What Are Financial Markets and Institutions - Essay Example

FINANCIAL MARKETS AND S An economic system is heavily dependent on financial resources and transactions provided by financial markets and institutions. Nations are evaluated based on their economic efficiency and sustainability, which rests in part on efficient financial markets. This paper will define what financial markets and institutions are and their implication in an economy particularly in a largely consolidating world market. What are Financial Markets and Institutions Financial markets "consist of agents, brokers, institutions, and intermediaries transacting purchases and sales of securities." The individuals and institutions operating in the financial markets are linked by contracts and communications networks that form an externally visible financial structure, laws, and friendships. (Govori, 2005) The financial market is divided between investors and financial institutions. Financial institutions are organizations, which act as agents, brokers, and intermediaries in financial transactions - usually a bank that keeps custody of an investment or assets. Agents and brokers contract on behalf of others while intermediaries sell for their own account. For example, a stockbroker buys and sells stocks for us as our agent, but a savings and loan borrows our money (savings account) and lends it to others (mortgage loan). The stockbroker is classified as an agent and broker, and savings and loan is called a financial intermediary. Brokers and savings and loans, like all financial institutions, buy and sell securities, but they are classified separately, because the primary activity of brokers is buying and selling rather than buying and holding an investment portfolio. Financial institutions are classified according to their primary activity, although they frequently engage in overlapping activities. The types of instruments exchanged in financial markets include promissory notes, commercial bills or bank-accepted bills. Other types of securities include treasury notes issued by a government, commercial papers and certificates of deposits. Why do we need financial markets and institutions One of the indicative signs of a robust economy is a dynamic exchange or circulation of money by business and government activities. This is where the financial markets play a significant role. Financial markets facilitate the movement of funds from those who save money (meaning idle money) to those who invest money in capital assets. Financial markets mobilize funds and reallocate them to uses that generate better returns than can be achieved by the holders of the funds through securities traded in the financial markets. Simplistically, they provide a convenient place where savers can safely invest excess money and consumers can easily borrow funds and be used for various purposes to further fuel the economy of a nation. What role do they play in a nation's economy The financial markets and institutions play a number of important roles in the financial system. The financial markets price funds so that businesses and governments can make rational economic allocations of capital. Business and/or government may decide upon a time pattern for expenditures that does not necessarily coincide with their current or expected income flows. Financial markets allow time adjustments in the payments for goods. Without them, there would be no opportunity to earn interest on savings, and expenditures would be limited to current receipts and cash. Savings allows many consumers to postpone consumption and to receive returns from investments. Another important function of financial markets is that it distributes economic risks. On a larger scale, the financial markets transfer the massive risks from people actually performing the work to savers who accept the risk of an uncertain return. The chance of failure for a $500 million computer chips manufacturer may be divided among thousands of investors living and working all over the world. If the computer chips business fails, each investor loses only part of his or her wealth and may continue to receive income from other investments and employment. Financial markets also provide banks with access to liquidity. It performs the price discovery function for short-term funds. The market's reference rates are an important means for communicating the current level of interest rates. These interest rates affect the decision of businesses in a local economy to borrow or not. Financial institutions also act as portfolio managers and advisers over most of the primary securities owned by investors. The private financial institutions manage most of the home mortgages, commercial mortgages, consumer loans, state and local government securities, and business loans. Hence, financial markets and institutions are part of not only the economic but the social fabric of a nation as well, making facilities and commodities available in the market by managing the funds available in an economy. Governments regulate and deal with issues affecting financial market and institutions - banks, trust and loan and insurance companies, credit unions, pension plans and all of their respective clients. Governments generally develop the rules and regulations that govern the institutions so they remain safe and sound and are responsive to consumers' needs. In recent years, many governments, particularly the US and Canada have also been vigilant in ensuring an effective regime to combat money laundering and the financing of terrorism. If the rules governing the