Global Markets and Centres - Modern Banking

International banking is a logical extension of domestic banking, and will include diversification away from the traditional core activities. However, before exploring this topic in detail, it is useful to provide a sketch of the international financial markets.

International Financial Markets

In economics, a market is defined as a set of arrangements whereby buyers and sellers come together and enter into contracts to exchange goods or services. An international financial market works on exactly the same principles. Financial instruments and services, which include diverse items such as currencies, private banking services and corporate finance advice, are traded internationally, that is, across national frontiers. Below, the different types of global financial markets and key international financial centres are identified, followed by a discussion of the different ways of classifying markets, and how imperfections and trade impediments affect market operations.

Financial markets are classified by several different criteria as follows.

  1. The markets are global if instruments and services are traded across national frontiers and/or financial firms set up subsidiaries or branches in different national markets. For example, while the trade in futures for pork bellies is global, the actual buying and selling of pork bellies themselves is likely to be confined to national or even local markets.
  2. Wholesale banking (banking services offered to the business sector) might include international trade of financial instruments on behalf of a client, or the establishment of branches and subsidiaries of the financial firm in other financial centres, to enable it to better assist home clients with global operations, and to attract new clients from the host and other countries.

  3. The maturity of the instruments being traded. Maturity refers to the date when a financial transaction is completed. For example, any certificate of deposit that repays its buyer within a year is classified as a short-term financial instrument. If a bank agrees to an international loan to be repaid in full at some date that exceeds a year, it is a long-term asset for the lender; a liability for the borrower. Sometimes, an instrument is designated medium-term if it matures between 1 and 5 years. Short-term claims are normally traded on money markets, and long-term claims (bonds, equities, mortgages) are usually traded on capital markets.
  4. Whether the instruments are primary or secondary. A primary market is a market for new issues by governments or corporations, such as bonds and equities. An example would be initial public offerings (IPOs) of shares in firms. Securities that have already been issued are traded on secondary markets. Financial institutions are said to be market makers if they buy/sell (‘‘make markets’’) in existing bonds, equities or other securities; they are acting as intermediaries between buyers and sellers.
  5. How the instrument is traded. In the past, almost all instruments were traded in a physical location, a trading floor. However, the advent of fast computer and telephone links means almost all instruments, including derivatives, equities and bonds, are traded electronically, without a physical floor. One notable exception is the New York Stock Exchange where, through ‘‘open outcry’’, equities are traded on the floor of the exchange.

It is also common to observe these traditional methods in some of the developing and emerging markets.

Key international financial markets

In the new millennium, nearly all financial markets in the main industrialised economies are international. The main exceptions are retail banking markets and personal stock broking, but even here there are some global features. Obtaining foreign exchange for holiday makers is a long-established international transaction, and now debit cards issued by banks may be used world-wide, allowing customers to withdraw cash in a local currency. Some foreign banks, if permitted by the authorities, are expanding into retail markets, though currently these institutions tend to offer a few niche products and/or target high net worth individuals.

In Europe, under the Second Banking Directive (1989, effective 1993), approved credit institutions from one EU country can set up banks in any other EU state and undertake a list of approved activities they offer in their home state. In 2000, the Financial Services Action Plan was launched, to bring about the integration of financial markets by 2005.

Likewise, personal customers effectively invest in foreign shares by buying or selling unit trusts (mutual funds), which include shares in foreign firms. Some financial firms hoped to use internet technology to enter established financial markets rather than physical locations or branches, but this option is proving more difficult than was first envisaged.

There are several reasons why most financial markets are global. First, investors are able to spread risks by diversification into global markets to increase portfolio returns. A bigger pool of funds should mean borrowers are able to raise capital at lower costs. With an increased number of players, competition is increased. Funds can be transferred from capital-rich to capital-deficient countries. Hence, global markets bring about a more efficient distribution of capital at the lowest possible price.

At the same time, there are impediments to free trade in global financial markets – they are by no means perfect. Market imperfections are caused by the following factors.

