A published report by the Hong Kong Monetary Authority titled "Analyzing Interconnectivity Among Economies" found that the trend of financial globalization has weakened the world economy by making it vulnerable to systemic collapse resulting from external shocks. The report goes on to state that individual countries have lost control over their own economic security as a result of this financial interconnectivity, creating policy problems for government leaders and central bankers. One of the major findings of the report was that "economies register a significantly higher sovereign risk once the condition that another economy is in distress is imposed." The problem is that traditional CDS pricing does not correctly price this risk, leaving market participants exposed to billions in potential losses. The threat becomes more severe if systemically important institutions like money center banks are affected by this mispricing of risk because of the domino effect during financial crises.
While the idea of systemic collapse brought about by financial globalization should not be new to anyone, the report does bring up an important point that CDS pricing often fails to account for this variable. One problem I have with the study is that it concludes that policy makers can guard against systemic collapse by monitoring structurally important countries and trying to get ahead of the problem. This is nonsense. If all it takes is a small shock somewhere in the world to endanger the entire worldwide economic system, there is very little policy makers or central bankers can do to prevent it. Are they simply supposed to bail out every trouble maker in the world to guarantee against systemic shocks? The only solution is to reverse the trend of financial globalization to protect it from external shocks. This could be easily done by preventing financial institutions from having operations in more than one economic region (e.g. North America, Latin America, etc). For example, I would ban entities like Citigroup, JP Morgan, etc from having operations in 150+ countries. It would also be necessary to prevent financial entities from becoming to big to fail (according to the Fed's litmus test is about 100 billion in assets). I would take it a step further and say that no bank or financial institution should be allowed to have more than $50 billion in assets. The reason is pretty straightforward--if you are too big to fail, then you are to big to exist. Global financial institutions lost their right to do whatever they wanted when they almost collapsed the worldwide economy in 2008. Unfortunately, this measure would require global cooperation among countries, so this could be a hard sell to economies dependent on large banking institutions.
Another measure would be to ban hedge funds from investing in multiple countries. They could still have individual investment funds that target certain countries or regions, but there could be no one global macro fund which is exposed to numerous economic regions. The reason this is important is because hedge funds and financial institutions are the catalysts that create global contagion risk. If you are a leveraged hedge fund or banking institution and you experience larges losses as a result of an economic shock in say Asia currencies, you are forced to start selling some of your equity and bond positions in Latin America and Europe. This process leads to the economically damaging domino effect as margin selling in one area of the world turns into a global margin call as investors dump assets everywhere. If you place these safeguards you could isolate crises and prevent worldwide economic problems.
The final thing I would do is reduced leverage in the global financial system. The current Basel III rules allow banks to maintain a leverage ratio of 33:1, indicating that the world's leaders have learned nothing from the 2008 financial crisis. If you really wanted to protect the world economic system, capital requirements would be increased dramatically and force banks to maintain a Tier 1 capital ratio of 25%. Along with reducing leverage, financial institutions should be required to seek long term funding to finance their operations. Institutions would no longer be able to rely heavily on wholesale funding; instead they would have to go back to old fashioned deposits which are more stable and secure. Wholesale funding (e.g. repos) is terribly precarious during market dislocations and increases the risk of major banks failing because it was unable to rollover its short term debts. These measures would bring a new level of confidence to the markets because financial institutions would have sufficient capital to guard against losses and less reliant on short term financing. No one would have to constantly worry about liquidity problems or whether institutions would have to raise more capital. But don't expect this to ever be implemented because it would reduce bank profitability and turn banks into boring utility like companies. The banking oligarchs who control politicians will never allow this to occur, and why not, considering that the taxpayers will always be there to bail them out in the end. After all who needs proper risk management when you have an explicit guarantee from government?
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