CHAPTER ONE

INTRODUCTION
This chapter begins with a discussion of definitions of international
finance, and the national authorities, multilateral organizations, and inter-
governmental institutions that regulate them. Second, it describes the major
instruments that comprise international finance. Third, it discusses the costs
and benefits of internationalization. It concludes with a road map of the rest
of the book.
The markets for international finance include a variety of
participants. The suppliers of funds are often referred to as savers and may
be depositors or investors, depending on the transaction. The users of funds
may be borrowers or issuers, depending on the transaction.
Financial intermediaries come between the savers and users.
Traditionally, banks intermediate between savers (as depositors) and users
(as borrowers) of funds. Banks as principals have continuing obligations to
depositors and bear credit risk. Securities companies help savers (investors)
and users (issuers) transact business directly. The saver invests in the user
by buying its securities. The security company does not normally have to hold
bonds or shares very long, and has no continuing obligation to the investor or
the issuer. The investor bears the risks of the issuer’s performance. In
addition, financial intermediaries may be counterparties on financial
contracts such as derivatives—a matter we examine in later chapters.

A. INTERNATIONAL FINANCIAL TRANSACTIONS

1. DEFINITIONS
Generally, international financial transactions involve some cross-
border activity with respect to a payment, credit or investment, or financial
contract.1
The cross-border aspect of finance can arise from the fact that the
activity of the provider and the user of funds may be located in two different
countries. A lender can market and transfer funds to a borrower in another
country, or the borrower can seek and attain funds from the lender in the
lender’s country.

1 G. Dufey and T. Chung, International Financial Markets: A Survey, 3 (R. Kuhn ed. 1990).

1
2 INTRODUCTION

Similarly, an issuer of securities can market and distribute securities

to investors in another country, or foreign investors can make investments by
coming to the issuer’s country, as when a foreign investor buys a U.S. equity
on a U.S. stock exchange.
During the 1960s, a new phenomenon in international financial
transactions developed, the use of offshore markets. Markets for dollar-
denominated loans, deposits, and securities in jurisdictions other than the
United States were able to avoid U.S. banking and securities regulations.
This gave birth to the so-called euromarkets. Once having located abroad,
particularly in London, these markets survived even when the domestic on-
shore regulation that gave rise to them was relaxed. London has enjoyed
great benefits in employment, production and tax revenue from its financial
markets. In 2006, financial services accounted for 8.5 percent of the U.K.’s
GDP (Gross Domestic Product). The City of London itself contributed 2.5
percent. Other types of offshore markets have also developed that exist to
book banking transactions for purpose of evasion of money laundering, anti-
terrorism and tax rules. Chapter 22 describes the efforts of the international
community to crack down on these types of offshore centers.
According to Maughan, financial markets have developed from
domestic to domestic-offshore, whereby domestic markets are connected to
each other through offshore markets, to global, whereby domestic markets
connect directly.2 The shift to global markets, according to Maughan, results
from deregulation and liberalization.
In Table 1A below, statistics on international lending are presented
following Ralph Bryant’s definition of “international” as claims:
• on foreign residents in foreign currency,
• on foreign residents in the bank’s home currency, or
• on domestic residents in foreign currency.3

2 D. Maughan, Global Capital Markets and the Implications for Financial Institutions, talk given
at Harvard Law School (September 20, 1993).
3 R. Bryant, International Financial Intermediation 26 (1987).
 CHAPTER 1 INTRODUCTION 3

Table 1A: Assets Reported by Banks Located in Selected Countries

(U.S.$ billions, June 2002)
Types of International Lending (by location of bank) (in %)
Banks in Inter- Non- Non- Resident Total
national resident resident Foreign
Total Foreign Home

12/31/82
Japan 11 37 14 49 100
U.S. 17 2 98 — 100
U.K. 72 68 4 28 100

6/30/02
Japan 65 27 8 100
U.S. 4 96 — 100
U.K. 69 8 23 100

Japan and the United States are similar. In 1982, both had a low
percentage of international lending. This is because their international
business is dwarfed by their large domestic economies. U.S. international
business was largely dollar loans to non-residents (claim on non-residents in
the home currency), while Japan had mainly dollar loans to residents and
non-residents. The U.K. has a very high percentage of international business.
It is an offshore banking centre, specializing in making foreign currency loans
to non-residents, e.g., dollar loans to Germans.
What significant changes in this picture appear in 2002? The only
important change is in Japan, where lending to non-residents in dollars and
yen increased and dollar loans to residents shrank substantially. The U.K. in
2006, within Europe, accounted for 20 percent of cross-border lending, 31
percent of foreign exchange trading, and 70 percent of the market in
secondary bond trading. London also accounts for 50 percent of investment
banking, and private equity and hedge fund management in Europe.4
Table 1B below shows the total international assets of banks from
five countries as an absolute amount and as a percentage of total
international assets of banks from all countries. Looking strictly at the
location of the bank (the first two columns), banks in Germany have the
highest percentage of international assets, followed by Japan, the U.S., the
U.K., and France. However, if one takes into account related offices, so that a
U.S. branch in the U.K. is counted as U.S. and not U.K., the U.K. appears a
lot less international, and the U.S. becomes a close second to Germany.

