Themes > Features

04.02.2001

International Finance: Consolidation Increases Systemic Risk

During the 1990s, the three-decade long process of proliferation and rise to dominance of finance in the global economy reached a new phase. On the one hand, evidence was growing that the rise of finance, and the financial liberalization it encouraged and enforced, was resulting in financial instability of a kind that was undermining the real economic gains registered in different parts of the world since the Second World War. On the other hand, the international financial system was being transformed in directions that were substantially increasing systemic risk, and rendering the system more crisis-prone. Central to this transformation was a growing process of financial consolidation that is concentrating financial activity and financial decision making in a few economic organizations and integrating hitherto demarcated areas of financial activity that had been dissociated from each other to ensure transparency and discourage unsound financial practices.
 
Concerned with the consequences and implications of this process Finance ministers and Central Bank Governors of the Group of 10 commissioned a study of financial consolidation, the recently released results of which are quite revealing. The study covered besides the 11 G-10 countries (US, Canada, Japan, Belgium, France, Germany, Italy, Netherlands, Sweden, Switzerland and UK), Spain and Australia. It found, as expected, that there has been a high level of merger and acquisition (M&A) activity in the study countries during the 1990s, with an acceleration of such activity especially in the last three years of the decade.
 
As Chart 1 shows, The number of acquisitions by financial firms from these countries increased from around 337 in 1990 to over 900 by 1995, and has more or less remained between 900 and 1000 a year since then. What is more the size of each of these acquisitions has increased substantially since the mid-1990s. The total value of financial sector M&A initiated by firms in these countries, which stood at $39 billion in 1990 and $53 billion in 1994, rose three-fold to $154 billion in 1995 and $299 billion, $499 billion and $369 billion respectively in 1997, 1998 and 1999 respectively (Chart 2). This was because the average value of the M&A instances covered rose from just $224 million and $111 million in 1990 and 1994, to touch $504 million, $793 million and $649 million respectively during the last three years of the decade (Chart 3). As a result the annual value of M&A transactions, which stood at less than 0.5 per cent of the GDP of these nations in the early 1990s, had risen to as much as 2.3 per cent of their GDP in 1998. Clearly, M&A in the financial sector is creating large and complex financial organizations in the international financial system (Chart 4).

The banking sector tended to dominate the M&A process in the financial sector, accounting for as much as 58 per cent of the value of M&A during the 1990s as a whole, as compared with 27 per cent in the case of ‘securities and other’ firms and 15 per cent in the case of the insurance industry (Chart 6). However, a closer look at the evolution of M&A activity through the 1990s suggests that while the instances of M&A in the banking industry were rising rapidly during the first half of the 1990s, they have tended to stagnate, while instances of M&A among securities and insurance firms have been on the rise. As a result, by the end of the 1990s, the number of instances of M&A among non-banking financial firms was almost as large as those among banking firms. The process of concentration is clearly sweeping through the financial sector as a whole (Chart 5). However, given the large size of the banks as financial institutions, the banking industry dominates financial sector merger activity in value terms (Charts 7 and 8).
 

 

Over the 1990s as a whole the evidence seems to be that M&A activity was largely industry-specific, with banking firms tending to merge dominantly with other banks (Charts 13 and 14). However, matters seem to be changing here as well. While in 1994 there was one instance of cross-industry M&A for every five instances of intra-industry mergers, the ratio had come down to one in every three by 1999. The merger and acquisition drive within the financial sector is not merely creating large and excessively powerful organizations, but firms that straddle the financial sector. Exploiting the process of financial liberalization these firms were breaking down the Chinese Walls that had been built between different segments of the financial sector.
 

 

Needless to say, in terms of region North America, especially the US, which has become the apex of financial dominance, accounted for a overwhelming share of M&A activity in the study countries in terms of both numbers and value (Charts 9 and 10). Europe was a close second. And given the much larger and more dispersed financial sector in the US, as well the compulsions generated by monetary union in Europe, M&A activity in North America was dominated by intra-country, ‘within-border’ transactions, whereas cross-border M&A played a much more important role in Europe (Charts 11 and 12). But as the report notes, through strategic alliances the American financial industry has also spread its tentacles across the globe. In the net, the 1990s have seen an acceleration of the concentration of financial power and financial decision-making in fewer hands worldwide.
 

