Understanding the work of financial markets - Essay Example

………………………………………………………………………….xxxxxx …………………………………………………………………….xxxxxx …………………………………………………………………………xxxxx ………………………………………………………………………..xxxxx @2012 Financial system Introduction It is important to understand how financial markets work. In the financial system, lenders of money include households and firms while borrowers include firms, governments and households. Lenders supply funds to borrowers in two ways. To begin with, lenders supply money through the financial markets. Financial markets which consists of the bond markets, equity markets and the money markets. Secondly, through which lenders supply money is through financial intermediaries such as the banks, mutual funds, market funds, pension funds and insurance companies (Allen and Santomero 1997 pg 1461). Financial systems play an important role in the economy. First, they eliminate information problems between investors and borrowers by monitoring and ensure that depositors’ funds are in the proper use. Secondly, they spur up economic growth. They provide intertemporal smoothing of non-diversifiable risk at a given time as well as insuring depositors against consumption shocks. They play an important role in corporate governance, considering that most countries experience the agency problem. Different role vary across countries and times, but banks always play a critical role in the financial system (Allen and Santomero 1997 pg 1461). It is vital to understand the role of the financial system. Role of the banks in bank-based system and market-based systems a) Informational problems Market based systems eliminate informational problems. You find that most information is publicly displayed in the market for public listed companies. The same case applies to Banks as they allow various informational problems, an argument that has often been put forward in favor of the bank based systems (Levine 2002 pg 398). One of the problems is if borrowers should take some action to make proper use of the borrowed funds. Here, action could be the level of effort or choice of the project from the many different risky alternatives. Therefore, borrowers might end up putting the blame that the unfavorable outcome is as a result of bad luck rather than taking the correct action. A fixed cost has to be paid so that lenders can monitor the actions of borrower. This is not possible because no one would be willing to pay a monitoring cost as they want a free- ride. The solution to this problem is to hire a single monitor to monitor the actions of the borrowers. A single monitor cannot solve this problem alone thus he uses a model of delegated monitoring called diamond model (Diamond 1996 pg 41). They monitor borrowers by promising lenders a fixed return from the diversified portfolio which the intermediaries offer. The diamond model demonstrates how banks have an incentive to act as a delegated monitor and produce the necessary information for efficient resource allocation. Thakor (1996 pg 917) also build another model in view of banks delegated role of monitoring borrowers. This model assumes that there are three types of information problem. To begin with, there is incomplete information regarding future projects a firm has or is available. Secondly lenders do not observe how borrowers invest their funds. Lastly, the possibility of borrowers investing in risky projects is very high. The argument of Thakor (1996 pg 917) is that the first problem can be solved by the financial market while the second and third problems can be solved by intermediaries. Thakor also argues that the emerging financial system will be predominated by the banks and the informational advantages of the markets may allow them to develop mature financial system. According to Allen (2002 pg 398), market –based systems such as U.S have informational advantages than bank-based system like France and Germany. b) Risk sharing Sharing of risks is one of the most important functions of the financial systems and is often argued that the financial markets are well suited in achieving this goal. Allen (2002 pg 400) points out that the traditional financial theory does not focus on hedging non-diversifiable risk, but focuses on the efficiency in risk sharing of assets through exchange. In this case, diversification requires individuals to exchange assets so that each investor holds a relatively small amount of one the risks. When risks are traded the risk-averse investors face lesser risk than the risk tolerant investors. Allen (2002) also focuses on the intertemporal smoothing of risks that are non-diversifiable at given point in time. Allen (2002 pg 410) argues that these risks can be used to reduce the welfare of individuals through intertemporal smoothing by banks. Intertemporal smoothing of banks involves banks building up reserves when high returns on assets held by the banks are being experienced and running the reserves when returns are low. Therefore, banks can pay constant amount each period and as a result less risk is imposed on depositors (Levine 2002 pg 400). According to Allen (2002 pg 400), intertemporal smoothing is difficult in the market based financial systems because of the presence of incomplete financial markets. There is also stiff competition in the financial markets which may not allow intertemporal smoothing. Another disadvantage of market –based system is that they experience market fluctuations which make risk sharing difficult. Financial markets can go to an extent of destroying risk sharing opportunities. Allen (2002 pg 426) points out that in U.S and U.K market-based systems expose household to more risk than bank-based systems in Japan and Germany. c) Corporate governance role In most countries, the role of corporate control or agency is weak, and as a result banks have been appointed to act as monitors for a large