Global Financial System: Functions and Risks

Introduction

Globalization has not only become one of the most defining forces of the 21st century but also one of the most impactful drivers of change in the financial sector. Several players are involved in the global financial system. Some of them include financial institutions, intergovernmental institutions, and central banks. Their activities are often centered on improving market operations by promoting transparency and regulation in the financial system.

The decision by countries to take part in international trade often has an effect on their monetary policies. Typically, their balance of payments reflects such decisions because they present a ratio of imports viz-a-viz exports. Individuals may also take part in the global financial system because they contribute to the production and consumption of goods and services in the same manner as companies do.

Governments and their proxies are also important stakeholders in the global financial system because they play the role of purveyors who are involved in crisis management and regulatory activities by formulating laws and collaborating with other international agencies to improve the quality of international trade. Research institutions and other organizations are also involved in the global financial system because they offer professional services in different fields of finance by acting as industry experts. Ordinarily, they publish reports, analyze data, and make policy briefs, which investors and governmental agencies rely on when making decisions regarding their investments or regulatory roles.

The global financial market carries with it several risks. These risks come from several areas of systemic vulnerability, which have necessitated the development of laws that guide international operations in the sector. However, there is a debate regarding how well these laws have addressed the inherent risks of globalization in the financial markets. This paper assumes a legal discussion regarding the extent that laws have addressed the main problems caused by globalization. However, to have a detailed understanding of the issue at hand, it is important to understand the key functions of the global financial system and the risks it generates.

Functions of the Global Financial System

The global financial system is simply a set of rules and procedures that countries and companies have agreed to abide by. Their objective is often to improve the financial flow of capital from one part of the world to another for purposes of investments or trade. At the core of the system are different players, including central banks, international treaties, and global organizations. Collectively, these tenets of the financial system interact in a broader global financial model that strives to promote transparency through regulation. This model serves several functions. Some of them are listed below.

Savings and Investment Function

It is difficult to imagine a world without financial institutions or a banking system because people would not have an opportunity to borrow against future income to make investments or even purchase personal items. The global financial system often acts as an instrument of financial savings, which allows investors to carry out different functions pertaining to the realization of their economic goals.

There are several financial instruments sold in the money market, which act as instruments for savings and investments. For instance, government bonds are often floated in the global money market to provide investors with an opportunity to save their surplus funds by making investments in the global financial system.

These funds generate wealth for individuals and companies alike. The saving function of global financial systems involves overcoming the transaction costs associated with processing savings and managing informational asymmetries involved with the same activity. Yan says convincing investors that their money will yield a profitable return is the only way people can entrust financial institutions with their savings. Over, they years, these institutions have comfortably done so.

As part of its investment function, the global financial system offers people opportunities for investing their excess money. Typically, such investment options are defined by the existence of firms that do business with multiple companies. To get the best returns, the banks have to convince their customers that the investments they will make with their money will be sound. Bell points out that most countries, which have well-developed financial markets can effectively pool people’s savings and generate significant economic opportunities for investment and exploit existing opportunities associated with economies of scale.

Credit Function

The provision of liquidity as a function of the global financial system is directly related to its credit function. The latter role is related to the need to provide credit services to finance consumption or support investment spending. In other words, the global financial system helps to mobilize savings from the market and make it available to investors who would then access credit by paying interest. In the absence of these financial systems, it would be difficult to undertake investments, which are not financed by individuals or closely-knit investment groups. At the same time, it would be difficult to envision a market where high-yield investments are pursued because low-risk ventures would be pursued because of limited access to credit.

The credit function played by the global financial system is linked with the development of many countries around the world. Elrod supports this view by saying that the economic growth of many countries is pegged on the availability of affordable credit. These insights show that the global financial system is responsible for the economic growth and development of many countries. In this regard, it supports market expansion, entrepreneurship, and the financing of important infrastructure projects.

Payment Function

The global financial system also acts as a guarantor of payments for people who are engaged in international trade. The system provides a mechanism for facilitating global trade. Available instruments of trade, which are offered to customers because of advancements in the financial system, include credit cards, checking accounts, and digital money. The payment role played by the global financial system is intermediary in nature because financial institutions simply guarantee transactions that occur between different players in the global market.

In this regard, the financial system creates a supportive framework for international trade by developing trust among people who have probably never seen each other. Some financial products, which support this role in financial market operations, include PayPal, MasterCard, and similar global payment services. Collectively, these services support financial transactions in different parts of the world. Therefore, the global financial system plays an important role in completing payments for different players in the financial system.

