Understanding Financial Interconnectedness

Ashby Monk

Here’s the thing with globalization: It’s got baggage. Don’t get me wrong, I love to start my days with an Ethiopian coffee and a French croissant while I watch my Japanese TV and surf my American computer (made in China), all while waiting for my Finnish phone to ring so I can explain to my Dutch and Australian colleagues (who work at Oxford) my plans for an upcoming conference in Tunisia (which is being run by an American company through offices in London) and a research trip to Abu Dhabi. Come on, how could you not love globalization? Could you live without curry, burritos, sushi, or Chinese takeout? Maybe, but I’m not sure I’d want to.

But…and there is always a but…globalization definitely has its detractions. Beyond the clear shortcomings of the ‘rising tide lifts all boats‘ analogy, globalization causes real problems for macroeconomic risk management. For example, when country A opens its markets up to country B (and vice versa), they create mutual dependencies through trade and specialization. Accordingly, each country implicitly accepts a certain level of vulnerability to the other country’s internal problems. And, when these problems are contagious, it follows that contagion can result.

This contagion can be in the form of a health related pandemic, such as SARS or [insert animal name here] flu. Alternatively, it can be in the form of an economic malaise, which is the case this morning. Indeed, global markets are off today due to fears that Ireland’s economic woes will spread to its economic partners around with world. In case you’re in a cave somewhere (…probably catching the Marburg virus before hopping a direct flight to my hometown…), Ireland may need an 85 billion euro rescue package (50 billion to finance the government and 35 billion to save Irish banks from collapse). And, as you might expect, there are plenty of reports out today about contagion fears — and these fears are already affecting currency and asset markets.

Anyway, all this interconnectivity and interdependence has inspired me to unleash some serious economic geography on you today. In particular, I think a brief discussion of a recent IMF Staff Paper, entitled “Understanding Financial Interconnectedness”, seems particularly apropos. Here’s a blurb:

“Countries are financially interconnected through the asset and liability management (ALM) strategies of their sovereigns, financial institutions, and corporations. This financial globalization has brought benefits as well as vulnerabilities. In particular, the speed with which illiquidity and losses in some markets can translate into global asset re-composition points to the risks of interconnectedness…

“This paper takes initial steps toward understanding financial interconnectedness by first outlining the architecture of cross-border finance and then exploring two related fault lines—funding models and ratings—that played a pivotal role in the global financial crisis….The paper uses available data on cross- border banking from the Bank for International Settlements (BIS) in the run up to and during the crisis, as well as a novel dataset on the global funds industry (money market, mutual, hedge, exchange-traded, and pension funds), to illustrate global financial interconnections and risk concentrations in the run up to the crisis. To be very clear, the paper does not construct a global risk map, nor does it attempt to point out where systemic risks are currently building up or might arise in the future. There are significant data gaps that preclude the completion of a comprehensive risk map—gaps that can only be bridged with buy-in from the membership on the value of such an exercise. The role of this paper is to suggest how such analyses might be undertaken and to offer some new perspectives on augmenting financial surveillance at the multilateral and bilateral levels.”

Gotcha. But these humble authors do offer up some cool insights that are worth flagging. For example, this figure shows the extent to which cross-border financial interconnectedness has increased over the past 25 years:

Next, the paper offers a cool graphic highlighting the “principal nodes” for cross-border funds in the global economy. What’s particularly relevant here is Ireland’s prominent role therein:

Finally, the paper illustrates the extent to which Ireland has become a major hub for assets under management. The country apparently has 3% of the world’s assets:

All this is to say that it’s in all our interests that Ireland get its act together. The global economy is highly dependent on this small European country, which makes a sovereign default or banking collapse potentially calamitous.

To bring this back to SWFs, this interconnectedness is, in large part, what inspired so many countries to begin hoarding reserves: self-insurance against other countries’ problems. You know what they say…

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This website is a project of Professor Gordon L. Clark and Dr. Ashby Monk of the School of Geography and the Environment at the University of Oxford. Their research on sovereign wealth funds is funded by the Leverhulme Trust and The Rotman International Centre for Pension Management.

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