 

The significance of these developments for the observed financial instability and recurrence of financial crises during the years of globalisation should be obvious. The major historical landmarks in the rise to dominance of finance are worth recalling. Till the early 1970s the private international financial system played only a limited role in recycling financial surpluses to the developing countries. The period immediately after the first oil shock saw a dramatic change in this scenario. Since oil surpluses were held in the main as deposits with the international banking system controlled in the developed world, the private financial system there became the powerful agent for recycling surpluses. This power was indeed immense. Expenditure fuelled by credit in the developed and developing world generated surpluses with the oil producers, who then deposited these surpluses with the transnational banks, who, in turn, could offer further doses of credit. By 1981, OPEC countries are estimated to have accumulated surpluses to the tune of $475 billion, $400 billion of which was parked in the developed industrial nations. This power to the finance elbow was all the more significant because a slow down in productivity growth in metropolitan industry had already been bringing the post-War industrial boom to a close - a process that was hastened by the contractionary response to the oil shocks. As a proportion of world output, net international bank loans rose from 0.7 per cent in 1964 to 8.0 per cent in 1980 and 16.3 per cent in 1991. Relative to world trade, net international bank loans rose from 7.5 per cent in 1964 to 42.6 per cent in 1980 and 104.6 per cent in 1991.
 
Two other developments contributed to the increase in international liquidity during the 1980s. First, the United States had built up large international liabilities during the Bretton Woods years, when the confidence in the dollar stemming from the immediate post-War hegemony of the US made it as good as gold. Such international confidence in its currency allowed the US to ignore national budget constraints on its international spending and resulted in the emergence of strong banking and financial interests with an international agenda. The influence of these interests was reflected in policies that affected domestic manufacturing interests adversely, as suggested by the widening and persistent US trade deficit after the mid-1970s. Second, the loss of manufacturing competitiveness in the US meant that during different periods since the 1970s the dollar lost its position as the only acceptable reserve currency, fuelling speculative demand for other currencies on the part of those holding them. Such speculative demand, needless to say, is sensitive to both interest rate differentials and exchange rate variations, resulting in volatile flows of capital across currencies and borders. The results of these developments are obvious. The daily volume of foreign exchange transactions in international financial markets rose to $1.2 trillion per day by the mid-1990s, which was equal to the value of world trade in every quarter of a full year. In the early 1980s the volume of transactions of bonds and securities between domestic and foreign residents accounted for about 10 per cent of GDP in the US, Germany and Japan. By 1993 the figure had risen to 135 per cent for the US, 170 per cent for Germany and 80 per cent for Japan. Much of these transactions were of bonds of relatively short maturities.
 
There were also other real factors that created pressures for the expansion of finance. These included the changing demographic structure in most of the advanced countries, with baby boomers reaching the age when they would emphasise personal savings for retirement. This was accentuated by changes in the institutional structures relating to pensions, whereby in most industrial countries, public and private employers tended to fund less of the planned income after retirement, requiring more savings input from employees themselves. All this meant growing demands for more variety in savings instruments as well as higher returns, leading to the greater significance of pensions funds, mutual funds and the like.
 
Financial liberalisation in the developed countries, which was closely related to these developments, further increased funds available in the system. First, it increased the flexibility of banking and financial institutions when creating credit and making investments, as well as permitted the proliferation of institutions like the hedge funds that, unlike the banks, were not subject to regulation. It also provided the space for "financial innovation" or the creation of a range of new financial instruments or derivatives such as swaps, options and futures that were virtually autonomously created by the financial system. Finally, it increased competition and whetted the appetite of banks to earn higher returns, thus causing them to search out new recipients for loans in different economic regions.
 
The massive increase in international liquidity that followed found banks and non-bank financial institutions desperately searching for means to keep their capital moving. At first, there were booms in consumer credit and housing finance in the developed industrial nations. But when those opportunities petered out, a number of developing countries were discovered as the "emerging markets" of the global financial order. Capital in the form of debt and equity investments began to flow into these countries, especially those that were quick to liberalize rules relating to cross-border capital flows and regulations governing the conversion of domestic into foreign currency The result of these developments was that there was a host of new financial assets in the emerging markets, which were characterized by higher interest rates ostensibly because of the greater risks of investment in these areas. The greater ‘perceived risk’ associated with financial instruments originating in these countries, provided the basis for a whole range of new derivatives that bundled these risks and offered a hedge against risk in different individual markets, each of which promised high returns.
 
