Financial liberalization helps improve domestic prudential supervision because local supervisors learn new risk management practices (Mishkin 2003). Financial globalization increases liquidity and lowers the cost of capital, which stimulates investment and economic growth.
Financial liberalization consists of two components. The first component is the internal financial liberalization which results in the lifting of regulations that restrict domestic financial institutions from lending their funds at market rates. The second component is the external financial liberalization which occurs when domestic financial markets are opened to flows of foreign capital and foreign financial institutions.
After a period of financial liberalization, the central bank supervisors already lack the technical expertise to monitor the banks' new lending programs. Without this capacity for prudential monitoring, the local bank regulators cannot stop the banks from doing excessive risk-taking activities. Banks expand their lending activities and go on a lending mood. In countries with well-developed banking sectors, financial liberalization has resulted in lending booms and banking crises in the 1980s in Japan and in 1990s in the United States.
The financial globalization process allows domestic banks to borrow abroad. ...