Links between the Financial System and the Real Economy - Essay Example

? Contemporary Issues in Financial Services Insert Insert Grade Insert Contemporary Issues in Financial Services Introduction Over the years, global trade has depended a lot on the control and operation of financial services. With the current shifts and twists in the global economy, it is increasingly important that factors that will continue to influence markets especially in the financial sector are closely watched. With globalisation taking a toll in the world’s economical dynamics, there are bound to be issues that will continue to emerge in the financial sector since it is one of the building blocks of national and international economies (Cebula, 2011). This paper will, therefore, identify and discuss some of the key and contemporary issues that have emerged in the financial services sector. The main aim will be to bring into focus some of the key issues in the nature and functionality of financial systems that continue to influence the economy and other financial service operations. To begin, it has been noted that the financial systems in the contemporary society have increasingly been associated with a linkage to overall economic conditions of nations. This will be discussed in the section that follows. Links between the Financial System and the Real Economy The relationship between a financial system and the real economy can be clearly understood in three components. They include the composition of aggregate demand, level of aggregate demand and allocation of resources. Composition of Aggregate Demand The financial system plays an important role in the economy in various ways. At the beginning, one should mention aggregate demands in relation to the total expenditure of goods and services of an economy for a specified period for a specified price (McEachern, 2011). The financial system of an economy has a bearing on the way its aggregate demand is constituted. One of the ways it influences economic dynamism is in the way it acts as a facilitator of lending on the one hand and borrowing on the other. Since scarcity is one of the great hindrances to economic growth, by providing a means of obtaining extra resources to offset deficits, the financial sector is therefore a good linkage to economic growth (Burton and Brown, 2009). In effect, the financial sector plays a direct role in the effective planning of expenditure independent of an individual or organization’s present income. A good example is the way creditors or lending institutions are able to store wealth for future consumption through giving out at certain levels of interest whereas borrowers are able to acquire finances to make purchases in advance of income. The result of positive influence of a well regulated and efficient financial system will lead to a relatively higher investment rate than that of consumption in the given economy. Since economic growth relies on investment levels, a financial system is, therefore, a necessary component of the economy. Level of Aggregate Demand Financial development levels may also have an influence on the level of aggregate demand. The level of agreement is subject to the rate of flow of the finances or money in the financial system. A high flow, or otherwise referred to as velocity, is a great determinant of the level of aggregate demand. In a financial system, individuals or lending institutions may decide to retain the cash they have at their disposal as a result of taking precautions for speculative purposes or by having them in solid assets. As a result, the flow or velocity of finances may be lowered as a consequence of decreased liquidity. On the other hand, a well functioning financial system that is able to effectively produce a range of assets that are liquid in nature may help reduce the amounts held by the said parties in the financial markets. The resultant effect will be that of increased velocity of money in the economy which is healthy for economic growth enhancement. The level of aggregate demand in this case, therefore, will be highly dependent on the nature of financial systems in a given economy. A well established financial system is characterised by developed financial markets, financial intermediaries or financial products. An economy that has a well developed financial system denoted by the listed properties is likely to flourish and such is the linkage between economic growth and financial sector development. Allocation of Resources Allocation of resources in any economy should be in a manner that they are able to be utilised to their maximum potentials. As mentioned earlier, efficiency of financial markets affects economic development. However, sometimes social costs not accounted for in the usual system may lead to over- or underproduction in the financial markets. In allocating resources, the efficiency of financial markets affects allocation of resources because of three key components. They include the operational, informational and allocative efficiency of the financial system. The operational efficiency refers to how fast and costly the financial system is deemed to handle transactions (Harker and Zenios, 2000). Secondly, informational efficiency refers to the speed at which the relevant information released may affect the pricing of commodities or the adjustment of commodities in the financial markets. Lastly, allocative efficiency in the financial market refers to the level at which the economy will effectively employ the scarce resources available. As a collective component, the three levels of efficiency will determine the effectiveness of the finance resource allocation and therefore influence the economy. From the discussions above on the link between financial systems and economic growth, it is evident that economic growth largely depends on financial sector development. At the same time, financial systems are likely to flourish in a well developed economic growth. Monetary factors have a great bearing in the financial services sector. One of the factors in the system that it may have a great influence on is the level of interest rates. The following section examines how the monetary factors may have a toll on interest rates. Role Played by Monetary Factors in the Determination of the General Level of Interest Rates Interest rates influence a great deal on decisions that investors and other financial sector players make in the acquisition or issuance of funds among other financing decisions (Amoako-Adu and Smith, 2002). For instance, the cost of capital is largely influenced by the prevailing market rates of interest and the same applies to the cost of debt. Monetary factors generally