financial markets are inadequate, investors are reluctant to buy securities because they might be unwilling to trust managers, and so firms do not need the finance that they need. There should be a well functioning financial market that manages a complex set of institutions to foster information flow. The impact of globalization of financial markets One of the important functions of governments is to be able to manage their debt and international reserves, which has become increasingly difficult with the globalization of financial markets. Worldwide economic changes (such as prices of oil products, even terrorist threats) affect sovereign economies depending on their volume of foreign debt exposures and vice-versa as markets become strongly linked. Many observe the increasing volatility of capital flows and asset prices because of the interrelated developments in global financial market. Some of these developments were cited by Alexander (2002) in his research which includes among others: the sustained rise in gross capital flows relative to net flows; the increasing importance of securitized forms of capital flows; and the growing concentration of financial institutions and financial markets. These events contribute to increase in foreign incursion of financial systems of emerging markets, which sometimes result to excess liquidity in financial markets as well as rise in competition among financial institutions, and markets, including cross border competition. The increased activities have sometimes contributed to extreme turbulence in international capital flows. Growing pains in the global financial system are where accidents and unintended consequences can and do occur. On a global scale, the impacts can be serious. One lesson from our recent past was that economic distress often leads to political turmoil, international tensions and military conflict. Factors that trigger sovereign risk could be attributed to various and complicated dynamics such as an economic decline, social unrest, possibility of war or a change in political ideology. At a national level, the effects can go deeper affecting the population and their social behaviour, even their ethical choices. A case in point is the Asian crises of 1997 caused primarily by the high gearing of many companies in the region that resulted in excessive debts that defaulted due to poor returns on their investments. This was further exacerbated by the fact that much of the debt was foreign dollar-denominated provided by global financial markets. At the time, Asia was in the middle of a building and investment boom. Their economy was fuelled by surging business optimism due to the years of exhilarating export-led economic growth. The investment boom was encouraged by governments (by facilitating loans through state-controlled banks) eager to take advantage of the wave to build national capabilities and economic power in order to catch up with the West (Hill, 2005). As always, over-supply usually follows excessive investment, and this was no different. Thailand was the first to tumble in what was the worst financial crisis in the Asian region. In February, 1997 a Thai property developer announced that it had defaulted on a scheduled $3.1 million interest payment. Similar problems became apparent in other peers as well as the banks that had lent these developers the money to invest in what turned out to be "white elephants". Currency speculators took flight after a growing current account deficit and high dollar-denominated debt burden became apparent, resulting in shorting the Thai baht and eventual collapse which further ballooned the debt burden. Other Asian currencies soon followed after being hit by waves of speculations. One after another in a period of weeks, all the Asian currencies were all marked sharply lower, as they allow their currencies to float under pressure from speculators. There are probably many contributing factors to these financial crises including the artificial boom in the property and infrastructure, but much of that "development" was funded by global financial markets that included lending from overseas financial banks and financial markets. While the crises were resolved at the local front giving a decisive end to the property speculation, it has still left people sitting on negative equity even after almost a decade. Many committed suicide and thousands lost their jobs. Currencies were highly devaluated which took its toll on ordinary household consumption increasing inflation and affordability of basic goods and services. On a broader scale, companies have restructured their capital base and have now become less highly geared and more equity-based, in effect adopting a more sustainable and less risky growth approach. Governments also pulled back from close cooperation with businesses, as they learn to let the market dictate the flow of funds, the so-called invisible hand in Western economies. Some of them probably had to do so, as preconditions for getting loans from the IMF. But things have worked out for the best for everyone in the end. What is most important is that the mistakes of over-investment and excessive borrowing should never be repeated again. In response to these crises, governments and regulators around the world started to evaluate their rapidly changing financial systems and the ways those systems influence national economies. Many of them began looking into some critical indicators such as credit to private sector, short term debt to reserves, money supply and debt burden that triggered the debt crises in the first