Knight: Developing Countries and the Globalization of Financial Markets

M Knight, “Developing countries and the globalization of financial markets,” World Development 26, no. 7 (1998): 1185-1200.

The author notes that, throughout the beginning of the 90s, there was a substantive move towards the globalization of financial markets. "These developments create the prospect of a more efficient worldwide allocation of savings and investment than was possible in the past4, when domestic investment in most countries was constrained by domestic caving" (1185). While there are upsides, the financial crisis of the late 90s demonstrated the risks.

"This paper analyzes the recent globalization of financial markets, considers some features that may raise concerns about financial stability in DTEs [developing and transition economies] and outlines recent initiatives to enhance the safety and stability of financial systems. In particular, it focuses on imperfect competition and gaps in the structure of financial markets as elements of financial instability in DTEs, and discusses the complementary roles of market discipline and official oversight as essential elements of a robust financial system" (1185).

"We consider an economy where domestic bank credit is the only source of financing for capital investment by productive enterprises, and examine the consequences of the structure of competition in the banking sector for the overall stability of the financial system. The key element of the analysis is that, in evaluating credit risks, banks assess the underlying profitability of the project they are considering financing using a different information set from that available to the prospective borrower. They therefore provide a valuable service to the productive firms: that of giving a 'second opinion' on the expected profitability of the project. The efficiency with which banks provide this financial service depends on a number of factors, including the structure of competition in the banking sector and the state of the macro economy" (1189).

"This analysis suggests that an imperfectly competitive banking system responds to bad loan problems by reducing lending and raising intermediation spreads" (1191).

"The discussion in the preceding sections shows that a number of factors--both microeconomic and macroeconomic--can cause financial problems in DTEs, and that regulatory oversight and market discipline are, in principle, complementary means for achieving a stable and robust financial system...The basic elements of a sound financial system are a supportive legal and regulatory environment, strong internal governance, external discipline provided by market forces, and external governance provided by regulation and supervision at both the domestic and international level" (1197).