4 M. Dickson, “Capital Gain: How London Is Thriving As It Takes on the Global Competition,”

Financial Times, March 27, 2006.

4 INTRODUCTION

Table 1B: International Assets of Banks in Selected Countries by

Nationality of Ownership (U.S.$ billions, end-June 2002)5
Banks based in: Total as % of total with related as % of total
offices
France 1,301.0 8.9 409.3 9.2
Germany 2,839.4 19.4 761.0 17.1
Japan 1,560.0 10.7 462.8 10.4
U.K. 1,389.0 9.5 287.7 6.5
U.S. 1,520.2 10.4 687.8 15.5
Total (all countries) 14,594.8 100.0 4,446.2 100.0

Choice of an offshore center is determined by a variety of factors, such

as avoiding home country regulation (some offshore centers are more
resistant to extraterritorial reach), infrastructure (educated elite,
telecommunications, and aviation), macroeconomic stability, local amenities,
and time zones. Becoming an offshore center can be important to a country’s
economy, as in the case of London.6 It generates employment and taxes, and
becomes a modifying force for domestic financial regulation.
There are different types of centers. Some are functional, like London,
whereas others are just booking centers like the Bahamas. Transactions are
booked there to minimize taxes and escape regulation. Much of the world’s
international financial activity goes on in offshore banking centers. In recent
years, Switzerland, a traditional offshore center in Europe, has diminished
its privacy protection and adopted withholding taxes in response to European
pressure (see Chapter 11, Section D on Eurobonds). This has recently given a
spur to Singapore that has no withholding taxes and maintains a high level
of privacy.7
Economic definitions of international transactions would normally
exclude cases where foreign citizens resident in a country engaged in a
transaction in that country, for example a U.S. citizen resident in Japan
buying securities issued in Japan. Nonetheless, such transactions may pose
concerns for countries like the U.S. that believe they should protect their
citizens abroad by exercising extraterritorial jurisdiction.
More generally, definitions of international transactions almost never
include purely domestic activity, e.g., a Japanese citizen borrows from a
Japanese bank in Japan. Nonetheless, in a worldwide integrated financial
system, what happens in one country’s economy has substantial impact on
other economies. For this reason, this book not only covers how the three

5 Bank for International Settlements, International Banking and Financial Market

Developments, Tables 2A, 2C, 4A, and 8 (Basel, June 2003).
6 See G. von Furstenberg, “Assessing the Competitiveness of International Financial Services in

Particular Locations: A Survey of Methods and Perspectives,” Working Paper (October 2007).
7 E. Taylor and C. Prystay, “Swiss Fight Against Tax Cheats Aids Singapore’s Banking Quest,”

Financial Times, February 6, 2006.

 CHAPTER 1 INTRODUCTION 5

major economies, the United States, Japan, and the European Union,
regulate their international financial transactions, but also how they
generally regulate their domestic financial systems. An understanding of
domestic regulation is also important because it is a baseline for
international regulation. For example, a Japanese bank entering the U.S.
encounters special regulation due to its international activity; but this is over
and above its need to comply with Japanese domestic regulation. The
European Union is a special case. Its internal regulation is itself
international since it establishes rules for transactions among its own
Member States.
Researchers at the International Monetary Fund (IMF) compared the
assets of banks owned more than 50 percent by foreigners to the assets of all
banks in certain countries of Asia (Korea, Malaysia, Thailand), Central
Europe (the Czech Republic, Hungary, Poland), and Latin America
(Argentina, Brazil, Chile, Colombia, Mexico, Peru, Venezuela). The study
reported that foreign control of bank assets was mainly below 10 percent in
1994 but rose substantially by 1999, in most countries to over 40 percent. In
almost all countries, the foreign banks’ return on equity was significantly
higher than that of domestic banks, many of which showed losses.8

Notes and Questions

1. According to Dufey and Chung (“International Financial Markets:
A Survey,” in Library of Investment Banking (R. Kuhn ed., 1990)), a banking
transaction is international if it involves a foreign resident in the domestic (or
national) banking market or involves offshore markets. A loan by a U.S. bank
to a foreign resident, or a deposit from a foreign bank to a U.S. bank, both
involving cross-border movement of funds, is an international transaction in
the U.S. domestic market. Consider the following for Citibank, a U.S. bank
with a New York headquarters:
a. Suppose Citibank (New York) made a Deutschmark loan to a U.S.
company. Dufey and Chung would presumably classify this as a
“Euro-loan” and therefore an international transaction. But their
classification is not certain because no foreign resident is involved
and the lender and borrower are subject to the regulations of their
home country.
b. Suppose Citibank’s U.K. branch or U.K. subsidiary made a
sterling loan to a resident of the U.K. According to Dufey and Chung,
this is not an international transaction. Do you agree with this aspect
of their definition?
2. Dufey and Chung define a securities transaction as international
according to the same criteria. A sale of securities of a U.S. corporation to a
foreign resident, or a sale of the securities of a foreign corporation to a U.S.