place. After the financial crisis, some Asian countries appear to be entering a banking and financial sector restructuring where further consolidation and the formation of financial holding companies will play a major role. A distinguishing feature of consolidation of emerging markets is that it has been a cross-border phenomenon that has resulted in substantial foreign penetration of domestic financial systems (Alexander, 2002) which provides for the introduction of more efficient and improved systems and policies. Some observable factors include progressive development in information technology, improved deregulation of financial sector and competitive pressures that have come about as a result of reduced margins in traditional banking business. (Alexander, 2002) The futures of financial markets After citing the good and the bad inside financial markets, financial institutions remain an important mechanism for development around the world. They facilitate and improve the distribution of funds, money, and capital in several respects particularly payments mechanism, security trading, transmutation, risk diversification and portfolio management. All of these functions are important to an efficient financial system, and managers are improving execution capability through improved electronic communication, computer processing, and institutional design. After the financial crises in the 1990's and the errors committed by credit rating agencies, there is now a growing interest in modeling sovereign credit evaluation which aims to lower the risk exposure of financial markets and institutions for lending to potentially unstable economies. Kalotychou and Staikouras (2004) described the sovereign credit evaluation as a two-stage process, where the repayment record is first assessed and then reliable signals about future stability of a borrower are sought. These models could invariably predict things such as external financing difficulties and financial systems vulnerabilities. Measurements to a degree of confidence maybe difficult as it can be convoluted and may prove highly prejudicial to emerging markets. Such measurements can also be subject to abuse such that it may alienate "non-favorable" sovereigns from the biddings of another who is holding substantial interest in the global financial market. In another front, remarkable changes have also occurred with the "deregulation, globalization and advances in information technology that are having a dramatic impact in the structure of domestic and international financial markets and the nature of financial services firms." (Herring, 2005) A series of technological innovations over the recent years transformed the securities industry. In some ways it has become more efficient and has made securities more accessible to the global market. However, this has also caused an uneven concentration on the number of exchanges in securities in favor of bigger trading entities. According to Herring & Litan (2002), over the past decade, technology has transformed the inter-dealer brokerage business which at the beginning of the 1990s was largely a telephone interface but has since been replaced by screen-based, electronic inter-dealer brokers. Now, instead of calling a bank, a customer has access to an electronic centralized limit order book providing them with several live quotes from multiple banks. Whereas, traditionally, exchanges have been physical places where traders met and negotiated transactions face to face, the financial market system has now been automated, which provides limitless possibilities. Where membership fees rationed access to these early exchanges, trade data may prove to be an exchange's most valuable asset in the automated exchanges. If that scenario comes true, exchanges will behave like media companies and attempt to charge for the provision of information. There are some inferences indicating that technological advances may someday lead to a stock market that mimics eBay, the Internet auction site, where buyers and sellers interact through a web site without the aid of brokers and dealers. As financial markets become increasingly global we are haunted by questions and doubts. How can we be protected against systemic risk in a globally integrated market place How can regulators prevent fraud How can transparency be maintained when trading takes place around the globe The future can be a complicated one which the policy makers and governments need to consider carefully. Note: The definitions and functions of financial markets and institutions are primarily quoted from the paper written by Fadil Govori in his paper Financial Markets and Institutions because his paper provided excellent illustrations. Works Cited Alexander, AJRC, "Trends in Global Markets and Institutions: Some Implications for Development in the Asian Region" Pacific Economic Papers. March, 2002. 11 http://www.eaber.org/intranet/documents/39/368/AJRC_Alexander_02.pdf Choi, Sungho and Hasan Iftekhar, "Ownership, Governance and Bank Performance: Korean Experience." 2005. 237 Govori, Fadil R., "Financial Markets and Institutions: Important Functions" Economic Papers, December, 2005. < http://econpapers.repec.org/paper/wpawuwpfi/0512025.htm> Herring, Richard J. and Litan, Robert E., "The Future of Securities Markets", Brookings-Wharton Papers on Financial Services, 2002. 8 Hill, Charles W., "The Asian Financial Crisis" University of Washington, 2005. 2 Kalotychou, E. and Staikouras, SK. " Factors Underlying the Credit Risk Exposure of Sovereign Loans". Cass Business School.. 2004. Read More