  1. Differences in tax regimes, financial reporting and accounting standards, national business cycles, and cultural and taste differences.
  2. Barriers to free trade including tariffs (e.g., governments imposing higher taxes on domestic residents’ income from foreign assets), non-tariff barriers (e.g., restricting the activities of foreign financial firms in a given country), and import or export quotas (e.g., nationals are prohibited from taking currency out of the country).
  3. Barriers to factor mobility, such as capital controls, or restrictions on the employment of foreign nationals.
  4. Asymmetric information, when one party to a financial contract has more information relevant to the contract than the other agent. For example, borrowers typically have more information than lenders on their ability to repay, which can cause a bank to make inappropriate lending decisions. The problem is more pronounced in the case of foreign loans if it is more difficult to obtain information on prospective foreign borrowers. Banks try to counter the problem by restricting the size of loans, requiring a potential borrower to obtain a minimum score on a credit risk check list, and so on. More generally, the greater the transparency in a financial market, the more efficient it is. Imperfect information is a central cause of inefficient financial markets.

The main financial markets are listed below.

Money markets (maturity of less than 1 year)

Money markets consist of the discount, interbank, certificate of deposit and local (municipal) authority and eurocurrency markets. The eurocurrency and interbank markets are wholly international, whereas the other markets listed are largely domestic. In the 1950s, the Soviet Union used the Moscow Narodny bank in London for US dollar deposits. The euromarket grew out of the eurodollar market later in the 1950s, after US regulators imposed interest rate ceilings on deposits and restrictions on US firms using dollars to fund the establishment of overseas subsidiaries. This increased the use of eurodollar deposits and loans in London, with funding from US investors wishing to escape US domestic deposit rate ceilings. Likewise, in other countries with exchange and other capital controls, eurocurrency markets were a way of getting around them. Although many of these regulations have long since been abandoned, the euromarkets continue to thrive. Interbank markets exist because, at the end of a trading day, banks may find themselves long on deposits or short on loans. The interbank market allows surplus banks to make overnight deposits at other deficit banks.

Currency markets

The foreign exchange markets are, by definition, global, consisting of the exchange of currencies between agents. As demand for the currency rises relative to all other currencies, it is said to be appreciating in value; depreciating if the reverse is true. This topic is mentioned for completeness. It is discussed elsewhere in specialised texts and courses, and for this reason is not analysed here.

Stock markets

Stock markets are part of the capital markets (maturity in excess of 1 year), as are the bond and mortgage markets. The mortgage market remains largely domestic and is not discussed here. Stocks purchased on these markets help diversify investor portfolios. Portfolio risk is thereby reduced, provided the correlation between stock returns of different economies is lower than that of a single country. Institutional investors and pension fund managers (if permitted), managing large funds, are likewise attracted to foreign shares.

The growth of global unit trusts or mutual funds has also increased the demand for foreign equity. Fund managers select and manage the stocks for the trust/fund, using their (supposedly) superior information sets compared to the majority of individuals. Also, transactions costs are lower than they would be with an independent set of investments. The euroequities market has grown quite rapidly in recent years, and caters to firms issuing stocks for sale in foreign markets. Investment banks (many headquartered in New York) underwrite the issues, which, in turn, are purchased by institutional investors around the world. Secondary markets for these foreign issues normally emerge. Firms issue equity on foreign stock markets for several reasons.

  • To increase their access to funds without oversupplying the home market, which would depress the share price. Foreign investors, with a different information set to home investors, may also demand the stock more.
  • To enhance the global reputation of the firm.
  • To take advantage of regulatory differences.
  • To widen share ownership and so reduce the possibility of hostile takeovers.
  • To ensure that their shares can be traded almost continuously, on a 24-hour basis.
  • Funds raised in foreign currencies can be used to fund foreign branches or subsidiaries and dividends will be paid in the currency, thereby reducing the currency exposure of a multinational enterprise.

However, foreign equity issues are not without potentially costly problems. First, foreign equity investments may expose some investors to currency risk, which must be hedged.

Second, to list on a foreign exchange, a firm must comply with that country’s accounting rules, and there can be large differences in accounting standards. For example, German firms have found it difficult to list and trade shares on the New York Stock Exchange because accounting rules are so different in the two countries. Attempts to agree on common accounting standards made little progress for over 30 years, but the problem may be largely resolved if new IAB standards are adopted by 2005, which will make it much easier for firms to list on foreign exchanges. Third, governments often restrict the foreign equity share of managed funds; these regulations tend to apply, in particular, to pension funds.