8 D. Mathieson and G. Shinasi, International Capital Markets (September 2000) at 153 and 166.
6 INTRODUCTION

resident, would be international securities transactions involving the U.S.

domestic market. Please consider the following:
a. If a Japanese company issued securities in Tokyo, and they were
bought in Tokyo by a U.S. citizen residing in Tokyo, Dufey and Chung
would not classify this as an international transaction. Do you agree
with this aspect of their definition?
3. Compare Bryant’s definition of international banking transaction
with the Dufey and Chung definition. Bryant’s explicitly includes foreign
currency lending to residents. Which do you prefer? Should any factors in
addition to currency and residence be included in a comprehensive definition?

2. REGULATION

a. NATIONAL GOVERNMENTS
National governments are the principal regulators of international
financial transactions. Often at least two jurisdictions may take an interest
in the same transaction. Consider, for example, a case in which a U.S.
depositor places funds in a Japanese bank. The U.S. will be concerned with
protecting the U.S. depositor from risk, while Japan will be worried about the
safety and solvency of its banks. Japan will also have to decide whether to
extend deposit insurance to foreign depositors (in fact, it does not). Or
suppose a U.S. investor purchases yen-denominated Japanese securities in
the U.K. The U.S. may be concerned with assuring that its investors (even
offshore) receive adequate disclosure, Japan may be concerned with the
international use of its currency, and the U.K. may be generally concerned
with financial transactions occurring in the U.K.

b. MULTILATERAL INSTITUTIONS
For international finance, the IMF and the World Bank, both
established in 1944 and based in Washington, D.C., are quite important. The
IMF, a multilateral institution controlled by the U.S. and other industrial
countries, was set up to help member countries maintain agreed exchange
rates. However, with the abandonment of fixed rates in 1972, its mission has
shifted to dealing with the short-term financial needs of developing countries
and the promulgation of international standards. More recently, it has
focused on global imbalances and monitoring exchange rate arrangements. It
had about $212 billion in assets as of 2006, funded by contributions of 185
members and borrowings. The World Bank began as the International Bank
for Reconstruction and Development (IBRD) to help Europe rebuild after
World War II. It now is a major international long-term lender to developing
countries. We will talk more about the IMF when we come to the chapters of
the book involving the emerging markets.
The International Finance Corporation (IFC) is an affiliate of the
World Bank. It was established in 1956 to promote private sector
 CHAPTER 1 INTRODUCTION 7

development. Unlike the World Bank, the IFC can invest in private entities.
It has carved out a niche analyzing investment opportunities in developing
countries and helping them solve investment problems, whether of
information or structure. In 2006, it had $12.73 billion in loans and equity
investments.
The U.S. controls about 17 percent of the votes in the two institutions
based on its contributions to funding. The seven largest industrialized
countries (G-7) hold a total of 45 percent of the votes. Important matters need
85 percent of the votes to pass. It is clear that the developed countries and
particularly the U.S. have the major say in what these institutions do. Some
realignment of voting power was approved by the Board of Governors of the
IMF in April 2008.9 Generally, so-called dynamic emerging market countries
achieved increases at the expense of the most-developed countries. Thus, for
example, the Chinese share increased .88 percent to 3.81 percent, while the
U.S. share dropped .29 percent to 16.73 percent. Overall, the change in voting
shares amounted to an aggregate shift of 5.4 percentage points to
underrepresented countries.10

c. INTERGOVERNMENTAL GROUPS
There are a number of important inter-governmental groups that
coordinate international policy. A brief description of the most important
ones follows. The International Monetary and Financial Committee (IMFC) is
the key policy group within the IMF.
IMFC
“The IMFC has the responsibility of advising, and reporting to, the
Board of Governors on matters relating to the Board of Governors’ functions
in supervising the management and adaptation of the international monetary
and financial system, including the operation of the adjustment process, and
in this connection reviewing developments in global liquidity and the transfer
of resources to developing countries; considering proposals by the Executive
Board to amend the Articles of Agreement; and dealing with disturbances
that might threaten the system.”11
The IMFC has 24 members, listed below, who are governors of the
IMF (generally ministers of finance or central bank governors). The
membership reflects the composition of the IMF’s executive board: each
member country that appoints, and each group of member countries that
elects, an executive director appoints a member of the IMFC.

IMFC Membership

9 IMF, Board of Governors Adopts Quota and Voice Reforms by Large Margin, Release 08/93,

April 29, 2008.

10 IMF, Executive Board Recommends Reforms to Overhaul Quota and Voice, Release 08/64,

March 28, 2008.

11 IMF, A Guide to Committees, Groups, and Clubs: A Factsheet (August 2006).
8 INTRODUCTION

Governors of the IMF for:

Algeria Gabon Russia
Argentina Germany Saudi Arabia
Belgium India Spain
Brazil Italy Switzerland
Canada Japan United Arab Emirates
China Korea United Kingdom
Finland Malaysia United States
France Nigeria

FSF
The Financial Stability Forum (FSF) was established in 1999 to
enhance cooperation in the area of financial market supervision and
surveillance among national and international supervisory bodies and
international financial institutions. It has 42 members, consisting of 25
senior representatives of national authorities responsible for financial
stability in 11 significant international financial centers (in Australia,
Canada, France, Germany, Hong Kong, Italy, Japan, the Netherlands,
Singapore, the United Kingdom, and the United States); six senior
representatives of four international financial institutions (Bank for
International Settlements, IMF, Organization for Economic Cooperation and
Development, and the World Bank); seven senior representatives of three
international regulatory and supervisory bodies (Basel Committee on
Banking Supervision, International Organization of Securities Commissions,
International Association of Insurance Supervisors); a representative from
each of two committees of central bank experts (Committee on the Global
Financial System and Committee on Payment and Settlement Systems); and
the Chairman, currently Mario Draghi, Governor of the Banca d’Italia.
The FSF has played an important role in coordinating the
international response to the credit crisis of 2007-2008.

