediately after the GFC of banks depended on the distance between the lender and the borrower countries and the largeness of their home markets. Whereas these factors greatly reduced the cross-border loans to emerging market economies on the other part large markets in borrowing economies increased the amount of cross boarder bank flows. This saw more movement of trade from the emerging economies to the advanced economies. Banks in the EMEs therefore received more foreign injection from the banks in the west. This therefore suggests that the GFC brought advantages and disadvantages. On one hand, it encouraged flow of foreign currency to the emerging economies; on the other hand in the developed economies little flow of the foreign currency due to exports was experienced (Hawks worth 2006 ; Bender, Neilsen & Subramanian 2012). Although there is no accurately known method of measuring the economic size and performance of emerging economies such as china and India, the use of variables of GDP can be employed to paint a picture of the economic strength of an emerging economy as well as those of the developed world. In this approach two variables of GDP are measured, the GDP at either Market Exchange Rates (MER) and GDP at Purchasing Power Parity (PPP)may serve as estimates of the size of the economy of a developing country and those with developed economies. This can thus indicate the performance of the banking sector in terms of the amount of funds in banks available or in circulation and ultimately for investment, credit, and insurance etc. Generally GDP at MER is a better indicator of the size of the market for advanced economies operating in dollars, yen or pounds similarly; PPP measure of GDP is a more accurate indicator of the average living standards or volumes of outputs or inputs in emerging markets (Hawksworth 2006). PPP therefore can as well indicate the amount of money in banks in the economy. Figure: Relative size of E7 and G7 economies Source: Price Waterhouse Coopers 2006. Emerging Market Economies (EMEs) provide an inflow of cheap imports to advanced economies resulting in a flow of income into their banking industry furthering economic growth by earning foreign exchange from banks in the developed nations. Whereas goods for export may boost emerging economies, the same countries may as well produce goods and services that are non-exportable and that may not attract economic growth. For example a haircut that costs about 80 dollars in the USA may cost less than a dollar in China, this is cheap however a non-exportable good and therefore incapable of earning the country any foreign exchange as it would be imprudent to travel all the way to China from the USA just to get a cheap haircut (Hawksworth 2006). The correlation of these factors to the flow of capital between the banks in theEMEs and the advanced economies is such that more capital flow is from the banks in the developed world to the EME banks, nonetheless not all products produced by these emerging economies are exported and thus they may not earn them foreign exchange or contribute to the inflow of money from the developed world. The GFC brought to the fore anarray of factors that threaten the status quo and calls for drastic measures to be taken to counter the effects of the GFC. Willem-te-Velde (2008) argues that the greater brunt of the crisis would be felt by the banks in the EMEs due to several factors. Foremost, a contagion of the financial crisis would be transmitted from the developed nations to their partners in trade in the developing world therefore a drop in the trading markets’ returns. For instance a country such as Germany undergoes a drop in stock markets by say a small percentage, in the long run this translates to a major drop in stock market trading of an emerging countries economy such as South Africa and Brazil which may be partners in trade with Germany. The implication is that financial risks are transmitted and the banks in the EMEs can no longer afford to transact business as usual (Willem-te-Velde 2008). Secondly Willem-te -Velde (2008) continues to point out a list of the impacts that would be borne by emerging economies in the event of the GFC. They include Trade and Trade Prices that would negatively influence trade in emerging markets. This is because, when banks in EMEs grapple with their dented economies they would cut costs on imports of raw materials such as oil and copper from the developing world. Thus reducing demand and market for products from these countries thus impoverishing them. Similarly Remittances to emerging economies would decline as no investors would want to risk investing capital in a dilapidating economy, subsequently foreign direct investments and equity investments would as well stand to reduce inflow of capital from the developed world economies to the banks in EMEs (Willem-te -Velde 2008; Keneourgios & Padhi 2012). The situation is similar when it comes to commercial lending as banks in the developed world in