Risk Protection

The global financial system is also associated with risk management because it allows players in the international market to spread their risks when making investments. In this regard, the system facilitates the operationalization of international trade. Indeed, without proper risk management, it would be difficult to create stability in the global financial system or even realize investor confidence. Banks play this vital role because they are partly the custodians of the global financial system in the sense that they are the guarantors of global payments. Therefore, through their proper risk management strategies, investors can gain the confidence to take part in the global financial system.

According to Chase, the global financial system carries out the role of risk protection in three ways. The first one is cross-sectional risk diversification, which refers to the mitigation of risks associated with individual projects, firms, or entities in the financial system. Through the provision of various risk diversification tools, such as trading and financial pooling, it is easier to manage risks and positively influence long-term economic growth by improving resource allocation and savings.

The second way the global financial system performs the risk management function is through inter-temporal risk sharing. This type of risk management approach involves the protection of assets by distributing risks across a wider operational platform. For example, risks can be shared through exchange and can be averaged over a long period to minimize the impact that they would have on one firm or individual.

Hedging is one financial product that is often associated with the inter-temporal risk-sharing approach. Different types of techniques can be pursued within the hedging model. For example, various stakeholders in the global financial system are known to spread risks across different generations to minimize the impact they would have on businesses. This strategy is considered an important part of inter-temporal risk sharing.

The last way that the global financial system performs the risk management function is through liquidity risk assessment. The liquidity function is characterized by the ability of the global financial system to offer liquidity to people who hold financial instruments in the global market. This is a primary function of the global economic system because, without proper liquidity, it would be difficult to complete financial transactions. Furthermore, liquidity helps to solve urgent financial needs, especially for investors who need cash but hold instruments of capital, such as immovable assets.

The important role played by banks in improving liquidity within the industry is partly highlighted by Barnekow who says that without proper liquidity, markets would be unable to properly function. The importance of this statement was witnessed during the 2008 financial crisis because of the lack of liquidity caused major financial turmoil in the markets. Therefore, the global financial system ensures there is adequate liquidity in the markets to sustain global operations.

Policy Function

Lastly, the global financial system acts as a platform for governments to execute their policy functions by stabilizing their domestic economies and leveraging specific aspects of their operations with the global financial system. Such a strategy has been associated with attempts by governments to minimize disruptions in their economies or control inflation.

Major agents in the global financial system, such as banks and insurance companies also play an important advisory role to lawmakers and government agencies because they offer the professional knowledge needed to make well-informed decisions. In this regard, the global financial system plays a policy role in making sure that all players in the financial system operate in a fair and regulated manner. Although the functions defined above outline the benefits of the global financial system, taking part in it also comes with several risks.

Risks

Political Risk

Some researchers argue that globalization is the product of sound politics. If this is true, then it means that the very foundation of globalization (politics) poses a risk to the system. This kind of system vulnerability is called political risk. It refers to the potential to suffer losses or damages because of the instability of partner countries. Currently, there is a debate among many countries that globalization is not only designed to benefit the rich. If this argument is lost, it could unravel a significant political risk whereby people would start to reject globalization and everything it stands for because of the idea that it is not beneficial to them.

Although a complete reversal to protectionist policies is unlikely in such a case, the risk that an investor could lose the value of his/her investment based on differences in the political environment of as host country is real. Relative to this assertion, researchers, such as Kovalčíková have argued that the current wave of globalization is only less than three decades old and it is yet to be understood how much political risk would affect it.

Therefore, people have a reason to worry because past cycles of globalization have been ended by political risks, such as the outbreak of international political conflict, as was witnessed in 1914 and in the 1930s through the rise of fascism.

Lastly, it is important to point out that political risks are intertwined with country risks because the latter represents a combination of political and credit risks. Stated differently, country risks often refer to the potential for a host country to negatively influence the ability of a company to make debt repayments or expatriate foreign capital to their countries of origin. Such risks may discourage investors from participating in international trade in the first place.

Regulatory Challenges

The regulatory challenges associated with the global financial system are mostly borne from the operational risks of operating in a different country’s legal environment. According to Klopotan, the spread of false information through speculative practices could cause this problem. Therefore, when one financial institution is affected, others that are similarly positioned could also be impacted.

Most regulatory issues, which are linked with the poor performance of international financial markets, are associated with weak governance structures and the lack of a clear framework outlining who should enforce associated laws. Other regulatory challenges are also associated with the lack of sophistication regarding how to manage data in a global system and how to undertake risk aggregation tasks for purposes of professional reporting.