G-7, G-8, and G-10

The Group of Seven (G-7) major industrial countries have held
annual economic summits (meetings at the level of head of state or
government) since 1975. At the level of finance minister and central bank
governor, the G-7 superseded the G-5 as the main policy coordination group
during 1986-87. Since 1987, the G-7 finance ministers and central bank
governors have met at least semi-annually to monitor developments in the
world economy and assess economic policies. The Managing Director of the
IMF usually, by invitation, participates in the surveillance discussions of the
G-7 finance ministers and central bank governors.
 CHAPTER 1 INTRODUCTION 9

G-7 Members
Canada Japan
France United Kingdom
Germany United States
Italy

The G-8 was conceived when Russia first participated in part of the
1994 Naples Summit of the G-7. At the 1998 Birmingham Summit, Russia
joined as a full participant, which marked the actual creation of the G-8.

G-8 Members
Canada Japan
France Russia
Germany United Kingdom
Italy United States

The Group of Ten (G-10) refers to the group of countries that have
agreed to participate in the General Arrangements to Borrow (GAB), a
supplementary IMF borrowing arrangement that can be invoked if IMF
resources are not sufficient for members’ needs. The GAB was established in
1962, when the governments of eight IMF members—Belgium, Canada,
France, Italy, Japan, the Netherlands, the United Kingdom, and the United
States—and the central banks of two others, Germany and Sweden, agreed to
make resources available to the IMF for drawings by participants, and, under
certain circumstances, for drawings by nonparticipants. The following
international organizations are official observers of the activities of the G-10:
The Bank for International Settlements (BIS), European Commission, IMF,
and Organization for Economic Cooperation and Development (OECD).

G-10 Members
Belgium Netherlands
Canada Sweden
France Switzerland
Germany United Kingdom
Italy United States
Japan

d. FUNCTIONAL REGULATORS
There are a number of international regulatory groups for specific
areas of regulation. For example, in banking, intergovernmental groups such
as the Banking Supervision Committee at the BIS in Basel play an important
role. In securities, there is the International Organization of Securities
Commissioners (IOSCO), in accounting there is the International Accounting
10 INTRODUCTION

Standards Board (IASB), and in auditing there is the Public Interest

Oversight Board (PIOB) created in 2005. We will focus on some of their
activities in subsequent chapters.

Notes and Questions

1. Is there a real need for these various international regulatory
bodies? How would you characterize the overall pattern of current
international regulation?
2. Ross Buckley points out that three features of national financial
systems are missing in the international financial system: a bankruptcy
regime, a financial regulator, and a lender of last resort.12 A key feature of
the system, however, is that these functions are nevertheless provided to a
great extent through cooperation of national regulators and private
arrangements.
3. As we shall see throughout this book, trade groups also play a key
role in setting standards for transactions, e.g., standard contractual terms.
These standards are an integral part of the overall framework for the conduct
of financial transactions.13

B. THE MAJOR FINANCIAL MARKETS COMPARED

The major international financial markets are foreign exchange,
lending and securities (debt and equity), and derivatives. Data is given on the
foreign exchange and derivatives markets in Chapters 14 and 15,
respectively. Here the focus is on banking and securities markets.
Aggregate data that allows one to compare the evolution of these
markets over many decades until the present do not exist. For almost 30
years up to the mid-1990s, the OECD reported statistics for funds raised on
international loan and bond markets, changing the series once, after 1982.
Table 1C shows that in the early 1980s international loan markets were
larger even than bond markets. Both were much larger than equity offers.

12Id.
13 E. Wymeersch, “Standardization by Law and Markets Especially in Financial Services,”
Financial Law Institute Working Paper Series WP 2008-02 (January 2008).
 CHAPTER 1 INTRODUCTION 11

Table 1C: Funds Raised by Non-Sovereigns on International Markets,

1967-1996 (in U.S.$ billions)14
INSTRUMENT 1967 1972 1977 1982 1987 1992 1996
Loans - 8.8 34.2 103.6 122.9 124.6 349.7
Of which: -
Syndicated Euro- 8.8 34.2 90.8 80.3 116.2 345.2
loans
Bonds 5.2 10.9 34.8 75.5 180.8 333.7 708.8
Distribution:
Euro-bonds 2.2 6.5 18.7 50.3 140.5 276.1 589.8
Foreign bonds 3.0 4.4 16.1 25.2 40.3 57.6 119.0
Type:
Floating-rate notes - - 2.2 15.3 13.0 43.6 165.7
Straight bonds 5.1 9.5 31.1 7.2 121.3 265.4 464.4
Convertibles - 1.1 1.2 2.6 18.2 5.2 25.6
with equity - .1 .1 .5 24.8 15.7 8.8
warrants
Equity offers - - - - 20.4 25.3 n.a.
Total 5.2 19.7 69.0 179.1 324.1 483.6

