Financial Environment & Role of Financial Institutions:FINANCIAL MARKETS &INSTITUTIONS

FINANCIAL INSTITUTIONS:Non Banking Financial Companies >>

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

FINANCIAL MARKETS & INSTITUTIONS:

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.

Definition

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

risk.

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

purpose?

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:

FinancialEnvironment

Lenders

FinancialIntermediaries

FinancialMarkets

Borrowers

Inter

bankIndividuals

Banks

Stock

Exchange Companies

Individuals

Insurance

Companies

Money

MarketCentral

Government

Companies

Pension

Funds

Bond

MarketMunicipalities

MutualFunds

ForeignExchange

PublicCorporations

Lenders

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.)

Borrowers

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

(PSBR).

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.

DerivativeProducts

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.

Currencymarkets

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.

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