Euphracia Ndinda Musyoki

By Euphracia Ndinda Musyoki
Kangwon National University

Globalization is introducing profound changes in the way that financial systems operate. Households, financial institutions, policy makers, supranational bodies, and international financial institutions like the IMF each have our own role to play in protecting the public good of financial stability.

The rapid growth in world trade, foreign direct investments and cross-border financial flows over the past decade has been the main manifestation of the increasing ``globalization'' of the world economy. This phenomenon has been driven primarily by a worldwide wave of economic liberalization ― the lowering of tariff and non-tariff barriers to international trade, the encouragement of foreign investments and deregulation of financial markets.

At the same time, technological developments have magnified the effects of this liberalization by reducing the cost of transportation and communications hence expanding the scope and volume of goods and services that are internationally tradable.

Consider this. A person wants to achieve a goal ― but because there are many outcomes, he cannot be sure that his investments will lead him to his goal. So if he does not reach his goal despite his investments of time and effort and money, his investments will be worthless. The chance that this may happen is ``risk.'' thus in order to reduce risks, he must predict uncontrollable external factors.

Financial risk enters the economic system when companies decide to make financial investments in their businesses. These companies face the risk of losing the invested money, if their investments do not meet their goals.

This risk is the fundamental financial risk in the economic system. All the other financial risks are ``derived'' from this. The risk that shares, bonds, mutual funds, loans, insurances, reinsurances, securitized debt obligations, commercial papers and the more exotic instruments face is that the business investment might not meet their goals. For example, financial risk in the system may flow from the investing company, to the bank that lent it the money to make that investment, to the insurer that insured the banks loan and finally to the shareholders of the reinsurer that reinsured the insurer's insurance.

And if the government bails out the reinsurer from it's troubles, it simply passes on the cost to the tax payers. But in the very end somebody has to bear the risk and pay the cost.

As mentioned above, in order to reduce risk, one must predict the uncontrollable external factors better and that can be done by acquiring more information on the external factors.

In today's globalized financial markets, four things complicate that process.

First, as risk flows from one entity to another in the financial system, as illustrated in the example above, it becomes more difficult to measure, especially the entities that are farther along the chain, as the investing company is directly involved in the business project, it has the most amount of information about risks associated with that project. But the successive entities have a decreasing amount of information about the same. Thus, they cannot predict the risk well.

Secondly, though a discipline named ``financial engineering,'' many financial institutions have been able to create mind-bogglingly complicated financial instruments by ``mixing-and-matching'' and ``slicing-and-dicing'' the underlying ``assets'' that are nothing but loans, such as sub prime mortgages. It is arguable that people who buy these exotic instruments have no idea what they are really buying, which leads to scenarios where nobody has any idea about what business investment they are ultimately financing. And if you have no idea about what you are investing in, how do you calculate the risks associated with it?

Third, the actual risk gets exaggerated through the practice of speculation. Things may not be really bad, but the fear of losing money makes people overly cautious, which starts a self-feeding cycle that makes things worse. It's a kin to a bank-run, where a false rumor that a bank will go bust leads to a disproportional large number of people claiming their deposits with the bank, which results in the bank actually going bust.

Fourth, and perhaps the most important thing that complicated the process of risk calculation, is that the financial returns to the individuals and the institutions ``managing'' the money are disassociated with the financial returns to the individuals and the institutions that actually ``own'' the money ― the end investors. For example, the returns that the asset management companies and their managers earn are completely disassociated with the returns that are earned by the investors employing their services. This leads to a moral hazard on the part of asset management ― companies and managers, start focusing on maximizing their benefits as opposed to their clients.

For these problems, I propose two solutions that will reduce the risks in today's globalized financial markets.

First, instead of paying the financial institutions and their managers the same amount of money irrespective of their performance, decide the percentage of commission and pay them exactly as per the rate of return that they have earned on the funds managed by them.

Financial companies and their employees would be a lot more responsible in making decisions about the funds they manage if their own livelihoods were at stake.

Second, create a stabilization fund for each individual market. The amount of money in each of these individual stabilization funds should be a pre-defined percentage of the total size of the respective marketed. The percentage of each market should be decided separately, based on the amount of volatility that market experiences. This fund should be employed in the market when its regulators think that a speculative ``bank-run'' type situation has kicked in the market. This measure will greatly help in avoiding the collapse of financial markets and in providing security to the investors. The money for such a fund should be pooled in from the market participants themselves, on the basis of the fairness principle.

The above mentioned solutions strike at the roots of the problems facing today's global financial markets ― inaccurate decision making by the employees of financial institutions because of the lack of an efficient reward system and high volatility in most financial markets because of the lack of a sane and stabilizing player. I speculate that these solutions will help combat the issues effectively.