There are a number of features characteristic of the global financial system which evolved in this manner. Principal among these is the growing importance of unregulated financial agents, such as the so-called hedge funds, in the system. Many years back the Group of 30 had cautioned governments that these funds were a source of concern because they were prone to "undercapitalisation, faulty systems, inadequate supervision and human error". Though hedge funds first originated immediately after the second world war, they are estimated to manage close to $500 billion of investors' money. These investors include major international banks, which are themselves forced by rules and regulations to avoid risky transactions promising high returns, but use the hedge funds as a front to undertake such transactions. The operations of the now infamous Long Term Capital Management illustrate this. On an equity base of a little less than $5 billion, LTCM had borrowed enough to undertake investments valued at $200 billion or more. This was possible because there was nothing in the regulatory mechanism that limited the exposure of these institutions relative to their capital base. Yet when several of its own investments came unstuck in 1998 and LTCM therefore faced major repayment problems of its own, it had to be rescued by the US Federal Reserve, because the costs of its collapse were seen to be too major.
 
Such flows of credit to a few institutions are significant because in a world of globalized and liberalised finance, when countries are at different phases of the business cycle and characterised by differential interest rates, capital will tend to flow in the direction of higher returns in the short term. Nothing illustrates this better than the "yen-carry trades" of the period 1995 to 1997, which emerged from the wide interest differentials between the United States and Japan, in conjunction with the belief that the Bank of Japan did not want the yen to strengthen in 1996–97. These trades involved borrowing in yen, selling the yen for dollars, and investing the proceeds in relatively high-yielding US fixed-income securities. In hindsight, these trades turned out to be considerably more profitable than simply the interest differential, for the yen depreciated continuously over the two years from May 1995 through May 1997, which reduced the yen liability relative to the dollar investment that it financed. The implications of these and other flows to the US was that international liquidity "was intermediated in US financial markets and invested abroad through purchases of foreign securities by US investors ($108 billion) and by net lending abroad by US banks ($98 billion)."
 
There are a number of points to note from these examples. To start with, the global financial system is obviously characterised by a high degree of centralisation. With US financial institutions intermediating global capital flows, the investment decisions of a few individuals in a few institutions virtually determines the nature of the "exposure" of the global financial system. Unfortunately, unregulated entities making huge profits on highly speculative investments are at the core of that system. The growing consolidation in the financial sector noted by the G-10 study increases this centralisation.
 
Further, once there are institutions that are free of the now-diluted regulatory system, even those that are more regulated are entangled in risky operations. They are entangled, because they themselves have lent large sums in order to benefit from the promise of larger returns from the risky investments undertaken by the unregulated institutions. They are also entangled because the securities on which these institutions bet in a speculative manner are also securities that these banks hold as "safe investments". If changes in the environment force these funds to dump some of their holdings to clear claims that are made on them, the prices of securities the banks directly hold tend to fall, affecting their assets position adversely. This means that there are two consequences of the new financial scenario: it is difficult to judge the actual volume and risk of the exposure of individual financial institutions; and within the financial world there is a complex web of entanglement with all firms mutually exposed, but each individual firm exposed to differing degrees to any particular financial entity. The increase in the incidence of cross-industry mergers within the financial sector consolidates this tendency towards entanglement of agents involved in sectors of financial activity characterized by differential risk and substantially differential returns, thereby increasing the share of high-risk assets in the portfolio of large financial agents.
 
It is in this light that the consolidation in the financial sector involving a reduction in the number of operators, a huge increase in the size of operators at the top end of the pyramid, and the growing integration of financial activity across sectors and globally needs to be assessed. While the rise to dominance of finance has been accompanied by a growing role for speculative investment and profit, the concentration of increasingly globalized financial activity would lead to higher share of speculative investments in the portfolio of financial agents and greater volatility in investments worldwide as well as make it difficult if not impossible for national regulators to monitor the activity of these huge entities. The risk of financial failure is now being built into the structure of the system.
 
