The Importance of the Flow of Funds Functions of a Financial System - Essay Example

The importance of the flow of funds functions of a financial system. Student’s Name: Institution’s Affiliation Course Code: Date Executive summary The flow of funds function of a financial system is very important. It ensures that there is a platform through which investors can use to raise finance for their investment. Financial system is divided into two namely primary market and secondary market and each of them has some important potential which it provides to the economy (William & Spaulding, 2011). The flow of funds function in financial system ensures that there is a vehicle for direct foreign exchange. It also enables the creation of investment opportunities by providing potential investors with an opportunity to access funds for investment at a cheaper cost. It is also vital in mobilizing savings for investment. In this paper there is also other additional discussion of the essential benefits of the flow of funds function of a financial system which will be understood after reading the entire essay paper. Introduction Finance is the art in which there is efficient allocation of scarce resources to produce highest returns on investment. Financial system involves the use of different financial institutions, markets and instruments which functions with the purpose of facilitation of the flow funds between discrepancy and excesses unit through the interaction of financial institutions, instruments and markets (William & Spaulding, 2011). To ensure that financial system to satisfy its role of facilitating the movement of funds in and out it must have the power to provide investment portfolios for any excess units, accepts the trading of the available financial instruments and risk management of products. Financial systems only have two lending methods namely direct and indirect lending which is done through the financial markets and the latter is through the intermediaries. Direct Lending This financing channel is where there is a movement of funds from the ultimate lender to the immediate borrower of the same funds. This is sometimes takes place through an intermediate which could be a financial institution or a bank (Sullivan et al, 2003). The most appropriate illustration is where a private investor buying the bonds issued by another firm. The bonds are usually issued out for the public to buy through underwriters who involves in the sale of securities at a profit (Elton et al 2003). They negotiate the purchasing conditions with the person who wishes to buy them and select trustees which is usually a commercial bank to assess the compliance. Due to involvement of cost, the issuance of securities is only reasonable when the funds to originate from the sales are substantial. In a case where the security is in the form of a bond, the borrower is required to pay back the principal sum upon reaching maturity date plus the interest payable within the loan period. The purchase of equity securities does not require the borrower to return the principal sum of money but required to pay divided annually only when the investment produced high returns at the end of the year (William & Spaulding, 2011). There is a situation when the shareholders are in need of the money; securities are sold in secondary market. This kind of a market only comes into existence when it is created by another person. Secondary market is in two forms namely dealers and brokers (Sullivan et al, 2003). Dealers in secondary market are ready to sell or buy securities through their own set prices while brokers are only responsible for inviting buyers and sellers to involve in the sale of shares. The brokers are only entitled to receive commission which is calculated on the profit received from the deal. Indirect Lending This is a type of lending where money is being given to a borrower through financial intermediaries who pools the funds of different lenders with the intention to re lend to other borrowers at a mark up (Sullivan et al, 2003). The ultimate borrowers are not known to either of the parties. In this kind of lending the lenders are exposed to less risk since the financial intermediaries are always have stable background in terms of credit standing. It is therefore means that this kind of lending has low returns as a result of low risk. This type of lending always provides lower cost to the borrower for short term loans. The borrowers in this case have no substantial credit standing to take a direct borrowing. Only borrowers who are lucky to have that option have the opportunity to pay for it at a low cost especially for large sums. Importance of flow of funds function Financial system has a number of functions which makes it to contribute significantly to the economy. Raising Capital for businesses It provides the company with the facilities to raise capital for its functions through the sale of shares to the investing public (Sullivan et al, 2003). The money which is raised through this method enables the company to have sufficient source of finance which it can use to finance different investment portfolios. Without the financial system, it will be very difficult to raise enough finance since one person cannot save enough money to finance the investment project. Mobilizing Savings for Investment When people draws their savings and buy shares, it leads to a more allocation of resources in more useful activities (William & Spaulding, 2011). This may help to provide commerce and industries. With the help of financial systems, different investors save part of their incomes which they may use to invest in different investment project. With this, different investors can be called upon to pool together their finances so that the company can have sufficient finance to fund the investment project. Without