The BIS also collects data about international financial markets,

using slightly different terms and grouping the markets in somewhat
different ways. For some instruments, the BIS tables give amounts
outstanding on a specific date. This is called the stock of funds and is
reported in “Stock end-2007” in Table 1D below. For example, on December
31, 2007, investors held about $22.8 trillion in debt instruments. It is
interesting to compare the stock of funds raised on international and
domestic markets. As of September 2007, the stock of bonds and notes
outstanding on international markets of $20.7 trillion was 46.8 percent of the
$44.2 trillion raised on domestic markets, up from 24.7 percent in 2002.15
The BIS data on new issues in Table 1D shows equity significantly
trailing debt. For example, in 2007 total international equity issued was
$496.2 billion as compared to $5.1 trillion or 9.7 percent of total debt.
However, this is misleading because debt constantly recycles, as issues come
to maturity or are refinanced, while equity does not. A better comparison
would be between international equity and debt outstanding, but we have no
complete data on the former. McKinsey’s data (see Figure 1.1 below) shows
that in 2007 the total value of all equity outstanding was $65 trillion
compared to $79 trillion of debt (which includes $28 trillion of government

14 Organization for Economic Cooperation and Development, Table F.T-O.a, “International

Capital Markets Statistics” (1996), OECD Financial Market Trends (November 1997), and
International Monetary Fund, International Capital Markets: Developments, Prospects, and
Policy Issues 189 (August 1995). Time series changes after 1982.
15 See BIS Quarterly Review (March 2008), Table 13b.
12 INTRODUCTION

debt) but these totals do not distinguish between international and domestic
holdings—they count them all.16 The total value of financial stock was $196
trillion, about 3.6 times world GDP of about $54.3 trillion.
The BIS data does not include government debt, which is a significant
part of the international capital market. For example, according to McKinsey,
as of 2006, government debt securities outstanding were $26 trillion as
compared with corporate debt of $43 trillion.17 As is well known, foreign and
international investors (particularly foreign central banks and sovereign
wealth funds) hold a high proportion of U.S. public debt, about 25 percent of
$8.8 trillion in 2007 (through March) compared to about 18 percent of $5.1
trillion in 1996.18 Foreign investors, principally foreign central banks, held
about 57 percent of long-term U.S. Treasury obligations as of April 2008.19

16 D. Farrell, S. Lund, et al., Mapping the Global Capital Markets: Fifth Annual Report,
McKinsey Global Institute (October 2008). (McKinsey)
17 Id., at 8.
18 Treasury Bulletin (June 2007).
19 Department of the Treasury, Federal Reserve Bank of New York, Board of Governors of the

Federal Reserve System, Report on Foreign Portfolio Holdings of U.S. Securities as of June 30,
2007 (April 2008).
 CHAPTER 1 INTRODUCTION 13

Table 1D: Funds Raised by Non-Sovereigns on International Markets,

1994-2007 (in U.S.$ billions)20

Instruments Net (new) Issues

Stock-
1994 1998 2000 2002 2006 2007 end
2007
Money 3.2 9.8 122.0 2.3 166.3 198.7 1,137.4
Market
Of which: 0.5 22.2 76.8 19.3 119.9 15.0 696.6
Commercial
Paper
Bonds & 168.0 668.7 1,016.2 1,013.7 2,606.8 2,803.9 21,635.4
Notes
Of which: 53.5 173.0 333.2 201.1 1,293.9 1151.5 7,210.2
Floating rate 132.7 479.6 674.5 801.0 1,306.7 1,616.2 14,026.1
Straight fixed -18.2 16.1 8.4 11.6 6.2 36.2 399.2
Equity-
related
Syndicated 250.4 902.2 1,460.3 1,299.7 2,164.1 2131.1
credit
Equity — 125.7 313.8 89.3 377.9 496.2
Total 421.6 1,706.4 2,912.3 2,405.0 5,315.1 5,629.8

One of the drivers between the choice of debt and equity is tax—
interest is usually deductible while dividends are not. On the other hand,
regulators and rating agencies prefer equity to debt as a more permanent and
residual source of capital. In 2006, the issuance of so-called “hybrid”
securities increased—these are securities treated as debt by tax officials and
equity by regulators and ratings agencies. Some estimate that in the U.S.
hybrids’ issuance reached $40 billion in 2006, up ten times from 2005.21

20 BIS Quarterly Review, International Banking and Financial Market Developments, 1994,

Tables 8, 9, 12; 1998, Tables 10, 13a, 13b, 18; 2000-2006 Tables 10, 13a, 13b, 18.
21 R. Beales, “Banks Hope to Cash in on Rush into Hybrid Securities,” Financial Times, February

6, 2006.
14 INTRODUCTION

Figure 1.122

Different countries and regions have different mixes of different

securities, as shown in Figure 1.2 below.23 The U.S. is dominated by capital
markets (debt and equity), as compared to Europe and Japan where banking
markets are more important.

