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Management of Financial Institutions

Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS Next >>>
Management of Financial Institutions - MGT 604
Lecture # 1
FinancialEnvironment & Role of FinancialInstitutions
Theeconomic transformation underway in the former centrallyplanned economies
(FCPEs) was motivated in part by therecognition that centralplanning has failed to allocate
financial and real resources efficiently.This paper addresses thequestion of what kind of
financialsystem should replace centralplanning in allocating capital and maintaining
effectivecorporate governance duringthe transformation period.Financial sector reform
has, at times, been portrayed as a question of adopting either a bank-based or a (securities)
market-based model. In the bank-basedmodel, commercial banks, oftenlicensed as
universalbanks, take the lead in financingenterprise restructuring and investment.
Proponents of the market-based model argue thatthe structural problems in the banking
sector cannot be overcome easily; so firms will have to look to equity and bond marketsfor
sources of new capital. Equity and bond markets in the FCPEsare not sufficientlywell
developed to support significant issues of new securities or to provide a mechanism for
corporatecontrol. They lack adequateliquidity, regulatory oversight,information
disclosure, and clearing and payment systems. Theimportant role of banks in maintaining
thepayment system and in providingcredit to market participants to support trading and
settlementmeans that until banks arerestructured and recapitalized,securities market
development will be constrained.
Investmentfunds emerging from massprivatization schemes maycreate concentrations of
equityownership that would allowthem to play an importantrole in corporate control and
perhaps, too, in finding sources of investment capital. They are a relatively recent
innovation,however, and it remains to be seenhow active they will be in financing and
managingprivatized enterprises.
Theauthorities should firstestablish a healthy bankingsector, because it is the banks that
arethe most promising source of working capital and corporatecontrol. This does not mean
thatsecurities market developmentshould be ignored, only that it should not be a priority
use of scarce government resources at the present time.
Many observers recommend that banks be giventhe power to act as universalbanks,
combininglending with securitiesmarket operations and equityinvestment. Thepotential
problemsassociated with such a model in the FCPEs during thetransformation period
outweighany potential benefits. It is recommended, therefore, thatcommercial banking and
investmentbanking activities be separated, at least until banks have demonstrated
competence in their commercial lendingoperations.
Long Run Performance of
FinancialInstitutions for EconomicGrowth:
Therecent economic difficulties in Southeast Asian economies are oftenlinked to the
financial sector in these countries. Thebusiness and popular pressaround the worldare
repletewith stories connecting theeconomic crisis withdifficulties in the financialsectors
in these economies. The connectionbetween the troubled banking sector and the economic
slowdown is especially stressed. Asian economies that have been lessimpacted by the
economiccrisis, for example Taiwan,are often characterized as having more stable
financialinstitutions then theirneighbors.
Yet this is not the firsttime "financial difficulties"have been linked withpoor
macroeconomicperformance. Many todaybelieve the Great Depression of the 1930s was
mademuch more sever by problems in the banking sector specifically and financial markets
inefficiencies in general. More recentlythe dramatic economicslowdown in the 1980s in
Management of Financial Institutions - MGT 604
thestate of Texas in the UnitedStates are often linked to the banking and savings and loan
crisisthat gripped the state at the same time. Thisraises the question, what is the link
betweenfinancial institutions and themacroeconomic performance of an economy?
Economistshold dramatically differentviews regarding thisquestion. From a muchearlier
time,Bagehot (1873), and Schumpeter(1911) argued that an efficientfinancial system
greatlyhelped a nation's economy to grow.  As Ross Levinehas pointed out it was
Schumpeter'scontention that well-functioning banks spurred technological innovation by
offeringfunding to entrepreneurs thathave the best chances of successfully implementing
innovativeproducts and productionprocesses.
Morerecent economists have moreskeptical about the role of the financial sector in
economicgrowth. Joan Robinson (1952)asserted that economicgrowth creates (emphasis
added) demand for financial instruments and that where enterprise leadsfinance follows.
RobertLucas (1988) has also dismissed the finance-economicgrowth relationshipstating
thateconomists "badly over-stress"the role financial factorsplay in economicgrowth.
However in recent years thanks to thework of Ross Levine (1997,1998), Robert King
(King and Levine 1993a, 1993b, 1993c) and others (Pagano 1993), economists are again
reexaminingthe role financial marketsplay in economic growth. On the theoretical side
complexmodels have been developed to illustrate the manychannels through whichthe
development of financial markets affect and are affected by economicgrowth. These
channelsinclude the facilitation of trading hedging, diversifying, and pooling of risk; the
efficientallocation of resources; the monitoring of managers and exerting corporatecontrol;
themobilization of savings; and thefacilitation of the exchange of goods and services.