corporation. Here, the bank helps to overcome the agency problem between managers and the firm. The system of monitoring the agency problem by the bank is characterized by a strong lasting relationship between the bank and its client and active intervention during financial distress. Also, the bank holds both debt and equity on behalf of the client (Levine 2002 pg 400). d) Growth Banks spur up growth. Empirical studies show that banks spur more growth than financial markets. According to Levine (2002 pg 420), a research conducted using data of 48 countries between 1980-1995 showed that the distinction of bank based and market based is not the best in explaining growth. This is because elements such as legal environment and the quality of financial services are the best in spurring the general economic growth. On the contrary, a study of 36 countries showed that in developed countries, financial markets spur economic growth while in less developed countries, banks spur economic growth (Fama 1980 pg 39). Levine (2002 pg 400) points out that greater bank development and stock market liquidity level spurs economic growth. Some other evidence indicates that in this case banks and financial markets are complements rather than substitute (Levine 2002 pg 400). Other evidence shows that stock markets that are more developed are associated with the use of the banking system in developed countries. In the market system, lenders are able to know the value of each firm. Also lenders are free to share information among firms for their own benefit. Financial markets also allow diversity of opinions by allowing people tom join and finance projects as loan as they have a similar opinion. Finance is provided by the market. The only problem is that there may be agency problem since the manager is delegated with the responsibility of expending costs necessary in forming an opinion. The opinion therefore made by the manager might vary from that made by the investor. As a result high costs end up being incurred in forming an opinion. In summary, the main argument is that market based system lead to more innovation compared to ban based systems. e) Contagion One shock can affect a wide area. This is the same case as banks because if a shock is experienced by the banks, then the whole financial sector will experience the same impact. According to Allen (2002 pg 400), a study conducted shows that when banks are having different network structures, they likely respond to contagion. Diamond (1996 pg 53) points out those banks insure against liquidity shocks by having their interbank deposits exchanged. As a result, swapping of deposits exposes the banking system into contagion. This means that if the banks are secure from liquidity, then the financial sector is also safe. Diamonds points out those better networked banks are resilient to contagion since losses are transferred to more than one bank through interbank agreements. On the contrary, other models capture the network externalities resulting from an individual bank risk. They consider banks to face liquidity and consumers uncertainty. Other models state that the stability of the banking system highly depends on the consumer’s choice in depositing with a certain bank. Allen (2002) feels that interbank networks increase resilience of the system and as a result insolvency of a certain bank. The drawback here is that the network weakens incentives. f) Financial crises Banks collect deposits and raise short term funds in the capital markets and invest them in the long term assets. According to Allen (2002 pg 410) individuals do not have a direct access of the market. They access the markets by making investments in financial intermediaries such as the capital markets. Therefore, financial intermediaries are the main players in the financial markets. Financial intermediaries in the bank based systems insure consumers against liquidity shocks (Fama 1980 pg 40). In the case of financial markets, they allow financial intermediaries and their depositors to share liquidity risk and asset return shocks. Financial markets are complete if it is possible for intermediaries to hedge all risks in the market. Debt is an example of an incomplete contract where the payoff is not dependent on the state of liquidity demand and return on assets. According to Allen (2002 pg 410) efficiency in resource allocation is only efficient in complete markets even if contract such as debts are incomplete. On the contrary crises are inefficient if markets are not complete and as result the effect of contagion can be experienced. Banking crises can be prevented through the natural outgrowth of business cycle. Normally, an economic downtown reduces the value of assets held by banks, making them unable to meet their commitments. g) Relationship banking Close and durable banking relationships provide better access to clients and eliminate some of the information problems associated with lending. Banking relationships can either be multiple or single. Multiple banking relationships are preferred as they help in mitigating soft budget constraints, improve entrepreneurial incentives and restore competition among banks. The number of banks influences the level of loan rates; ban’s monitoring incentives and a firm’s choice on the type of relationship. Multiple relationships enjoy economies of scale and low costs associated with monitoring. This aspect makes it attractive to the clients. The demerit associated with multiple banking is that it suffers from duplication of efforts. Another demerit can occur when banks choose an excessive level of monitoring leading to high costs. Multiple relationship banking reduces the degree of liquidity risks. Allen (2002) points out that when relationship banks experience liquidity problems, borrowing from multiple banks can avoid liquidation of projects which are profitable; many