McKinsey, supra note 16, p. 9.

22
23D. Farrell, A. Key, and T. Shavers, Mapping The Global Capital Markets, The McKinsey
Quarterly, Special Edition (2005).
 CHAPTER 1 INTRODUCTION 15

Figure 1.2

As Figure 1.3 below shows, there is a weak link between financial

depth (financial stock as a percent of GDP) and wealth. For example, the
financial depth of the Netherlands is twice that of Italy, although both
countries have similar GDP per capita.
16 INTRODUCTION

Figure 1.324

In 2006, many commentators noted the world was awash in liquidity,

but few defined what that meant. When people worry about a glut of liquidity
they are usually thinking of overall monetary conditions—money supply,
official interest rates and the price of credit.25 Another significant
development was the development in 2006 of the Islamic finance market,
estimated to be about $495 billion and growing at 15 percent annually.26 In
the summer of 2007, the international markets began a significant
contraction as a result of the subprime crisis, examined at length in Chapter
12.

C. HOW GLOBALIZED ARE FINANCIAL MARKETS?

There are difficulties in defining and measuring the globalization of
financial markets. There appear to be four main approaches. First, one can
look at the correlation of prices between markets. The higher the correlations
in rates of returns on similar assets across countries, arguably the more
integrated the markets. One might also look to integration across asset
classes internationally as compared to domestically.

24 Id, at p. 12.
25 “A Fluid Concept,” The Economist, February 8, 2007.
26 Ed Balls (MP, Economic Secretary, HM Treasury), speech to the Euromoney Conference on

Islamic Finance, January 30, 2007.

 CHAPTER 1 INTRODUCTION 17

A second approach looks at quantity. For example, one can look at

portfolio diversification. The evidence here is that investors overweight
domestic securities in their portfolios. This so-called “home bias” effect is
prevalent to various degrees in all local markets. In 2001, the portfolio share
of foreign equities of U.S. investors was 22 percent of what it would have
been had these investors held the world market portfolio, so that the home
bias measure was 78 percent. Home bias averaged 63 percent in 2001 for a
sample of 18 developed countries.27 There is continued debate as to whether
this home bias is due to transaction costs, information availability, or just a
preference for what investors are familiar with.28 Cai and Warnock find that
if one changes the basis for defining a firm to be “foreign” from the location of
the firm’s headquarters to the location of its operations, the home bias is
greatly reduced, albeit that domestic investors still prefer domestic to foreign
multinationals.29 Khoo et al. believe the continued strength of home bias is a
function of high domestic insider ownership—where domestic insiders hold
significant portions of companies, the home bias is higher.30 Schoenmaker
and Bosch find home bias has decreased among E.U. countries that have
adopted the euro, suggesting that foreign exchange risk plays an important
part in home bias.31 Lewis finds that the problem of home bias cannot be
resolved by U.S. investors investing in foreign companies trading in U.S.
markets. One of the principal virtues of investing in foreign markets is to
achieve more diversification since there will be less covariance in the returns
on U.S. and foreign stocks. The Lewis study finds that U.S. companies have
less covariance with U.S.-listed foreign companies than with foreign
companies that only trade abroad.32
Quantitative approaches may also look at the actual amount of cross-
border flows over time. Stulz finds for the United States, that trading by
foreign investors in U.S. stocks and bonds increased from 5.76 percent of
GDP in 1977, to 344.18 percent of GDP in 2003, or a factor of 60.33 The U.S. is
a major beneficiary of capital flows as investments by foreigners in the U.S.
finances the U.S.’s chronic and deep trade deficits. In fact, the U.S. imports
an astounding 71.9 percent of the capital exported by other countries. Of the
capital exporting countries, Japan is the highest, accounting for 20.5 percent

27 R. Stulz, “The Limits of Financial Globalization” LX J. of Finance 1595 (2005). (Stulz)

28 See e.g., R. Portes and H. Rey, “The Determinants of Cross-Border Equity Flows,” 65 Journal
of International Economics 269 (2005).
29 F. Cai and F. Warnock, “International Diversification at Home and Abroad,” NBER Working

Paper 12220 (May 2006).

30 B. Kho, R. Stulz, and F. Warnock, “Financial Globalization, Governance, and the Evolution of

the Home Bias,” Preliminary Working Paper (July 2006).

31 D. Schoenmaker and T. Bosch, “Is the Home Bias in Equities and Bonds Declining in Europe?”

Working Paper (June 2007).

32 K. Lewis, “Is the International Diversification Potential Diminishing for Foreign Equity Inside

the U.S.?” Working Paper (December 2007).