With the dawn of the new century, a number of important changes are occurring in stock markets around the globe. A major change in the equity markets is the merger or alliance of stock exchanges in an attempt to offer 24-hour global trading in blue chip firms. In the United States, the trend has gone still further: electronic broker dealers have become exchanges in themselves and have applied to be regulated as such. To quote the Chairman of NASDAQ (taking its name from its parent, the National Association of Securities Dealers and the ‘‘alternative’’ US stock exchange for technology and new high growth firms), ‘‘in a few years, trading securities will be digital, global, and accessible 24 hours a day’’.

However, European stock exchange mergers are in a state of flux, due partly to the failure to integrate European cross-border payments and settlements systems. The cost of cross-border share trading in Europe is 90% higher than in the USA, and it is estimated that a central counterparty clearing system for equities in Europe (ECCP) would reduce transactions costs by $950 million (¤1 billion) per year.23 The cost savings would come primarily from an integrated or single back office. With a single clearing house, acting as an intermediary between buyers and sellers, netting is possible, meaning banks could net their purchases against sales, reducing the number of transactions to be settled and therefore the amount of capital to be set aside for prudential purposes. The plan is backed by the European Securities Forum, a group of Europe’s largest banks.

The existence of EU state exchanges is increasingly an anachronism with the introduction of a single currency. London is in the unusual position of being the main European exchange, even though the UK is outside the eurozone. There are plans to create a pan European trading infrastructure (to include common payment and settlement facilities) for the large, most heavily traded European stocks. It would involve an alliance among the 6 key euro exchanges, together with Zurich and London.

Like the eurocurrency markets, the emergence of the eurobond markets was a response to regulatory constraints, especially the imposition of withholding tax on interest payments to non-resident holders of bonds issued in certain countries. For example, until 1984, foreign investors purchasing US bonds had to pay a 30 per cent withholding tax on interest payments. Financing subsidiaries were set up in the Netherlands Antilles, from which eurobonds were issued and interest payments, free of withholding tax, could be made.

Investment banks are the major players in the eurobond markets. Many are subsidiaries of US commercial banks which were prohibited, until recently24 from engaging in these activities in the USA. Normally a syndicate of investment banks underwrites these bond issues.

Repos or repurchase agreements have grown in popularity over the last decade. A bond or bonds are sold with an agreement to buy them back at a specified date in the near future at a price higher than the initial price of the security, reflecting the cost of funds being used, and a risk premium, should the seller default. Thus, a repo is equivalent to a collateralized loan with the securities acting as collateral but still owned by the borrower, that is, the seller of the repo.

Another important trend in the bond markets is the reduced issue of debt by key central governments, shifting borrowing activity to the private sector. It means the traditional benchmarks (e.g. government bond yields) are less important, leaving a gap which has not been filled.

Key Financial Centres: London, New York and Tokyo

London, New York and Tokyo are the major international financial centres. Among these, London is pre-eminent, because most of the business conducted in the City of London is global. The London Stock Exchange has, since 1986, allowed investment houses based in New York and Tokyo to trade in London, meaning one of the three exchanges can be used to trade equity on what is nearly a 24-hour market. Compared to London, the activities of financial markets in Tokyo and New York are more domestic. Though London’s falling share of traditional global intermediation is associated with the general decline in direct bank intermediation, there is a great deal of expansion in markets for instruments such as euroequities, eurocommercial paper and derivatives.

Competitiveness: Key Factors

An important question is: what are the factors that make a centre competitive? A survey of experts undertaken by the CSFI (2003)25 identified six characteristics considered important to the competitiveness of a financial centre. The score beside each attribute is based on a scale of 1 (unimportant) to 5 (very important).

  • Skilled labour: 4.29
  • Competent regulator: 4.01
  • Favourable tax regime: 3.88
  • Responsive government: 3.84
  • A ‘‘light’’ regulatory touch: 3.54
  • Attractive living/working environment: 3.5

Using the characteristics listed above, respondents were then asked to rank four centres, London, New York, Paris and Tokyo, on a scale of 1 to 5. London or New York placed first or second in all but the environment attribute, where Paris came first. From these figures it was possible to derive an index of competitiveness,26 where 1 is least competitive and 5 is most competitive.