financial system, it will be very difficult to mobilize savings since there will be no joint investments. Re-distribution of Wealth By giving a wide spectrum of people a chance to buy shares, therefore become part owners of profitable enterprises. It helps in reducing luck of income inequalities since many people get a chance to share profit of the firm which was set up by other people. With the formation of a new company through raising funds from the use of financial system, it ensure that different people have a chance to buy share in which they will have a chance to get annual income (Sullivan et al, 2003). Financial market is also important in ensuring that different companies are formed which act as a source of employment opportunities where different employees derive their income. Improves corporate governance By having varied scope of owners, company generally lends to improve on their management standards and efficiency in order to satisfy the demand of shareholders (Andrew &Chisholm, 2009). It is evidence that generally public companies lend to have better management records than private companies. Financial system is very important in ensuring that different companies have efficient management so that it expands effectively. This will enable different companies to have more investors attracted to finance their investment projects. Creates investment opportunities For small investors as opposed to other businesses that require large capital outlay investing in shares is open to small or large companies since one buys only the number of shares they may afford. Financial system enables different investors to come together with the purpose of generating finance or funds to invest (Keith, 2010). The investment they form will be able to create investment opportunity for other investors. Without the financial system, it will be very difficult to raise sufficient finance to support an investment portfolio. With the knowledge of financial system, it is evident that more funds can be raised directly or indirectly to support the financial portfolio. Measures the activities of the Economy Share prices rise or fall based on the market forces. Share prices tend to rise or remain table where the company and the economy shows stability therefore the movement of share prices can be the indicator of the general trend in the economy. Provision of liquidity The flow of fund function is also very important in improving economic liquidity. The relationship between liquidity in an economic performance result from the increase in high returns investment projects which needs long term capital commitments with risk a verse. This is because savers are usually unwilling to increase their control over their savings to borrowers for a long period of time (Keith, 2010). The flow of funds functions in a financial system ensures the business organizations have sufficient funds to meet its financial obligations. This is because when there are financial shortages, the investors will have the potential to mobilize other people to pool together their savings. This contribution by different investors will be used to finance the financial need of business organization. Without financial system, it will be very difficult to mobilize savings and therefore the business organization will have to sell the entire business organization since there will be no opportunity to diversifies portfolios. The flow of funds in financial system is also essential in enhancing risk sharing through the use of financial intermediaries. This is also important in ensuring that the business organization is more liquid (Andrew &Chisholm, 2009). Without financial intermediaries such as banks, different investors are only able to be in illiquid long term business investments that can only produce high profits to only investors who returns at the end of the investment while those at the beginning receives low profit returns (Keith, 2010). This is because early investors are only able to receive premature liquation of long term investment. When brokers require to get investment returns at varied times, the intermediary will have the potential to improve risk sharing by promising high profits in the future for investors who expects to have early consumption and a reduced profit for late consumption in comparison with non intermediate. The use of financial markets is also important in transforming illiquid assets into liquid liabilities (Keith, 2010). Financial market with high liquidity, savers or lenders has the capacity to treat assets like equities or bonds which can be changed easily into purchasing power in a case the investor wants to access part of their saving (Steven, 2002). In the case of lenders, the action or the functions of the financial markets or intermediaries are substitutable within the expected risk, returns and liquidity generated by different portfolios. The availability of financial markets and intermediaries are also responsible for making long term investments more attractive and viable since they provides sufficient funds which are used to finance long term investment which in return able to produce more returns. They ensure that firms have varied forms of finance to borrowers (Sullivan et al, 2003). These markets also ensure that there is arm length debts or equities finance which can be borrowed at a lower cost than those that originate from financial intermediaries. Through this firms are able to have sufficient funds to finance both its long term and short term investment projects. Transformation of the risk characteristics of assets The funds in financial markets is also essential important in transformation of the risk characteristics of assets (Steven, 2002). This is done by financial markets in two different methods. The initial one is through the enhancement of risk