The complexities of cross-border regulatory changes have also made the international financial system less responsive to the regulatory needs of operating in a globalized system. For example, the uncertainty regarding property ownership is often a common problem for international players in the financial market because different jurisdictions have varied rules of property ownership. In some cases, countries do not have a well-developed legal structure to govern the ownership of intangible assets, such as intellectual property. The uncertainty regarding property ownership may affect operations in the global financial market because of variations in the legal environments of multiple countries.

Foreign Exchange Controls

Risks associated with foreign exchange controls refer to currency exchange costs when two or more parties are trading by using different currencies. In this regard, foreign exchange risks refer to the possibility that the value of an investment may change because of the use of multiple currencies in one transaction. Based on this type of vulnerability, foreign exchange risks have different types of exposures, which are often economic, translational, or contingent in nature. Poor foreign exchange controls may emerge as credit risks, especially in countries whose legal systems are unable to offer protection to foreign investors.

The Effectiveness of Regulation in Addressing Global Financial Risks

As mentioned in earlier sections of this essay, globalization has caused several risks in the financial market. To manage them, different countries have signed treaties that force them to abide by a common financial framework, which is supported by a larger umbrella group of laws known as the international financial law. It is important to respect these sets of laws because doing so creates stability in the global financial market.

However, as evidenced in several financial crises of a global nature, the stability sought in the financial market is often elusive because of weaknesses in the international regulatory environment. In other words, several legal loopholes in the legal environment allow credit, market, or financial risks to affect financial operations or investor confidence in the markets.

For example, regulation failed to effectively address the risks posed by having a global financial system. The 2007/2008 global financial crisis is evidence of this fact because it became clear to lawmakers that the legal environment was ill-equipped to manage the risks created by financial innovation. Researchers such as Kovras and others who recognize that institutional failures may have catalyzed the crisis support this view because lawmakers and important financial regulatory players were unable to contextualize the risks posed by a global financial system.

The pursuit of monetary-inspired legislative policies by central banks around the world has also partly failed to yield desired results because such policies cannot work in liberalized economies. Here, it is essential to point out that the main goal of pursuing a monetary-inspired policy is to create economic stability by controlling for inflation. However, experience has shown that inflation may go hand in hand with increases in the price of assets, which is often a product of growth in the credit market.

The financial risks posed by globalization were ineffectively addressed in the 2007 economic crisis because the types of products that were developed during the period were too sophisticated for lawmakers to understand the risks they posed.

Often, it was not that laws were absent; it is that they were ineffective in holistically regulating the financial environment to avert the crisis. For example, the Basel Accord, which is a series of banking laws supposed to protect the industry from market, capital, and operational risks, was unable to deliver its mandate. Particularly, the law is supposed to ensure that banks and financial institutions have enough capital to meet expected and unexpected financial obligations.

However, financial institutions that were subject to these laws were unable to meet their financial obligations because of illiquidity issues. In some instances, such as the case of the AIG Insurance firm, these organizations assumed too much risk than they could possibly handle and this is why they needed a government bailout to meet their financial obligations. Ideally, existing regulations should have presented such a risk from causing havoc in the sector, but this did not happen. Therefore, the Basel Accord was ineffective in protecting the banking sector from the 2007/2008 crisis because it contained several loopholes of legislative arbitrage, which made it difficult to respond to market risks caused by globalization.

In a different sphere of analysis, it is important to note that the ability of a housing market crisis in America to affect global financial markets is another testament to the ineffectiveness of the global legal environment to contain financial crises when they happen. In other words, the spread of the 2007/2008 global financial crisis shows how interconnected the global financial system is. This interconnectedness means that the financial risks of one market or part of the world could easily affect a seemingly unrelated part of the globe. This phenomenon is partly explained by the pursuit of several liberal trading policies by governments, which are trying to attract more investors who have capital resources.

The main challenge facing many of these governments is the difficulty in balancing their national or domestic interests with those of their investors because they want to avoid a situation where companies would choose to relocate their capital to other countries because of the fear that their interests would not be protected. The current legal environment is unable to effectively respond to some of these risks because the interconnected nature of the global financial system today still means that a crisis in one part of the world could cause serious financial losses in another. Therefore, although international trade is interlinked, financial regulation is yet to demonstrate the same interconnectivity to manage any risks that could emerge from the same linkage.