33 Stulz, supra note 28.
18 INTRODUCTION

of all exports.34 Overall, in 2005 and 2006, the share of global saving invested
abroad climbed above 50 percent for the first time.35
A third approach looks at the links between savings and investment
levels within countries. Feldstein and Horioka36 showed in 1980 that there
was a very tight link between domestic savings and investment levels
(savings retention coefficient). However, as investors diversify
internationally, these rates should become less closely related to each other.
This link appears to be weakening significantly. For the decade ending in
1980, the savings retention coefficient for 16 OECD countries, weighted by
GDP, was 0.93, as compared with 0.57 by 2002.37
A fourth approach looks at formal barriers to trade in financial
assets. This can be done by constructing indexes of openness. Quinn has
shown, for example, that out of an index of 1-12, most developed countries
have become fully open by 1997.38 However, these indexes only deal with
explicit barriers rather than implicit ones. For example, the U.S. may be fully
open to foreign banks, but may calculate their capital adequacy differently, or
be fully open to foreign companies listing in the U.S., but require them to
reconcile their accounts to U.S. GAAP (generally accepted accounting
principles). Further, implicit barriers may be created just because two
countries have different rules. For example, integration of global equity
markets are impeded because the U.S. has different rules for distributing
securities than do other countries, thus making global offerings more
expensive than they would be if all countries have the same rules. In fact,
this book largely focuses on the manner in which implicit barriers restrict
cross-border financial flows.

34 F. Cave, “IMF Warns Financial Markets Against Complacency,” Financial Times, April 5,
2005.
35 M. Higgins and T. Klitgaard, “Financial Globalization and the U.S. Current Account Deficit,”

13 Current Issues in Economics and Finance, Federal Reserve Bank of New York (December
2007). The authors find that the financing of the U.S. current account deficit by the inflow of
foreign capital may depend on high levels of worldwide liquidity. This permits capital inflow into
the U.S. to rise without making foreign investors overly dependent on dollar-denominated
assets—in fact, they are investing higher proportions than before in investments outside the U.S.
36 M. Feldstein and C. Horioka, “Domestic Savings and International Capital Flows,” 90

Economic Journal 314 (1980). See also C. Kearney and B. Lucey, “International Equity Market
Integration: Theory, Evidence and Implications,” 13 International Review of Financial Analysis
571 (2004).
37 M. Feldstein, “Monetary Policy in a Changing International Environment: The Role of Capital

Flows,” NBER Working Paper 11856 (December 2005).

38 D. Quinn, “The Correlates of Change in International Financial Regulation,” 91 American

Political Science Review 531 (1997).

 CHAPTER 1 INTRODUCTION 19

D. COSTS AND BENEFITS OF THE INTERNATIONALIZATION OF

FINANCE
A debate about whether the internationalization of finance—often
referred to as globalization—is good or bad rages worldwide. The potential
benefits of international finance are fairly clear. First, access to worldwide
capital markets may allow a country to smooth its financial needs, borrowing
in bad times and lending in good times. Second, international markets can
promote domestic investment and growth by allowing countries to import
capital. Third, globalization may enhance macroeconomic discipline—capital
flows may police bad government behavior, although this discipline may be
modified by sovereign bailouts, a problem we examine in Chapter 19. Fourth,
internationalization may discipline regulators. The possibility of financial
institutions changing the locale of their operations, or investors investing in
foreign markets abroad, may constrain excessive domestic regulation. Fifth,
internationalization may increase competition, and therefore lead to more
efficient banking systems or cheaper securities offerings.
Economists debate the effect of financial integration on growth. A
study of 57 countries, using many measures of financial integration, was not
able to reject the hypothesis that international financial integration does not
accelerate economic growth even when controlling for particular
characteristics of the country.39 However, a 2006 study comprehensively
reviewing the literature on this subject comes to a more nuanced conclusion.40
Kose et al. find that when economic integration is measured by de facto
rather than de jure integration, the effect of integration on growth is more
pronounced. This study further finds that the greatest impact from
integration comes from equity market liberalization. Various macroeconomic
thresholds—the development of domestic financial markets, the quality of
institutions and corporate governance, the nature of macroeconomic policies
and the extent of the openness to trade—must be met for integration to lead
to greater growth. On the other hand, it seems clear that domestically better
financial systems do increase growth by providing information about possible
investments and by allocating capital, through the monitoring of investments
and exercising corporate governance after providing finance, by facilitating
the trading, diversification and management of risk, by mobilizing and
pooling savings and by easing the exchange of goods and services.41

39 H. Edison, R. Levine, L. Ricci, and T. Slok, “International Financial Integration and Economic
Growth,” 21 Journal of International Money and Finance 749 (2002). See, however, G. Bekaert,
C. Harvey, and C. Lundblad, “Does Financial Liberalization Spur Growth?” 77 J. of Financial
Economics 3 (2005), showing liberalization of equity markets led to a 1 percent increase in
annual real economic growth.
40 M. Kose, E. Prasad, K. Rogoff, and S. Wei, “Financial Globalization: A Reappraisal,” IMF

Working Paper 06/189 (August 2006).