diversification and the second through the resolution of an information asymmetry problem that may prevent the exchange of different commodities. Through this it involves in the facilitation of risk sharing by ensuring that information and transactions have a reduced cost. In a case where there is a cost connected with directing funds between borrowers and lenders, the financial market will ensure that there is a cost reduction in holding diversified investments assets (Andrew &Chisholm, 2009). With the use of financial markets, it is possible to reduce the cost of information and transactions that comes from information asymmetry that arise between the borrowers and lenders (Keith, 2010). The information asymmetry exists because borrowers always have more knowledge about their investment as compared to lenders. The borrower may have entrepreneurial information which should not be disclosed to the lender or may have information concerning looming financial risk to the business organization which it is inappropriate to disclose to potential lenders (Marc, 2009). This information asymmetry can only occur either ex ante or ex post. Ex ante information asymmetry only takes place when lenders have difficulties in determining borrowers with varied credit risk before they avail credit facilities to them which may cause a verse selection problem. This problem occur when lenders intend to make the loan to have high risk borrowers since the borrowers who are willing and able to pay loans with high interest rate are there and those with the average will have worst risk (Steven, 2002). The information asymmetry problem only takes place ex post when borrowers are the only people to acknowledge actual investment returns immediately after the completion of the investment project (Sullivan et al, 2003). This has the potential of causing moral hazard problem which occur when borrowers involve in activities that lowers the chances of their debts being repaid back. This also takes place when borrowers accept excess risk in the expectation of further fall in the cost of securities as compared with the returns of lenders. Development of Public Projects The flow of funds in the financial system also helps the Government to raise capital for their public development projects (Steven, 2002). It provides the Government with an opportunity to borrow money from them with the intention of financing public projects (Andrew &Chisholm, 2009). The flow of funds through the financial system helps also the Government to collect more revenues from different companies or different investment portfolios which are able to get funds to finance their investment project. Through this the citizen of a given country will be able to complete their public projects without selling the public bonds or treasury bonds. Facilitate Capital Formation The flow of funds in financial system is also very important in ensuring that investors have sufficient funds to invest (Steven, 2002). The market provides a platform in which people or different investors collect their savings for the purpose of investing in a given project. Without this market, it will be very difficult to collect enough capital for investment. Facilitate Foreign Exchange The flow of funds in financial markets acts as a vehicle for direct foreign exchange. This is because shares can be purchased by different people across the globe. This involves the exchange of currency of different countries (The Business Finance Market, 2002). Through this the country is able to obtain currency of other countries which is important for economic growth and development. Increase Diversification of Investment The flow of funds in a financial system is able to increase and influence diversification of investment projects (Andrew &Chisholm, 2009). It ensures that investors put their finances in different project to reduce the vulnerability of their investment project from high risk. The market gives investors opportunity to select the investment to put their funds in. Through they will have a chance not to invest in only one portfolio but to invest in varied investment project available in the public. Conclusion Financial markets is divided into two namely direct and indirect methods where direct method the flow of funds in directly from the lenders to borrowers while indirect one there is financial intermediaries between the lender and the borrower. The flow of funds in financial system has very much importance such as raising capital for investment, facilitation of capital formation, mobilizing savings for investment, increase diversification of investments and ensure there are many investment opportunities for different investors. These importances which have been created by the flow of funds in the financial system are very essential in economic growth and development of any given country and therefore it is important to conclude that the impacts of financial market in any economy are incomparable with any business process. References Andrew M. Chisholm, (2009). An Introduction to International Capital Markets: Products, Strategies, Participants, Wiley, see esp Chapters 1, 4 & 8 Elton M, et al (2003) Modern Portfolio Theory and Investment Analysis, John Wiley & Sons, New York Keith, P (2010) Finance and Financial Markets, Palgrave ISBN 978-0230233218 Marc M. (2009) Forbes Guide to the Markets, John Wiley & Sons, Inc., New Steven V, (2002) .An Introduction To Global Financial Markets, Macmillan Press Ltd. The Business Finance Market, (2002). A Survey, Industrial Systems Research Publications, Manchester(UK), new edition Sullivan, et al(2003). Economics: Principles in action. Upper Saddle River,: Pearson Prentice Hall. p. 283. I William C. & Spaulding H (2011). Investment Banking—Issuing and Selling New Securities. thisMatter.com. Retrieved 2012-09-06. Read More