Overall, the challenge associated with the pursuit of global financial stability stems from jurisdictional differences across the world. At the same time, these countries are pursuing their own agendas and interests that may at times be to the detriment of their partners. Therefore, the goal of international regulation should not only be focused on facilitating global transactions but also making sure that the entire financial ecosystem is stable.

Particularly, there should be an attempt to make sure that institutional problems in one part of the system are not allowed to affect others. Furthermore, in a world where markets are converging and people are becoming more integrated, it is necessary to introduce new regulations that guard against the moral hazards of operating in the global financial system. These moral hazards largely explain why regulation has been unable to address the challenges associated with the global financial system.

Some jurisdictions have already recognized this challenge and are developing new regulatory frameworks to address these challenges. For example, the European Union (EU) has introduced changes to its legislative framework to create a new supervisory structure, which transposes new international standards of operation in the global financial system.

Conclusion

This paper has shown that the main functions of the global financial system are to promote savings and investments, provide credit services, facilitate payments, manage risks, and develop trade policies. These functions of the global financial system are premised on the fact that most financial services sought by the public (in the global financial system) include payment, thrift, insurance, credit, hedging, and agency services.

Therefore, the global financial system is aimed at supporting the activities of these key players in trade development. However, as alluded in the introduction section of this report, participation in the global financial system is associated with several risks, which include foreign exchange control, regulatory control, and political control. If left unaddressed, these risks could have a significant impact on the soundness of the global financial system.

Regulation has not effectively managed to address the above-mentioned risks because the global financial system is characterized by rapid innovation, which could easily by-pass existing regulatory controls. For example, the failure of the Basel Accord to protect banks from systemic risks associated with the 2007/2008 global financial crisis is a testament to this fact. In this regard, regulation is too slow to change and cannot keep up with the pace of change that is characteristic of the global financial system.

The pursuit of monetary-inspired legislative agreements by most of the world’s central banks is also another evidence of the ineffectiveness of the regulatory framework to manage the challenges that exist in the global financial network because monetary policies are unable to effectively address all types of risks evident in the market. Based on these insights, there is a need to review the policy environment to make it more responsive to changes in the global financial sector.

However, in a world where different investors and nations have varied interests in the global market, it is important to be realistic and recognize that difficulties may exist in making stakeholders support a common regulatory goal. Therefore, going forward, there is a need for countries to reconcile their national interests and those of their investors because there should be harmony between the two to avert the possibility of future financial catastrophes.

Bibliography

Arestis P and others, ‘Regional Financialisation and Financial Systems Convergence: Evidence from Italy’ (2017) 49 EPES 141.

Barnekow S and others, ‘Why Regionalism? A Look at the Costs and Benefits of Regional Trade Agreements in Africa’ (2017) 18 GBR 99.

Bauer M, ‘The Political Power of Evoking Fear: The Shining Example of Germany’s Anti-TTIP Campaign Movement’ (2016) 15 EV 193.

Bell S and others, ‘Structural Power and the Politics of Bank Capital Regulation in the The United Kingdom’ (2017) 65 PS 103.

Best A and others, ‘Financial Deepening and Economic Growth in Jamaica’ (2017) 18 GBR 1.

Beveridge R, ‘The (Ontological) Politics in Depoliticisation Debates: Three Lenses on the Decline of the Political’ (2017) 15 PSR 589.

Bulmer S and others, ‘European Integration in Crisis? Of Supranational Integration, Hegemonic Projects and Domestic Politics’ (2016) 22 EJIR 725.

Cerny P and others, ‘The New Anarchy: Globalisation and Fragmentation in World Politics’ (2017) 13 JIPT 378.

Chase P, ‘TTIP, Investor-State Dispute Settlement and the Rule of Law’ (2015) 14 EV 217.

Dwivedi A, ‘Book Review: Harinder S. Kohli and Ashok Sharma, A Resilient Asia Amidst Global Financial Crisis: From Crisis Management to Global Leadership’ (2017) 26 JE 130.

Elrod A, ‘Beg, Borrow, or Steal: Between Debt and the Devil: Money, Credit, and Fixing Global Finance and How the Other Half Banks: Exclusion, Exploitation, and the Threat to Democracy’ (2017) 26 NLF 112.

Emenike K, ‘Weak-Form Efficiency After Global Financial Crisis: Emerging Stock Market Evidence’ (2017) 16 JEMF 90.

Englert M and others, ‘The Effects of Financial Crisis on the Organizational Reputation of Banks: An Empirical Analysis of Newspaper Articles’ (2018) 3 BS 1.

