Three decades ago, a manufacturer building a new factory would probably have been restricted to borrowing from a domestic

bank. Today it has many more options to choose from. It can shop around the world for a loan with a lower interest rate and borrow in foreign currency if foreign-currency loans offer more attractive terms than domestic-currency loans; it can issue stocks or bonds in either domestic or international capital markets; and it can choose from a variety of financial products designed to help it hedge against possible risks. It can even sell equity to a foreign company. A look at how financial globalization has occurred, and the form it is taking, offers insights into its benefits as well as the new risks and challenges it has generated. Forces driving globalization What has driven the globalization of finance? Four main factors stand out. Advances in information and computer technologies have made it easier for market participants and country authorities to collect and process the information they need to measure, monitor, and manage financial risk; to price and trade the complex new financial instruments that have been developed in recent years; and to manage large books of transactions spread across international financial centers in Asia, Europe, and the Western Hemisphere. The globalization of national economies has advanced significantly as real economic activityproduction, consumption, and physical investmenthas been dispersed over different countries or regions. Today, the components of a television set may be manufactured in one country and assembled in another, and the final product sold to consumers around the world. New multinational companies have been created, each producing and distributing its goods and services through networks that span the globe, while established multinationals have expanded internationally by merging with or acquiring foreign companies. Many countries have lowered barriers to international trade, and crossborder flows in goods and services have increased significantly. World exports of goods and services, which averaged $2.3 billion a year during 1983-92, have more than tripled, to an estimated $7.6 billion in 2001. These changes have stimulated demand for cross-border finance and, in tandem with financial liberalization, fostered the creation of an internationally mobile pool of capital and liquidity. The liberalization of national financial and capital markets, coupled with the rapid improvements in information technology and the globalization of national economies, has catalyzed financial innovation and spurred the growth of cross-border capital movements. The globalization of financial intermediation is partly a response to the demand for mechanisms to intermediate cross-border flows and partly a response to declining barriers to trade in financial services and liberalized rules governing the entry of foreign financial institutions into domestic capital markets. Global gross capital flows in 2000 amounted to $7.5 trillion, a fourfold increase over 1990. The growth in cross-border capital movements also resulted in larger net capital flows, rising from $500 billion in 1990 to nearly $1.2 trillion in 2000. Competition among the providers of intermediary services has increased because of technological advances and financial liberalization. The regulatory authorities in many countries have altered rules governing financial intermediation to allow a broader range of

institutions to provide financial services, and new classes of nonbank financial institutions, including institutional investors, have emerged. Investment banks, securities firms, asset managers, mutual funds, insurance companies, specialty and trade finance companies, hedge funds, and even telecommunications, software, and food companies are starting to provide services similar to those traditionally provided by banks. Changes in capital markets These forces have, in turn, led to dramatic changes in the structure of national and international capital markets. First, banking systems in the major countries have gone through a process of disintermediationthat is, a greater share of financial intermediation is now taking place through tradable securities (rather than bank loans and deposits). Both financial and nonfinancial entities, as well as savers and investors, have played key roles in, and benefited from, this transformation. Banks have increasingly moved financial risks (especially credit risks) off their balance sheets and into securities marketsfor example, by pooling and converting assets into tradable securities and entering into interest rate swaps and other derivatives transactionsin response both to regulatory incentives such as capital requirements and to internal incentives to improve risk-adjusted returns on capital for shareholders and to be more competitive. Corporations and governments have also come to rely more heavily on national and international capital markets to finance their activities. Finally, a growing and more diverse group of investors are willing to own an array of credit and other financial risks, thanks to improvements in information technology that have made these risks easier to monitor, analyze, and manage. Second, cross-border financial activity has increased. Investors, including the institutional investors that manage a growing share of global financial wealth, are trying to enhance their risk-adjusted returns by diversifying their portfolios internationally and are seeking out the best investment opportunities from a wider range of industries, countries, and currencies. At the wholesale level, national financial markets have become increasingly integrated into a single global financial system. The major financial centers now serve borrowers and investors around the world, and sovereign borrowers at various stages of economic and financial development can access capital in international markets. Multinational companies can tap a range of national and international capital markets to finance their activities and fund crossborder mergers and acquisitions, while financial intermediaries can raise funds and manage risks more flexibly by accessing markets and pools of capital in the major international financial centers. Third, the nonbank financial institutions are competingsometimes aggressivelywith banks for household savings and corporate finance mandates in national and international markets, driving down the prices of financial instruments. They are garnering a rising share of savings, as households bypass bank deposits to hold their funds in higher-return instrumentssuch as mutual fundsissued by institutions that are better able to diversify risks, reduce tax burdens, and take advantage of economies of scale, and have grown dramatically in size as well as in sophistication. Fourth, banks have expanded beyond their traditional deposit-taking and balance-sheetlending businesses, as countries have relaxed regulatory barriers to allow commercial banks to enter investment banking, asset management, and even insurance, enabling them to