This has two kinds of consequences. First it increases systemic risk within the financial sector itself. If transactions of the kind that led upto the savings and loan crisis or the Barings debacle come to play a major role in any of these large behemoths, and go unnoticed for some period by national regulators, the risks to the system could be extreme, given the integration of the financial system and entanglement of financial firms. Second, once a crisis afflicts one of these agents, the process of bailing them out may be too costly and the burden too complex to distribute. The G-10 report is quite candid on this count. To quote the report:
 
"It seems likely that if a large and complex banking organisation became impaired, then consolidation and any attendant complexity may have, other things being equal, increased the probability that the work-out or wind-down of such an organisation would be difficult and could be disorderly. Because such firms are the ones most likely to be associated with systemic risk, this aspect of consolidation has most likely increased the probability that a wind-down could have broad implications.
 
Important reasons for this effect include disparate supervisory and bankruptcy policies and procedures both within and across national borders, complex corporate structures and risk management practices that cut across different legal entities within the same organisation, and the increased importance of market-sensitive activities such as OTC derivatives and foreign exchange transactions. In addition, the larger firms that result, in part, from consolidation have a tendency either to participate in or to otherwise rely more heavily on “market” instruments. Because market prices can sometimes change quite rapidly, the potential speed of such a firm’s financial decline has risen. This increased speed, combined with the greater complexity of firms caused in substantial degree by consolidation, could make timely detection of the nature of a financial problem more difficult, and could complicate distinguishing a liquidity problem from a solvency problem at individual institutions.
 
The importance of this concern is illustrated by the fact that probably the most complex large banking organisation wound down in the United States was the Bank of New England Corp. Its USD 23.0 billion in total assets (USD 27.6 billion in 1999 dollars) in January 1991 when it was taken over by the government pale in comparison to the total assets of the largest contemporary US firms, which can be on the order of USD 700 billion.”
 
The systemic risk relates not just to the financial sector itself. It also stems from the possible impact this would have on weaker participants in the international financial system, such as the developing countries. Along with the globalization of finance, financial crises in individual countries and economic regions have become the norm. And globalization has also meant that the effects of a crisis in one part of the world are quickly transmitted elsewhere, making contagion a word as often referred to in financial as in medical parlance. The number of instances of crises of significant dimensions has been growing. To quote one set of observers, among the major crises that have accompanied the rise of finance have been: “the crisis in the Southern Cone in the late 1970s; the Third World debt crisis of the early 1980s; the savings and loan debacle in the US in the late 1980s; the so-call ERM crisis in 1992; the Mexican crisis of 1994-95 and its follow-on crisis in Latin America; the East Asian crisis of 1997; the Russian meltdown of 1998; and the collapse of the real in Brazil and its impact on the rest of Latin America.” Besides these there have been crises in individual countries in the 1990s such as in India, Argentina and Turkey. Of these instances, in all cases where the crisis affected developing countries, the impact on the real economy as well the large proportion of people in those countries living at the margins of subsistence has been devastating. One only needs to refer here to the “lost decade” of the 1980s in Latin America and the evidence on unemployment, poverty and deteriorating quality-of-life indicators in Sputheast Asia.
 
These and other instances suggest that the dominance of finance has substantially increased systemic risk in the international financial system, with extremely adverse implication for the progress of the real economy. Yet little is being done to prevent the autonomous transformation of the system in directions that enhance such risk. What is more, the influence of the finance capital is so great that despite the weight of the evidence collated by the G-10 report, it chooses to argue against intervention in the financial sector. In its view: “The complexity and different effects of the consolidation processes taking place within the payment and settlement industry make it impossible to categorise consolidation either as purely positive or as purely negative from a social welfare viewpoint… In general, at the present stage, it does not seem to be advisable for public authorities to interfere with the market competition between financial institutions or between payment and settlement systems. In fact, public authorities, as a public policy objective, may wish to remove potential obstacles to the consolidation process when it enables the market to develop initiatives aimed at reducing risks and enhancing efficiency in the field of payment and securities settlement.” Clearly evidence, theory and logic are no more the determinants of public policy.