Ferdinand S, ‘Book Review: Narrating the Global Financial Crisis: Urban Imaginaries and the Politics of Myth’ (2018) 15 US 3492.

Hajilee M and others, ‘Financial Depth and Exchange Rate Volatility: A Multicountry Analysis’ (2017) 62 TAE 19.

Hall N and others, ‘Global Climate Adaptation Governance: Why Is It Not Legally Binding?’ (2018) 24 EJIR 540.

Klopotan I and others, ‘Early Warning System in Business, Finance, and Economics: Bibliometric and Topic Analysis’ (2018) 10 IJEBM 1.

Kopp S and others, ‘Protecting Appearance and Atmospherics: Trade Dress as a Component of Retail Strategy’ (2014) 33 JPPM 34.

Kovalčíková N, ‘Globalisation and the Threats It Poses in the Twenty-First Century’ (2014) 13 EV 169.

Kovras I and others, ‘Truth Commissions After Economic Crises: Political Learning or Blame Game?’ (2018) 66 PS 173.

Lysenko D and others, ‘Does Canada Need Trade Adjustment Assistance?’ (2017) 72 IJ 91.

Mathur S and others, ‘Modelling the Impact of Global Financial Crisis on the Indian Stock Market Through GARCH Models’ (2016) 12 AJMRI 11.

Nölke A and others, ‘Domestic Structures, Foreign Economic Policies and Global Economic Order: Implications from the Rise of Large Emerging Economies’ (2015) 21 EJIR 538.

Pappalardo J, ‘Contributions by Federal Trade Commission Economists to Consumer Protection: Research, Policy, and Law Enforcement’ (2014) 33 JPPM 24.

Pernell K and others, ‘The Hazards of Expert Control: Chief Risk Officers and Risky Derivatives’ (2017) 82 ASR 511.

Peters M and others, ‘Global Financial Crisis and Educational Restructuring’ (2015) 14 CSEE 15.

Raheem I, ‘More Finance or Better Finance in Feldstein–Horioka Puzzle: Evidence from SSA Countries’ (2017) 18 GBR 132.

Steenbergen M and others, ‘Better the Devil You Know? Risk-Taking, Globalization and Populism in Great Britain’ (2017) 18 EUP 119.

Stephen M, ‘Rising Powers, Global Capitalism and Liberal Global Governance: A Historical Materialist Account of the BRICS Challenge’ (2014) 20 EJIR 912.

Swami O and others, ‘Value-at-Risk Estimation of Foreign Exchange Rate Risk in India’ (2016) 12 AJMRI 1.

Tate J, ‘Locke, Toleration and Natural Law: A Reassessment’ (2017) 16 EJPT 109.

Tejpar A, ‘The Challenges of Federalism to Canada’s International Trade Relations: The Canada-European Union Comprehensive Economic and Trade Agreement’ (2017) 72 IJ 111.

Tovar-García E and others, ‘The Third Pillar of the Basel Accord: Evidence of Borrower Discipline in the Kyrgyz Banking System’ (2016) 7 JES 195.

Treepongkaruna S and others, ‘Explaining the Bid-Ask Spread in the Foreign Exchange Market: A Test of Alternate Models’ (2014) 39 AJM 573.

Tyc A, ‘Workers’ Rights and Transatlantic Trade Relations: The TTIP and Beyond’ (2017) 28 ELRR 113.

Yan S and others, ‘The Rise of Socially Responsible Investment Funds: The Paradoxical Role of the Financial Logic’ (2018) 12 ASQ 1.

Cite this paper

Select style

Reference

BusinessEssay. (2024, November 25). Global Financial System: Functions and Risks. https://business-essay.com/global-financial-system-functions-and-risks/

Work Cited

"Global Financial System: Functions and Risks." BusinessEssay, 25 Nov. 2024, business-essay.com/global-financial-system-functions-and-risks/.

References

BusinessEssay. (2024) 'Global Financial System: Functions and Risks'. 25 November.

References

BusinessEssay. 2024. "Global Financial System: Functions and Risks." November 25, 2024. https://business-essay.com/global-financial-system-functions-and-risks/.

1. BusinessEssay. "Global Financial System: Functions and Risks." November 25, 2024. https://business-essay.com/global-financial-system-functions-and-risks/.


Bibliography


BusinessEssay. "Global Financial System: Functions and Risks." November 25, 2024. https://business-essay.com/global-financial-system-functions-and-risks/.