Financial Institutions and Markets - Essay Example

FINANCIAL S AND MARKETS The bedrock of modern economies is financial s. We have evolved far away from the simple barter economyto a sophisticated and complicated economic system which is based on financial institutions. A financial market consisting of many different types of financial institutions is one of the most vital components and a very important characteristic of any economy. Financial markets are a mechanism that facilitates exchange of capital and credit in an economy, examples of which include; stock market, bond market, commodities market, and foreign exchange market. The institutions in such markets can be very simply defined as an establishment that deals with all the financial transactions that take place in an economy ranging from depositing, taking loans, exchanging currencies to buying bonds, securities or other investments, with a sole purpose of collecting funds from public or other sources and placing them in financial assets (Investopedia) . Financial institutions are also commonly referred to as financial intermediaries as they act as the middle man between savers and borrowers. It is imperative to understand as to how financial institutions serve as intermediaries. Individuals deposit funds at commercial banks, purchase mutual funds or insurance premiums, and contribute to pension plans and the financial institutions then channel these funds towards the borrowers Categorization of FI varies from country to country, changes over time and is largely governed by the current financial customs and legal system (GOLDSMITH, Raymond W, 1958). Financial intermediaries are divided into 2 major categories; Banks (deposit-type) and non banks (non-deposit-type). The deposit-type institutions are further divided into commercial banks, savings and loans associations and credit unions, whereas the non-deposit-type institutions are divided into mutual fund companies and brokerage companies (Know the Different Types of Financial Institutions). Furthermore, there exist some differences and commonalities between these institutions. One element that is common to all financial institutions is that they all function by channeling funds from the savers to the borrowers. Moreover, they are all regulated by the Central Bank. On the other hand the Differences between these institutions are many, the basic difference being that some institutions accept deposits and others don’t. Within deposit taking institutions, there exist a difference in ownership and governance as in the case of banks and credit unions. Another difference between banking and non banking institution is marked by the fact that the former is involved in savings, investments and business transaction while the latter focuses primarily on investments only. Yet another difference is in terms of the range of services the institution offers, some offer basic services like checking and savings account as in the case of a bank while others offer full range of services like mortgages (The Difference between a Bank, a Credit Union and a Savings Institution). Amongst all the financial institutions the banks are the single most regulated entities and unlike the others banks collectively have the ability to create money through the credit multiplier process. The basic role of a financial intermediary is to provide “low-cost” funds to those who require them by collecting from those who wish to save. Another very common role of a financial intermediary is that of an advisor for investment by telling their clients as to where it is profitable to invest. The creation of money or funds that people/businesses/governments borrow takes place at these financial institutions by their efficient channeling of funds from the surplus units to the deficit units. Their role is to bring together the lenders and the borrowers and facilitate the transactions between the two which is favorable to both (MORAWSKI, Adriana, 2007) There are six basic functions of financial institutions: borrowing and lending, price determination, information aggregation and coordination, risk sharing, liquidity, efficiency. In order to understand the functions of the financial institutions let us introduce 2 units in the economy; the surplus spending unit and the deficit spending unit. These 2 units consist of household, businesses, government and foreigners. When these units save they become lenders and when they borrow they become borrowers. Financial intermediaries deals with indirect financing by acting as a middle man between the surplus and deficit units and it deals with direct financing by collecting and providing funds for a particular sector or individual in the financial markets (IRELAND, Peter N.). Because of their large size and expertise they are able to take advantage of economies of scales. The low transaction costs allow them to offer liquidity services. in addition, In addition, financial intermediaries are able to greatly reduce potential risks by sharing the risks among various investors and achieving significant diversification due to the large and varied volume of resources the operate upon, thereby turning the risky assets into safer ones for the benefit of investors. A large pool of academic research across the world has demonstrated that a highly developed financial system has played an important role in economic development which clearly proves how beneficial financial institutions and markets are for any economy. (TUMPEL-GUGERELL, Gertrude, 2003). They allow the economy to reach its potential by providing means, in terms of funds, to exploit the opportunities worldwide. There was an era of debate and disagreement between different economists on finance-economic growth relationship. However, in the recent years economists are reexamining the importance of financial markets in economic growth (BRANDL, Michael W.). The fact that the commercial banking system as a whole can create money makes them critical factor in the economic