41 R. Levine, “Finance and Growth,” NBER Working Paper 10766 (September 2004).
20 INTRODUCTION

Still another study finds that for countries with deep institutional
development, e.g., rule of law, good corporate governance, financial
development follows economic development. However, in countries with low
institutional development, economic development follows finance.42
There are also some potential costs of globalization. First, markets
are not politically correct, so hostile or poorly performing markets may fail to
attract capital, and may experience capital outflows and unemployment.
While neo-classical economic theory predicts capital should flow from rich to
poor countries, the so-called Lucas Paradox shows this is not the case. A
prime explanation is low institutional quality, e.g., lack of rule of law and
corruption.43 Another explanation is that domestic institutions resist
openness to avoid competition.44 Second, the volatility of capital flows can
quickly destabilize an economy, as was the case in the 1997 Asian crisis,
where short-term international bank lending quickly dried up. These
potential volatility effects can be minimized by the accumulation of large
reserves, controls on deficit financing, and export promotion strategies, but
these “self-insurance” policies may themselves be costly. One paper argues
that countries should hedge their volatility exposures through derivatives.45
A related problem arises from the increasing ability to spread risk globally.
As we shall see, the development of securitization and derivatives allows
banks making loans in one country to transfer this risk to investors around
the world. This exposes these global investors, and the countries in which
they are situated, to the risk that poor policy or supervision in the risk-
exporting country can expose those in risk-importing countries. This problem
was acutely illustrated in 2007 by the mortgage financing crisis. Third, the
entry of foreign institutions, while increasing competition and efficiency, can
lead to the demise of local financial institutions. Fourth, the integration of
the world’s financial system can result in quick transmissions of economic
shocks between world economies, a phenomenon often referred to as
contagion.46 This book examines many of the costs and benefits.47

42 J. Ju and S.-J. Wei, “When Is Quality of Financial System a Source of Comparative

Advantage?” NBER Working Paper 13984 (April 2008).

43 L. Alfaro, S. Kalemli-Ozcan, and V. Volosovych, “Why Doesn’t Capital Flow from Rich to Poor

Countries? An Empirical Investigation,” NBER Working Paper 11901 (December 2005). See also,
O. Causa, D. Cohen, and M. Soto, “Lucas and Anti-Lucas Paradoxes,” Centre for Economic Policy
Research Discussion Paper 6013 (December 2006) (lack of productive infrastructure explains
paradox). M. Roe and J. Siegel show that lack of political stability can significantly hamper
financial development, “Political Instability’s Impact on Financial Development,” Working Paper
(May 30, 2008).
44 R. Rajan and L. Zingales, “The Great Reversals: The Politics of Financial Development in the

Twentieth Century,” 69 J. of Financial Economics 5 (2003).

45 R. Caballero and K. Cowan, “Financial Integration Without the Volatility,” Massachusetts

Institute of Technology, Department of Economics Working Paper 06-31 (November 27, 2006).
 CHAPTER 1 INTRODUCTION 21

Notes and Questions

1. Is more globalization inevitable? How does law and regulation
affect its pace?
2. A Joint Statement of the Asian, European, Japanese, Latin
American and U.S. Shadow Financial Regulatory Committees, “Enhancing
International Financial Market Integration,” (November 15, 2004) concludes
that there are major regulatory obstacles to integration. Countries, including
the U.S., restrict the access of foreign firms and securities issues to their
markets, both directly and indirectly. The WTO has made little progress in
eliminating these barriers. As discussed in the next chapter, the U.S.
regulatory requirements for foreign issues, such as use of U.S. GAAP
accounting standards or compliance with Sarbanes-Oxley, can also restrict
global integration.
3. An active area of inquiry is the role of legal institutions in
explaining financial development. Basically, the literature finds that the
Anglo-Saxon countries with stronger protection of property rights have had
higher levels of financial development.48 One study finds that effective legal
institutions, particularly those requiring disclosure and enforcing those
requirements, also reduce firms’ cost of capital. The effects of disclosure
requirements are strongest for markets that are the least integrated.
Enforcement appears not to matter at all in the most integrated markets.
The authors say that these findings are consistent with the notion that, in
integrated economies, risk is priced globally.49 What do you think of these
findings?

E. THE ROAD MAP

The book is organized into five parts. Part I deals with the
international aspects of major domestic markets, the U.S., the E.U., and
Japan. Part II deals with the infrastructure of international finance: capital
adequacy, foreign exchange regimes, the payment system, and clearing and
settlement. Part III deals with instruments and offshore markets. It covers
the euromarkets, asset securitization, stock market competition, derivatives,
and offshore mutual funds. Part IV deals with emerging market issues,

46 M. Ehrmann, M. Fratzscher, and R. Rigobon, “Stocks, Bonds, Money Markets and Exchange

Rates: Measuring International Financial Transmission,” NBER Working Paper 11166 (March
2005).
47 See P. Agénor, “Benefits and Costs of International Financial Integration: Theory and Facts,”

(2003) 26 The World Economy, pp. 1089-1118. For a recent critique of globalization, see J.
Stiglitz, “The Social Costs of Globalization,” Financial Times, February 25, 2004.
48 R. La Porta, F. Lopez-de-Silanes, A. Shleifer, and R. Vishny, “Law and Finance,” 106 J. of

Political Economy (1998), pp. 1113-1155.

49 L. Hail and C. Leuz, “International Differences in Cost of Equity Capital: Do Legal Institutions

and Securities Regulation Matter?” 44 J. of Accounting Research 485 (2006).

22 INTRODUCTION

project finance, privatization, emerging market debt, and banking reforms.

Part V covers the attempt to control the financing of terrorism.
This book is a blend of different perspectives on international finance.
While concentrating on law and regulation, it also provides information on
important transactions and major markets. Finally, it attempts to provide
perspective and critical analysis with respect to the current policy issues in
the field.