The current credit crunch has added new urgency to discussions about redesigning the rules of the game for global capital markets. Clearly, risk management has lagged behind innovation in the financial system, and existing regulatory frameworks and institutions need to be updated to keep pace. National governments are clearly still important to the world financial system, but their ability to unilaterally manage and regulate financial activity is diminishing. Instead, as global capital markets grow, they are dispersing financial power. The United States remains the world’s biggest economy and home to the largest financial markets, but the influence of Europe, China, and the Middle East (among others) now extends globally. Investment of trade surpluses by Asian countries and of petrodollars by oil exporters has pumped liquidity into global capital markets, lowered interest rates in developed countries, fueled a new wave of leveraged financial activity, and propped up struggling Wall Street investment banks.
All this has happened as the world’s capital markets have undergone an extraordinary transformation. The value of the world’s financial assets—including equities, private and public debt, and bank deposits—has soared from $12 trillion in 1980 to $195 trillion in 2007. In fact, those assets have grown faster than the world economy. This phenomenon is called as Financial Deepening. In 1980, the total value of global financial assets was roughly equal to world GDP; by the end of 2007, world financial depth, or the ratio of assets to GDP, was 356%. Today, one-third of owners of government bonds, one-fourth of equities owners, and one-fifth of people who own private debt securities are not from the country where the assets were issued. Even the individual investor who buys only U.S. stocks on U.S. exchanges is paying prices determined in global markets.
Pension and insurance funds continue to be the major private investors, but other private and public players are increasing in importance. Hedge funds, private equity funds, central banks, sovereign wealth funds, government investment corporations, and government controlled companies all with different investment goals and strategies are now prominent on the global landscape. The recent crisis has highlighted the weaknesses of systems that regulate some actors but not others and that have no international reach. At a minimum, this patchwork approach encourages investors to operate in the realms with the fewest restrictions a race to the regulatory bottom.
Policy makers need to grasp how much financial activity is taking place outside traditional publicly traded and regulated markets and to ensure adequate oversight. Several Western banks and other companies have recapitalized in 2008 not by selling shares or debt on public exchanges but by seeking large cash infusions from private investors. As debt markets froze up, banks unloaded lots of loans by selling them to private equity firms. And while the credit crisis cooled the leveraged buyout boom of early 2007, many private equity firms have adapted in 2008 by acquiring stakes in public companies.
Deeper financial markets, though unruly and unpredictable, have many benefits. They can provide broader access to capital for borrowers, increase opportunities for sharing risk, and spur economic growth. Of course, market turmoil can also cause great disruptions, such as the currency crises that led to devastating recessions in Asia during the late 1990s and shortly thereafter in Argentina not to mention the U.S. subprime mortgage debacle, which continues to unfold. As policy makers look ahead, their goal should be to enable the world to enjoy the benefits of evolving global capital markets while managing the risks more effectively. But success depends on updating our thinking, not just our rules.
Source: McKinsey & Company and HBR.