fear of defaulting on the part of borrowers from emerging markets opted to minimise or withdraw their lending due to the effects of the financial crisis. It is not any different when the question of financial Aid flow from the developed world to emerging economies arises as the developed nations are at pains to salvage what’s left in their own economies after the GFC to even think of giving aid to the developing world (Willem-te-Velde 2008). The result is such that less of inflow of finances trickles into banks in the EMEs and therefore banks in the EMEs experience less deposits from external sources after the GFC. Risks that accompanied the global financial crisis range from market risks, credit risks, investment risks, debt risks amongst other financial related risks. Assessment of these and many other risks in reaction to the GFC saw governments take decisive steps in developing strategies to counter the effects of economic meltdown brought about by the GFC. Coulibaly (2012) acknowledges that history can attest to the fact that in the period before the GFC and during previous financial melt downs banks in EMEs have tightened monetary policies to defend their currency values, to contain capital flight and bolster policy credibility.However, during the periods that followed the GFC the same banks in the EMEs took a turn from this trend and instead loosened their monetary policy considerably to cushion their economies from the shock brought about by the GFC (Coulibaly 2012). This move by banks in the EMEs is seen to follow the actions of banks in countries with advanced economies as they are seen to take countercyclical policy when it comes to financial crises. Though risky, the countercyclical policy measures have enabled banks in the EMEs cushion effects of the global financial turmoil.At the centre of the strategy the banks in EMEs carried out financial reforms and also adopted inflation targeting changes commensurate with countercyclical policy measures to cushion against the GFC (Coulibaly 2012). Among adoption of inflation targeting and financial reforms other factors that EMEs adopted to achieve the cushioning effect from the global recession as pointed out by Coulibaly (2012) include; stronger macroeconomic fundamentals and reduced vulnerabilities as well as greater openness to trade and financial flows. All these factors were incorporated to formulate the countercyclical action by banks in the EMEs to take control of the economic financial huddles contrary to common practice. Coulibaly (2012) adds that of all these moves taken by EME banks to cushion against the GFC,inflation targeting and financial reforms stand out in that they result in these banks achieving greater policy credibility, in this right the banks were capable of dispel fears by investors who would otherwise opt to invest elsewhere. Coulibaly (2012) explains that when the central bank loosens monetary policy in a situation of doubtful credibility, the move is perceived as one that would result in loss of money on the part of investors. This then would mean that the confidence of lenders to banks in the EMEs is fragile and thus attracts higher premiums due to risks involved as demanded by the foreign investors. Therefore building trust and confidence in the monetary system by the EMEs banks is a move that would not only cushion the banks from the adverse effects paused by the GFC but as well create an investor friendly environment for foreigners to boost and stabilize the banking sector in EMEs (Eichengreen 2010; Coulibaly 2012). Conclusion The global financial crisis in its aftermath left an array of effects that emerging market economies struggled to counter in attempts to strategize on the best move to take so as to gain financial advantage over the crisis.Banks in the EMEs stand to attain considerable financial growth in the years following the GFC as banks in the advanced economies change strategy to recover from the crisis with a centred focus on clearing outstanding debts brought about by the GFC. Notwithstanding, banks in the EMEs must rise to the occasion and restructure their monetary policy to be countercyclical in nature and concentrate in developing solutions that would steer them to recovery from the GFC. Banks in EMEs must as well ensure that strategies employed are commensurate with economic growth and stability of their economies when faced with financial crises such as the GFC in the future (Coulibaly 2012; Eichengreen 2010). References Bender, J., Neilsen, F. & Subramanian, M., 2012, ‘Emerging markets during the crisis’, Journal of Alternative Investments, vol 13, issue 2, pp. 104-126. Coulibaly, B., 2012, Monetary Policy in Emerging Market Economies: What Lessons from the Global Financial Crisis? [Online] Accessed on 6th September 2012. Dinc, I.S, 2005, ‘Politicians and banks: Political influence in government owned banks in emerging markets’, Journal of Financial Economics ,vol 77, pp.453-479. 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