On the empirical side a growingbody of studies at the firm-level,industry-level, country-
level and cross-country comparisons have demonstrated the strong link betweenthe
financial sector and economic growth. King and Levine's (1993a, 1993b, and 1993c)
researchhas shown that level of financial depth (defined as the ratio of liquid assets to
GDP)does in fact help to predicteconomic growth. Other work by Levine (1997,1998)
hasshown that financialintermediary development doespositively influenceeconomic
growth,these results are shown to be robust, that is therelationships still holdwhen other
factorsthat are know to influenceeconomic growth are heldconstant. In many waysthe
currentresearch has opened as manynew questions as it hasattempted to answer. On the
theoreticalside, questions still exist on how and why do financial markets and institutions
evolve? Why are financial markets at different levels of development in different markets?
Thisresearch has also raised a number of very interestingpublic policy questions.Such as:
underwhat legal environment do financial institutions developmentmore rapidly?Financial
regulation -- how are countries'financial systems regulated and supervised, how can these
be quantified, and to what extent do the differences matter. What is role of regulation in
encouragingfinancial market development?What impacts both positive and negative will
therecent bailout of financialinstitutions and financial marketshave on the longrun
development of financial markets?
I would like to turn ourattention to one of these issuesthat I find most intriguing: why do
financialmarkets develop at differentrates in differenteconomies?
Thatis, why do
financialinstitutions tend to cluster in high-income areas or economies and low-income
areasseem to suffer from a lack of financial institutions? A relatedquestion is; do financial
marketsdrive economic growth or does economic growth drivethe creation of financial
market and institutions?
Management of Financial Institutions - MGT 604
In economics a financialmarket is a mechanism that allows people to easily buy and sell
(trade)financial securities (such as stocks and bonds), commodities (such as precious metals
or agricultural goods), and other fungibleitems of value at lowtransaction costs and at
prices that reflect the efficientmarket hypothesis.
Financialmarkets have evolvedsignificantly over severalhundred years and areundergoing
constantinnovation to improveliquidity.
Bothgeneral markets, where manycommodities are traded and specialised markets (where
only one commodity is traded) exist.Markets work by placing manyinterested sellers in
one "place", thus making themeasier to find forprospective buyers. An economywhich
reliesprimarily on interactions betweenbuyers and sellers to allocateresources is known as
a market economy in contrasteither to a command economy or to a non-market economy
that is based, such as a gifteconomy.
In Finance, Financial marketsfacilitate:
Theraising of capital (in thecapital markets);
Thetransfer of risk (in thederivatives markets); and
International trade (in the currencymarkets).
Theyare used to match those whowantcapital to those who haveit.
Typically a borrower issues a receipt to the lender promising to pay back the capital. These
receipts are securitieswhichmay be freely bought or sold. In return for lendingmoney to
theborrower, the lender will expect some compensation in the form of interest or dividends.
Theterm financialmarkets can be a cause of muchconfusion.
Financialmarkets could mean:
1. Organizations that facilitatethe trade in financial products.i.e. Stockexchanges facilitate
the trade in stocks, bonds and warrants.
2. The coming together of buyers and sellers to trade financialproducts. i.e. stocks and
sharesare traded between buyers and sellers in a number of ways including: the use of
stock exchanges; directly between buyers and sellers etc.
In academia, students of finance will use both meanings butstudents of economics will only
usethe second meaning.
Financialmarkets can be domestic or they can be international.
Types of financial markets:
Thefinancial markets can be dividedinto differentsubtypes:
Capitalmarkets which consistof:
Stockmarkets, which providefinancing through theissuance of shares or
commonstock, and enable the subsequent tradingthereof.
Management of Financial Institutions - MGT 604
Bondmarkets, which providefinancing through theissuance of Bonds, and
enable the subsequent tradingthereof.
Commoditymarkets, which facilitatethe trading of commodities.
Moneymarkets, which provide shortterm debt financing and investment.
Derivativesmarkets, which provideinstruments for the management of financial
Futuresmarkets, which provide standardized forward contracts fortrading
products at some future date; see also forward market.
Insurancemarkets, which facilitatethe redistribution of variousrisks.
Foreignexchange markets, whichfacilitate the trading of foreign exchange.
Thecapital markets consist of primary markets and secondarymarkets. Newly formed
(issued)securities are bought or sold in primary markets.Secondary markets allowinvestors
to sell securities that theyhold or buy existingsecurities.