firms prefer borrowing from multiple banks and disclosing confidential information regarding the quality of their projects. Multiple bank relationships are not the only way of solving the problem of non-commitment that affects bank relationships. An alternative way of solving this problem can be developing a valuable reputation. It might be a bit costly to maintain reputation but the outcome is worth. Another strategy of reducing non commitment through delegation in decision making to agents does not have discretion to renegotiate. On the contrary renegotiation improves welfare as pointed out by Allen (2002). Therefore, financial institutions that establish long term relationships with clients have an advantage compared to financial markets since it is easier for them to renegotiate contracts. Comparing the dimensions in bank based and market based systems To analyze the financial structure, we classify countries as either market-based or bank- based. In comparing the bank based and market based systems, factors such as size, activity and efficiency will be considered. Basically, ratios in the bank based and market based systems will be studied. Countries with high ratios are considered to be bank based while those with low ratios are considered to be market based. a) Size Here, we will Use bank vs. capitalization in measuring the size of the financial structure. Bank vs. capitalization is given by bank assets divided by market capitalization. Levine (2002 ) points out that bank do not become larger or smaller relative to the size of stock markets in countries with high income. Considering countries with low income, Research indicates that there is no strong relationship between the income level of a country and the size of bank assets relative to the size of the domestic market. Now consider countries with large market size relative to the size of the banks (Fama 1980 pg 45). For example, Philippines, Jamaica and Mexico are considers by the bank vs. capitalization as marked based rather than bank based. In these countries banks are small and underdeveloped. The relative size measure is useful in providing information though it has limitations. For instance, the fact that a country has a large value of the relative measure does not indicate that it has well banking system compared to other banking systems of other countries. Similarly, if a country has a low relative measure, this does not indicate that it has a well developed market compared to the other markets of other countries. b) Efficiency To measure the efficiency of the market, the value of stock market transaction relative to the economy’s size will be considered. For banks, we consider the overhead cost and bank net interest margin (Fama 1980 pg 40). Using these measures, countries with high income tend to have more efficient domestic markets compared to banks. c) Activity Using the ratio of deposits by banks and the total value of stock transactions, markets in high income countries tend to be more active than banks (Levine 2002 pg 400). You find that countries become more market based rather than ban based when they become richer. Bank credit vs. trading is usually larger in countries where banks are channeling credit to the private sector relative to the value of stock trading in the stock markets. d) Laws and regulations Countries with strong protection of shareholders rights, common laws and low levels of corruption tend to be more market based relative to bank based systems. Merits and demerits of bank based and market based systems Merits Growth Stock markets allow growth of commerce by allowing investors to invest in stocks of corporations. The reward to investors is a return on their investments. Stock markets provide transparency as every process is publicly displayed (Levine 2002 pg 400). You find that price quotations, bids and transaction results are publicly displayed. Liquidity They enhance liquidity as money keeps on flowing through the system. Financial markets allow easy access to the value of stock asset through the open market. Banks lend money to households and firms thus this enhances liquidity in the financial system. Demerits Economic effect The financial system is fragile thus causing banks to be at the center of the financial crises. Therefore, blame for the crises is put on the banks. The contagion effect is felt by the bank and since they have networks the whole economy and financial system experiences the crisis. A good example of a crisis is the financial crisis that happened in august 2007 affecting the whole economy globally. On the other hand; decline in stock can have a great impact on the economy. It can cause unemployment and as a result the quality of lifestyles reduces due to low or no income. Risks of investing in the stock market are very high since higher the return on investment the higher the risk (Levine 2002 pg 400). Conclusion In this report, we have pointed out and discussed the role of banks in the financial systems, comparisons between bank –based and market based systems and their merits and different. Both systems play major role in the economy, no greater system is greater than the other and their impacts on growth have also been elaborated. It is recommendable for countries to adopt both systems. The merits and demerits of bank based and market based systems have also been discussed in details References Allen, F. and Gale, D., 2001. Comparing Financial Systems, MIT Press. Ch.1, 2, 3 & 15. Madura, J. (2012) Financial Markets and Institutions (10th ed), Thomson. Allen, F. and Santomero, A, 1997. The theory of financial intermediation, Journal of Banking and Finance, 21, 1461-1486. Boot, A., and A. Thakor, 1997. Financial System Architecture, Review of Financial Studies 10, 693-733. (1997b). Corbett, J. and T. Jenkinson, 1996. 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