diversify their revenue sources and business risks. The deepening and broadening of capital markets has created another new source of business for banksthe underwriting of corporate bond and equity issuesas well as a new source of financing, as banks increasingly turn to capital markets to raise funds for their own investment activities and rely on over-the-counter (OTC) derivatives marketsdecentralized markets (as opposed to organized exchanges) where derivatives such as currency and interest rate swaps are privately traded, usually between two partiesto manage risks and facilitate intermediation. Banks have been forced to find additional sources of revenue, including new ways of intermediating funds and fee-based businesses, as growing competition from nonbank financial intermediaries has reduced profit margins from banks' traditional business corporate lending financed by low-cost depositsto extremely low levels. This is especially true in continental Europe, where there has been relatively little consolidation of financial institutions. Elsewhere, particularly in North America and the United Kingdom, banks are merging with other banks as well as with securities and insurance firms in efforts to exploit economies of scale and scope to remain competitive and increase their market shares. Benefits versus risks All in all, the radical change in the nature of capital markets has offered unprecedented benefits. But it has also changed market dynamics in ways that are not yet fully understood. One of the main benefits of the growing diversity of funding sources is that it reduces the risk of a "credit crunch." When banks in their own country are under strain, borrowers can now raise funds by issuing stocks or bonds in domestic securities markets or by seeking other financing sources in international capital markets. Securitization makes the pricing and allocation of capital more efficient because changes in financial risks are reflected much more quickly in asset prices and flows than on bank balance sheets. The downside is that markets have become more volatile, and this volatility could pose a threat to financial stability. For example, the OTC derivatives markets, which accounted for nearly $100 trillion in notional principal and $3 trillion in off-balance-sheet credit exposures in June 2001, can be unpredictable and, at times, turbulent. Accordingly, those in charge of preserving financial stability need to better understand how the globalization of finance has changed the balance of risks in international capital markets and ensure that private risk-management practices guard against these risks. Another benefit of financial globalization is that, with more choices open to them, borrowers and investors can obtain better terms on their financing. Corporations can finance physical investments more cheaply, and investors can more easily diversify internationally and tailor portfolio risk to their preferences. This encourages investment and saving, which facilitate real economic activity and growth and improve economic welfare. However, asset prices may overshoot fundamentals during booms and busts, causing excessive volatility and distorting the allocation of capital. For example, real estate prices in Asia soared and then dropped precipitously before the crises of 1997-98, leaving many banks with nonperforming loans backed by collateral that had lost much of its value. Also, as financial risk becomes actively traded among institutions, investors, and countries, it becomes harder to identify potential weaknesses and to gauge the magnitude of risk. Enhanced transparency about economic and financial market fundamentals, along with a better understanding of why asset market booms and busts occur, can help markets better manage these risks.