Raising Capital
To understand financial markets,let us look at what theyare used for, i.e.what is their
Withoutfinancial markets, borrowerswould have difficultyfinding lendersthemselves.
Intermediariessuch as banks help in thisprocess. Banks take depositsfrom those who have
money to save. They can then lendmoney from this pool of deposited money to those who
seek to borrow. Banks popularlylend money in the form of loans and mortgages.
Morecomplex transactions than a simple bank deposit requiremarkets where lenders and
theiragents can meet borrowers and their agents, and where existing borrowing or lending
commitments can be sold on to other parties. A good example of a financial market is a
stockexchange. A company can raisemoney by selling shares to investors and itsexisting
shares can be bought or sold.
Thefollowing table illustrateswhere financial markets fit in the relationshipbetween
lenders and borrowers:
Exchange Companies
Manyindividuals are not aware that they are lenders,but almost everybody doeslend
money in many ways. A person lendsmoney when he or she:
putsmoney in a savings account at a bank;
contributes to a pension plan;
pays premiums to an insurancecompany;
invests in government bonds; or
Management of Financial Institutions - MGT 604
invests in company shares.
Companiestend to be borrowers of capital. When companies have surplus cashthat is not
neededfor a short period of time,they may seek to make moneyfrom their cash surplus by
lending it via short term marketscalled money markets.
Thereare a few companies thathave very strong cashflows. These companies tend to be
lendersrather than borrowers. Such companies may decide to returncash to lenders (e.g.via
a share buyback.) Alternatively,they may seek to make moremoney on their cash by
lending it (e.g. investing in bonds and stocks.)
Individualsborrowmoney via bankers' loans forshort term needs or longerterm mortgages
to help finance a house purchase.
Companiesborrowmoney to aid short term or long term cash flows.They also borrow to
fundmodernization or future businessexpansion.
Governments oftenfind their spendingrequirements exceed theirtax revenues. To make up
thisdifference, they need to borrow. Governments also borrow on behalf of nationalized
industries,municipalities, local authorities and other public sector bodies. In the UK, the
totalborrowing requirement is oftenreferred to as the public sector borrowing requirement
Governmentsborrow by issuing bonds. In the UK, the government also borrows from
individuals by offering bank accounts and Premium Bonds. Government debt seems to be
permanent.Indeed the debt seemingly expands rather than being paid off.One strategy used
by governments to reduce the value of the debt is to influence inflation.
Municipalities and local authorities mayborrow in their own name as well as receiving
fundingfrom national governments. In the UK, this would cover an authority like
HampshireCounty Council.
PublicCorporations typicallyinclude nationalised industries. These may include thepostal
services, railway companies and utility companies.
Manyborrowers have difficultyraising money locally. Theyneed to borrowinternationally
withthe aid of Foreign exchangemarkets.
Duringthe 1980s and 1990s, a majorgrowth sector in financial markets is the trade in so
calledderivativeproducts, or derivatives forshort.
In the financial markets, stock prices, bond prices, currency rates,interest rates and
dividends go up and down, creating risk. Derivative products arefinancial productswhich
areused to controlrisk or paradoxically exploitrisk.
Seemingly,  the  most  obvious  buyers  and  sellers  of  foreign  exchange  are
importers/exporters.While this may havebeen true in the distantpast, whereby
Management of Financial Institutions - MGT 604
importers/exporterscreated the initial demand for currency markets,importers and exporters
now represent only 1/32 of foreignexchange dealing, according to BIS.
Analysis of financial markets
Mucheffort has gone into thestudy of financial markets and how prices vary withtime.
CharlesDow, one of the founders of Dow Jones & Company and The Wall Street Journal,
enunciated a set of ideas on thesubject which are nowcalled Dow Theory. This is the basis
of the so-called technicalanalysis method of attempting to predict future changes. One of
the tenets of "technical analysis" is thatmarket trends give an indication of the future, at
least in the short term. Theclaims of the technicalanalysts are disputed by many academics,
whoclaim that the evidencepoints rather to the randomwalk hypothesis, whichstates that
thenext change is not correlated to the last change.
Thescale of changes in priceover some unit of time is called the volatility. It was
discovered by Benoît Mandelbrot thatchanges in prices do not follow a Gaussian
distribution,but are rather modeledbetter by Lévy stable distributions.The scale of change,
or volatiliy, depends on thelength of the time unit to a power a bit more than1/2. Large
changes up or down are more likelythat what one wouldcalculate using a Gaussian
distributionwith an estimated standard deviation.