The scores were as follows.

  • New York: 3.75
  • London: 3.71
  • Paris: 2.99
  • Frankfurt: 2.81

London comes a very close second to New York, and the slight difference is mainly due to London’s third place position in terms of working/living environment. There were concerns about transport, housing and health care.

Looking at figures on market share in a number of key financial markets (Table below), London appears to be a leading centre. Ignoring the ‘‘other’’ category, which is the rest of the world, the UK has the highest market share for most activities listed in the table, the exceptions being fund management, corporate finance and exchange traded derivatives, 727 questionnaires were sent out to banks, insurance firms, fund managers, professional firms and other institutions. There were 274 responses (38%) all with offices in ‘‘the City’’ – 55% were headquartered in other countries.

Market share–Key Financial Markets (% share)

Market share–Key Financial Markets (% share)

Since monetary union, London’s percentage share of cross-border euro-denominated claims has risen by 4% since 1999, bringing it to 25% in 2001. The respective figures for Frankfurt, Paris, Luxembourg and Switzerland are 20%, 12%, 9% and 7%. London’s net exports of financial services (1997) stood at $8.1 billion, followed by Frankfurt ($2.7 billion), New York ($2.6 billion), Hong Kong ($1.7 billion) and Tokyo ($1.6 billion).

Tokyo’s position as an international financial centre has declined in the 1990s. During the 1980s the trading volumes on the New York and Tokyo stock markets were roughly equal but by 1996, Tokyo’s volume was only 20% of New York’s, with 70% fewer shares traded. Some of this decline is explained by Japan’s recession, but other figures support the idea that the Tokyo stock market is no longer as important as it was. In London, 18% of Japanese shares were traded in 1996, compared to 6% in 1990. Singapore conducts over 30% of Japanese futures trades. In the first half of the 1990s, the number of foreign firms with Tokyo listings fell by 50%.

Table below shows London as the key international centre if measured by the number of foreign financial firms. Though Frankfurt briefly overtook London in 1995, by 2000, the numbers had declined quite dramatically, as they had in Japan, suffering from a recession which has lasted over a decade, and hit its financial sector particularly hard. After uropean laws on the transfer of deposits around Europe were eased, London gained from the consolidation of foreign operations, at the expense of Frankfurt.

Number of Foreign Financial Firms in Key Cities

Number of Foreign Financial Firms in Key Cities

Frankfurt is hoping to usurp London’s leading position. There is a trivial time zone difference of just one hour, and the European Central Bank is located in Frankfurt, making it the heart of Euroland. However, the powerful Federal Reserve Bank is located in Washington, but this did not stop New York from emerging as the key financial centre in the North American time zone. London leads Frankfurt in terms of size of employment in the financial sector, the volume of turnover and the ability of London to innovate to meet the needs of its global clients. As Tables below show, Frankfurt has some way to go before it knocks London from its financial perch. The major challenge for Frankfurt is to turn itself into a key financial cluster, a phenomenon observed in the other international centres.


It is argued that clustering is the main explanation for the competitive success of a financial centre. Porter (1998) defines a cluster as geographical concentrations of interconnected firms, specialist suppliers of goods and services, and firms in related industries. Clustering is made possible and sustained by the availability of factor inputs, such as capital, labour and information technology, the demand for the financial instrument/service, firm specific economies of scale (in some cases) and external economies arising from the operation of related institutions in the same location, which can reduce some costs of information gathering.

Financial firms want to locate with other related financial institutions for a number of reasons. These include the following.