Finally, creditworthy banks and firms in emerging market countries can reduce their borrowing costs now that they are able to tap a broader pool of capital from a more diverse and competitive array of providers. However, as we saw during the Mexican crisis of 199495 and the Asian and Russian crises of 1997-98, the risks involved can be considerable including sharp reversals of capital flows, international spillovers, and contagion. (Even though the extent of contagion seems to have decreased, for reasons that are still unclear, since the 1997-98 crises, the risk of contagion cannot be ruled out.) Emerging market countries with weak or poorly regulated banks are particularly vulnerable, but such crises can threaten the stability of the international financial system as well. Safeguarding financial stability The crises of the 1990s underscored the need for prudent sovereign debt management, properly sequenced capital account liberalization, and well-regulated and resilient domestic financial systems, to ensure national and international financial stability. Private financial institutions and market participants can contribute to financial stability by managing their businesses and financial risks well and avoiding imprudent risk takingin part by responding to market incentives and governance mechanisms, such as maximizing shareholder value and maintaining appropriate counterparty relationships in markets. In effect, the first lines of defense against financial problems and systemic risks are sound financial institutions, efficient financial markets, and effective market discipline. But, because financial stability is also a global public good, national supervisors and regulators must also play a role. Indeed, this role is becoming increasingly international in scopefor example, through a strengthening of coordination and information sharing across countries and functional areas (banking, insurance, securities) to identify financial problems before they become systemic. The IMF itself has an important role to play. In accordance with its global surveillance mandate, it has launched a number of initiatives to enhance its ability to contribute to international financial stability: identifying and monitoring weaknesses and vulnerabilities in international financial markets; developing early warning systems for international financial market imbalances; conducting research into the nature and origins of international financial crises and the channels of contagion; and seeking ways to contain and resolve crises quickly and smoothly, for example, by involving the private sector. I would like to acknowledge the assistance of my colleagues in the International Capital Markets Department in preparing this article, in particular, the Financial Market Stability Division.

In this age of globalization, the key to survival and success for many financial institutions is to cultivate strategic partnerships that allow them to be competitive and offer diverse services to consumers. In examining the barriers to - and impact of - mergers, acquisitions and diversification in the financial services industry, it's important to consider the keys to survival in this industry: 1. Understanding the individual client's needs and expectations 2. Providing customer service tailored to meet customers' needs and expectations In 2008, there were very high rates of mergers and acquisition (M&A) in the financial services sector. Let's take a look at some of the regulatory history that contributed to changes in the financial services landscape and what this means for the new landscape investors now need to traverse. Diversification Encouraged by Deregulation The ability for business entities to use the internet to deliver financial services to their clientle also impacted the product-oriented and geographic diversification in the financial services arena. Because large, international mergers tend to impact the structure of entire domestic industries, national governments often devise and implement prevention policies aimed at reducing domestic competition among firms. Beginning in the early 1980s, the Depository Institutions Deregulation and Monetary Control Act of 1980 and the Garn-St. Germaine Depository Act of 1982 were passed. By providing the Federal Reserve with greater control over non-member banks, these two acts work to allow banks to merge and thrift institutions (credit unions, savings and loans and mutual savings banks) to offer checkable deposits. These changes also became the catalysts for the dramatic transformation of the U.S. financial service markets in 2008 and the emergence of reconstituted players as well as new players and service channels. (For more on this, check out our Financial Crisis Survival Guide special feature.) Nearly a decade later, the implementation of the Second Banking Directive in 1993 deregulated the markets of European Union countries. In 1994, European insurance markets underwent similar changes as a result of the Third Generation Insurance Directive of 1994. These two directives brought the financial services industries of the United States and Europe into fierce competitive alignment, creating a vigorous global scramble to secure customers that had been previously unreachable or untouchable. Going Global Asian markets joined the expansion movement in 1996 when "Big Bang" financial reforms brought about deregulation in Japan. Relatively far-reaching financial systems in that country became competitive in a global environment that was enlarging and changing swiftly. By 1999, nearly all remaining restrictions on foreign exchange transactions between Japan and other countries were lifted. (For background on Japan, see The Lost Decade: Lessons From Japan's Real Estate Crisis and Crashes: The Asian Crisis.) Following the changes in the Asian financial market, the United States continued to