Financialmarkets in popularculture
Onlynegative stories about financialmarkets tend to make thenews. The general
perception,for those not involved in the world of financialmarkets is of a place full of
crooks and con artists. Big stories like the Enron scandal serve to enhance this view.
Stories that make the headlinesinvolve the incompetent, thelucky and thedownright
skillful.The Barings scandal is a classic story of incompetence mixed withgreed leading to
direconsequences. Another story of note is that of BlackWednesday, when sterlingcame
underattack from hedge fundspeculators. This led to major problems for theUnited
Kingdom and had a serious impact on its course in Europe. A commonly recurringevent is
thestock market bubble, wherebymarket prices rise to dizzying heights in a so called
exaggerated bull market. This is not a new phenomenon; indeed thestory of Tulip mania in
theNetherlands in the 17thcentury illustrates an early recorded example.
Financialmarkets are merely tools.Like all tools theyhave both beneficialand harmful
uses.Overall, financial marketsare used by honest people. Otherwise, people wouldturn
awayfrom them en masse. As in other walks of life, thefinancial markets have theirfair
share of rogue elements.
Table of Contents:
  1. Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS
  2. FINANCIAL INSTITUTIONS:Non Banking Financial Companies
  3. CENTRAL BANK:Activities and responsibilities, Interest Rate Interventions
  4. POLICY INSTRUMENTS:Open Market Operations, Capital Requirements
  5. BALANCE OF TRADE:Balance of Payments Equilibrium, Public Policy and Financial Stability
  6. STATE BANK OF PAKISTAN:History, Regulation of Liquidity, Departments
  10. STATE BANK OF PAKISTAN - VARIOUS DEPARTMENTS (Contd.):Human Resources Department
  13. PAKISTAN ECONOMIC AID & DEBT:Macroeconomic Stability, Strengthening Institutions
  14. INCREASING FOREIGN DIRECT INVESTMENT:Industrial Sector, Managing the Debt
  15. ROLE OF COMMERCIAL BANKS:Services Typically Offered by Banks, Types of banks
  16. ROLE OF COMMERCIAL BANKS:Types of investment banks, The Management of the Banks
  17. ROLE OF COMMERCIAL BANKS:Public perceptions of banks, Capital adequacy, Liquidity
  19. ROLE OF COMMERCIAL BANKING:Private Deposit Insurance,
  20. BRANCH BANKING IN PAKISTAN:Remittances, Online Fund Transfer
  22. Mutual funds:Types of international mutual funds, Mutual funds vs. other investments
  23. Mutual Funds:Criticism of managed mutual funds, Money Market Fund
  24. Mutual Funds:Balanced Funds, Growth Funds, Specialized Funds, Measuring Risks
  25. Mutual Funds:Cost of Ownership, Redemption Fee, Reports to Shareholders
  26. Mutual Funds:Internet Fraud, The Pyramid Scheme, How to Avoid Investment Fraud
  27. Mutual Funds:Investing In International Mutual Funds, How to Pre-Select a Mutual Fund
  28. Role of Investment Banks:Recent evolution of the business, Possible conflicts of interest
  29. Letter of Credit:Elements of a Letter of Credit, Commercial Invoice, Tips for Exporters
  30. Letter of Credit and International Trade:Terminology, Risks in International Trade
  31. Foreign Exchange & Financial Institutions:Investment management firms, Exchange Traded Fund
  32. Foreign Exchange:Factors affecting currency trading, Economic conditions include
  33. Leasing Companies:Basic Purpose of Leasing, Technological Benefits
  34. The Leasing Sector in Pakistan and its Role in Capital Investment
  35. Role of Insurance Companies:Indemnification, Insurer’s business model
  36. Role of Insurance Companies:Life insurance and saving
  37. Role of financial Institutions in Agriculture Sector:What is “Revolving Credit Scheme”?
  38. Agriculture Sector and Financial Institutions of Pakistan:What is SMEs
  39. Can Government of Pakistan Lay a Pivotal Role in this Sector?:Business Environment
  40. Financial Crimes:Process of Money Laundering, Terrorist Financing
  41. DFIs & Risk Management:Managing Credit Risk, Managing Operational Risk
  42. Banking Fraud & Misleading Activities:Rogue Traders, Uninsured Deposits
  43. The Collapse of ENRON:Auditing Issues, Corporate Governance Issues, Corrective Actions
  44. Classic Financial Scandals:Corruption, Discovery, Black Wednesday