  1. Thick labour markets may be of particular importance for the financial sector. Marshall (1860/1961) showed the benefits of producers sharing specialised inputs. In the financial sector these include legal, accounting, information technology and executive search skills, among others. Individuals can invest in human capital skills and firms can employ them more quickly. A mix of mathematics and physics PhDs with bankers illustrates the more general point that a diversity of knowledge concentrated in one place will speed up innovation.
  2. In a sector where information is an important component of competitive advantage, external economies may be created from the nearby operation of related institutions, which reduces the cost of information gathering. For example, Stuart (1975) argued that firms producing similar but not identical products will reduce search costs for buyers, and therefore increase the size of sellers’ markets.
  3. Defensive strategy: firms may enter the home market of rivals because it is easier to react to their competitors’ actions, which could challenge their profitable operations.
  4. Some services require face-to-face contact. Walter and Saunders (1991) reported a costly error made by an investment bank when it moved its corporate finance team to the suburbs of New York. Prospective clients looking for an investment bank confined their search to New York’s financial district, unwilling to use time to travel to the suburbs. Tschoegal (2000) argues that the type of legal system can influence the attractiveness of a centre. Countries such as the USA and UK use contract law, which facilitates financial innovation more than civil law systems. In common law, it is taken that an action is permitted if not explicitly forbidden; but the opposite is true in countries (e.g. Japan) with a system of codified law. Tschoegal notes the need for financial legal expertise, and cites a study of 47 countries by La Porta et al. (1997), where a direct link was found between common law countries and the development of capital markets. Rosen and Murray (1997) found a preference for financial transactions based on US or UK law.
  5. Joint services, including clearing houses, research institutions, specialised degree courses and sophisticated telecommunications27 systems, improve the flow of information, ease access to knowledge and make the centre more attractive.
  6. Political stability and a reputation for liberal treatment of financial markets with, at the same time, sufficient regulation to enhance a centre’s reputation for quality.

All of the above points mean every financial firm in the cluster enjoys positive externalities.

Each firm benefits from the proximity of the others. Once established, such positive externalities reduce the incentive to locate elsewhere, even if operating costs appear to be lower. Pandit et al. (2001) report that financial service firms have a higher than average growth rate if they locate in a cluster, and a disproportionately large volume of firms will locate in a cluster.

Taylor et al. (2003) identified four clusters of London financial firms. The first was a highly integrated group of banks, insurance, law and recruitment firms located in the ‘‘City’’, with Canary Wharf viewed as an extension of it, a less cohesive sector in the West End of London, a law cluster in the ‘‘City’’ and the West End, and a more general cluster immediately north of the ‘‘City’’, with architecture and business support firms. The authors identified a number of benefits for financial firms locating in London, which are consistent with the points made above. These include having a ‘‘credible’’ address, proximity to customers, skilled labour and professional/regulatory organisations, access to knowledge, and wider attractions such as a cosmopolitan atmosphere, arts, entertainment and restaurants. The main disadvantages were property costs, poor transport infrastructure and government-related problems such as increases in taxation, onerous regulation and lack of policy coordination.

Offshore centres

Offshore financial centres are primarily concerned with global financial transactions for on-residents; nationals are usually prohibited from using these services. Some centres (for example, Switzerland and Hong Kong) are ‘‘offshore’’ because foreign banks locate there to avoid certain national regulations and taxation, thereby reducing the costs of raising finance or investing. Other centres such as the Grand Cayman Islands, Guernsey and Bermuda go further and exempt global activities of registered firms from all taxes and regulations.

Recently there has been pressure for these centres to come into regulatory line by eliminating exemptions. It is argued that they attract very high net worth private clients and the large multinationals. As a result, legitimate centres lose business and tax revenues, which in turn raises the tax burden for smaller firms and average net worth individuals.

Some centres offering clients a high degree of secrecy (as opposed to confidentiality, where official regulators are given access to client files) are accused of encouraging the growth of money laundering rather than legitimate business and finance. In the wake of 11 September 2001, a few have come under special scrutiny because they are thought to harbour terrorist funds; all are under pressure to freeze the assets of any account thought to be linked to terrorist organisations.

The Financial Stability Forum (FSF, for the G-8 finance departments) has called for the IMF to offer international financial policing, and for sanctions to be applied to offshore centres with tax regimes that can undermine the fiscal objectives of the major industrialized countries and/or allow money laundering. Switzerland has been one proactive centre, suspending secrecy laws which had protected clients. Other offshore centres are fighting back, arguing that as very small fish in the global economic pond, their views will never be properly represented by organisations such as the IMF, OECD or FSF. Williams (2000) and Francis (2000), governors of the central banks of Barbados and Bahamas, respectively, put forward convincing arguments that they have, through due diligence and careful regulation, granted offshore licences to high quality financial firms which are seeking out tax-efficient regimes for their clients rather than engaging in anything illegal.

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