implement several additional stages of deregulation, concluding with the Gramm-LeachBliley Act of 1999. This law allowed for the consolidation of major financial players, which pushed U.S.-domiciled financial service companies involved in M&A transactions to a total of $221 billion in 2000. According to a 2001 study by Joseph Teplitz, Gary Apanaschik and Elizabeth Harper Briglia in Bank Accounting & Finance, expansion of such magnitude involving trade liberalization, the privatization of banks in many emerging countries and technological advancements has become a rather common trend. (For more insight, see StateRun Economies: From Public To Private.) The immediate effects of deregulation were increased competition, market efficiency and enhanced consumer choice. Deregulation sparked unprecedented changes that transformed customers from passive consumers to powerful and sophisticated players. Studies suggest that additional, diverse regulatory efforts further complicated the running and managing of financial institutions by increasing the layers of bureaucracy and number of regulations. (For more on this topic, see Free Markets: What's The Cost?) Simultaneously, the technological revolution of the internet changed the nature, scope and competitive landscape of the financial services industry. Following deregulation, the new reality has each financial institution essentially operating in its own market and targeting its audience with narrower services, catering to the demands of a unique mix of customer segments. This deregulation forced financial institutions to prioritize their goals by shifting their focus from rate-setting and transaction-processing to becoming more customer-focused. Challenges and Drawbacks of Financial Partnerships Since 1998, the financial services industry in wealthy nations and the United States has been experiencing a rapid geographic expansion; customers previously served by local financial institutions are now targeted at a global level. Additionally, according to Alen Berger and Robert DeYoung in their article Technological Progress and the Geographic Expansion of the Banking Industry (Journal of Money, Credit and Banking, September 2006), between 1985 and 1998, the average distance between a main bank and its affiliates within U.S. multibank holding companies has increased by more than 50%, from 123.4 miles to 188.9 miles. This indicates that the increased ability of banks to make small business loans at greater distances enabled them to suffer fewer diseconomies of scale and boost productivity. (To learn more, check out Competitive Advantage Counts.) Deregulation has also been the major factor behind this geographic diversification, and beginning in the early 1980s, a sequence of policy changes implemented a gradual reduction of intrastate and interstate banking restrictions. In the European Union, a similar counterpart of policy changes enabled banking organizations and certain other financial institutions to extend their operations across the member-states.Latin America, the transitional economies of Eastern Europe and other parts of the world also began to lower or eliminate restrictions on foreign entry, thus enabling multinational financial institutions headquartered in other countries to attain considerable market shares. Transactions without Boundaries, Borders Recent innovations in communications and information technology have resulted in a reduction in diseconomies of scale associated with business costs faced by financial institutions contemplating geographic expansion. ATM networks and banking websites has

enabled efficient long-distance interactions between institutions and their customers, and consumers have become so dependent on their newfound ability to conduct boundary-less financial transactions on a continuous basis that businesses lose all competitiveness if they are not technologically connected. An additional driving force for financial service firms' geographic diversification has been the proliferation of corporate combination strategies such as mergers, acquisitions, strategic alliances and outsourcing. Such consolidation strategies may improve efficiency within the industry, resulting in M&As, voluntary exit, or forced withdrawal of poorly performing firms. Consolidation strategies further empower firms to capitalize on economies of scale and focus on lowering their unit production costs. Firms often publicly declare that their mergers are motivated by a desire for revenue growth, an increase in product bases, and for increased shareholder value via staff consolidation, overhead reduction and by offering a wider array of products. However, the main reason and value of such strategy combinations is often related to internal cost reduction and increased productivity. (For further reading, check out What Are Economies of Scale?) Unfavorable facts about the advantages and disadvantages of the major strategies used as a tool for geographic expansions within the financial services sectors were obscured in 2008 by the very high rates of M&As, such as those between Nations Bank and Bank of America (NYSE:BAC), Travelers Group and Citicorp (NYSE:C), JP Morgan Chase (NYSE:JPM) and Bank One. Their dilemma was to create a balance that maximized overall profit. Conclusion The conclusion regarding the impact, advantages and disadvantages of domestic and international geographic diversification and expansion on the financial service industry is the fact that with globalization, the survival and success of many financial service firms lies in understanding and meeting the needs, desires and expectations of their customers. The most important and continually emerging factor for financial firms to operate successfully in extended global markets is their ability to efficiently serve discerning, highly sophisticated, better educated, more powerful consumers addicted to the ease and speed of technology. Financial firms that do not to realize the significance of being customer-oriented are wasting their resources and eventually will perish. Businesses that fail to recognize the impact of these consumer-driven transformations will struggle to survive or cease to exist in a newly forged global financial service community that has been forever changed by deregulation. (To learn more about this industry, check out The Evolution of Banking.) Read more: http://www.investopedia.com/articles/financial-theory/09/risk-free-ratereturn.asp#ixzz1UHMMQ02Z