development of a country. They are the instruments through which the governments implement their monetary policies. Role of a commercial bank in developing a country includes a number of areas. Commercial banks help in mobilizing savings through a network of branch banking. By mobilizing savings, the bank channelizes them into productive investment, helping capital formation. Commercial banks help finance industrial sector by providing short term, medium term and long term loans to the industry. Besides this they also underwrite the shares and the debentures of large scale industries which not only provide finance for the industry but also help in developing the capital market. Commercial banks also help in financing both internal and external trade. The banks provide loans to retailers and wholesalers to stock goods and they also help in the movement of goods from one place to another by providing all types of facilities such as discounting and accepting bill of exchange, providing over draft facilities etc. They also finance both imports and exports by providing foreign exchange facilities to importers and exporters. (Banking Services and Financial Institutions) Commercial banks help agricultural sector by providing the agricultural credit to farmers and financial assistance to dairy farmers, poultry farmers, livestock breeders etc. Furthermore, they advance loans to consumers to buy durable consumer goods like houses television sets cars etc. In this way they help raise the living standards of people by providing loans for consumptive activities. Commercial banks also help give loans to young entrepreneurs and other technically trained persons who are interested in establishing their own businesses. Thus these banks not only help in human capital formation but also help in increasing entrepreneurial activities. Finally commercial banks help the economic development of any country by faithfully following the monetary policy of the central bank. In fact the central bank depends upon the commercial banks for the success of its policies of monetary management in keeping with the requirements of the economy. (JHINGAN, M.L, 1984) However the line between commercial banks and other financial intermediaries has been steadily blurred as commercial banks have undertaken more and more functions previously carried out by non-bank intermediaries. Today commercial banks routinely deal in foreign exchange, offer higher purchase, leasing and mortgage facilities, provide investment portfolio services, act as capital market intermediaries by facilitating IPOs etc. This has created both benefits and drawbacks. The benefits to the consumer are that the commercial bank now offers a one-stop experience for its clients. On the other hand banks reap the advantages of economies of scales, higher profits and diversification of risk. But it was this increased blurring of the line which lead to the sub-prime financial market crises in 2007. Banks created, sophisticated and complicated financial products called derivatives based on sub-prime mortgages and sold them to eager investors wanting to make quick returns. With the booming economy, excess liquidity and the growing demand for such products, no one questioned the risk involved in lending to sub-prime borrowers and further using these mortgages to create the derivatives. When the housing market collapsed, it brought down the whole structure and whipped out the investment portfolios of many investors, including the whole countries like Iceland (REINHART, Carmen M. and rogoff, Kenneth S., 2008). This lack of regulation of commercial banking activity caused the entire global economy to pay a very heavy price leading it into a recession. In conclusion we can say that commercial banks have evolved into arguable the most important of all financial institutions by taking over more and more of the roles played by other institutions in the economy. Coupled with the fact that they accept the depositor’s money, this makes them one of the most critical elements in a countries economy. But as their importance in economic development grows with their increasing participation in many different aspects of the economy so does their ability to cause serious damage as evidenced by the subprime crises. The answer lies not in limiting their role, but in regulating their behavior so that they act as catalysts for development and growth and not as exploitative, unfettered market forces. References Investopedia. [online]. [Accessed 20 Nov 2011]. Available from World Wide Web: GOLDSMITH, Raymond W. 1958. Types of Financial Intermediaries. In: Raymond W GOLDSMITH, (ed). Financial Intermediaries in the American Economy Since 1900, Bureau of Economic Research, pp.50 - 55. Know the Different Types of Financial Institutions. [online]. [Accessed 20 Nov 2011]. Available from World Wide Web: The Difference between a Bank, a Credit Union and a Savings Institution. [online]. [Accessed 21 Nov 2011]. Available from World Wide Web: MORAWSKI, Adriana. 2007. The Role of Financial Intermediaries and the Increased Need for Recognition of Financial Market. [online]. [Accessed 21 Nov 2011]. Available from World Wide Web: IRELAND, Peter N. Money Banking and Financial Market. [online]. [Accessed 20 Nov 2011]. Available from World Wide Web: TUMPEL-GUGERELL, Gertrude. 2003. The role of institutions in the financial system. [online]. [Accessed 2011 Nov 21]. Available from World Wide Web: BRANDL, Michael W. The Role of Financial Institutions in Long Run Economic Growth. [online]. [Accessed 21 Nov 2011]. Available from World Wide Web: Banking Services and Financial Institutions. [online]. [Accessed 21 Nov 2011]. Available from World Wide Web: JHINGAN, M.L. 1984. Money Banking International Trade and Public Finance. New Delhi: Kolark REINHART, Carmen M. and Kenneth S. ROGOFF. 2008. Is the 2007 U.S sub-prime Crises so different? An international Historical comparision. [online]. [Accessed 21 Nov 2011]. Available from World Wide Web: Read More