refer to those factors that are as a result of adjustments in the value of money in the financial markets. Interest rates are affected by the shift in the balance between lending and borrowing (Brigo and Mercurio, 2006). This can be seen in terms money supply versus the demand for money. Some of the factors include depreciation, inflation, appreciation, foreign exchange value among others. The depreciation or appreciations are monetary factors that play a major role in the determination of interest rates. When the value of currency in a given economy depreciates, it means that its value relative to the other currencies in a financial market is lower and hence less demand for it. Depreciation is therefore likely to negatively affect the rate of interest for a given economy. This is because it will likely result in decreased money supply since lenders will be holding their finances waiting for the prevailing market situation to improve. Decreased flow of money in the market will, therefore, result in higher interest rates. Inflation is a major factor that has a great influence on the level of interest in given economies. Inflation refers to the general prices of a collection of selected basic consumer goods. A rise in the prices of goods results in high inflation and vice versa. It, therefore, goes that a high level of interest will mean that the prevailing market prices of commodities have shot up and few lenders are ready to release the amount of money they are holding because of the lower purchasing power they possess at this given time. As a result, the interest rates will shoot up from the resulting high demand for money that will be contrasted with a lower supply. Foreign exchange rates may also play an important role in the determination of interest rates. This is because they will indicate the value of an economy’s local currency with respect to the other countries. As a result, a high relative value will result in the demand for the local currency and hence more circulation which positively affects the rate of interest in the said economy. Other monetary factors are tied to policy issues like the level of taxation. For instance, if the financial sector through the intermediaries is faced with higher taxes, they are likely to pass this cost to the borrowers and other sector players through increased interest rates. Role of Financial Intermediaries Financial intermediaries act as middle men between lenders and borrowers in any financial system. They exist due to obvious availability of lenders or borrowers who may freely operate in financial markets because of many reasons (Mishra, 2005). To begin, the existence of financial intermediaries is based on the potential economies of scale in the financial sector, which amongst other things can result in risk-reduction as a result of diversification and maturity transformation. The incentive explanation is based on the existence of information or transaction costs and incomplete contracts. Hence, economic agents form financial intermediaries to mitigate market frictions and reduce transaction costs. Lower transaction costs induce a greater number of transactions, thus allowing for more specialisation. Moreover, it is costly for individuals to acquire information and to evaluate and monitor firms and their managers. Since financial intermediaries can economise on the costs of acquiring information, they have an advantage over individuals and non-specialised entities to intermediate between borrowers and lenders. Therefore, financial intermediaries can contribute to economic growth by facilitating the exchange process, monitoring performance of firms, and due to their information acquisition capabilities, improve resource allocation in the credit market. There are financial intermediaries that are subject to specific regulation and supervision; their programs, activities and transactions are regulated and overseen by the central bank in many countries. These include commercial and governmental banks, savings and also cooperative and private financial institutions, which are officially registered under formal legislation (Neville, 2002). Financial intermediaries emerge to reduce those asymmetries and lower the costs of researching potential investments, exerting corporate control, managing risk, and mobilising savings. Therefore, countries with superior financial systems will, ceteris paribus, allocate savings to more efficient and productive endeavours and will grow faster than countries with less effective financial systems (Mayo, 2007). In the era of globalisation, the potential contribution of financial development to the acceleration of growth is further financial intermediaries have an advantage in gathering information on investment projects and hence allocate the funds to high-return investments and can positively affect growth. Intermediaries collect information on alternative projects and invest the funds in projects that yield highest returns. The process of growth also stimulates higher participation in financial markets and their expansion. The intuition is that financial intermediaries provide liquidity to individuals that face an uncertain future liquidity need. Importance of Capital Adequacy for Financial Intermediaries and Their Investors For financial intermediaries to operate in the market at a stable and reliable state, the capital adequacy requirement is an important prerequisite. Capital adequacy, therefore, refers to the measure of an institution’s asset strength relative to its liabilities. For a financial intermediary, it may refer to the ratio of its loans to the deposits or the value of finances available for lending with respect to the amount being deposited or that is being requested by borrowers. Capital adequacy is, therefore, important for various reasons in any financial system. Firstly, it ensures that there is a good cover of withdrawn funds or funds given out in the financial system. In simple terms, capital adequacy requirement in any financial institution will ensure that it does not issue funds and outstrip its capacity to do so. For investors, the risk of losing out their money on uncovered lending programs is catered for, hence providing stability in the financial system. Secondly, a borrowing request may not be foreseen, as a result a financial intermediary with a good capital base will cater for unforeseen future demand for financing. Thus, the financial system is more reliable and funds are available at request. This is a very important characteristic of the financial system that would be otherwise ineffective in the event that it cannot sustain the economy. Another important factor for adequacy requirement is that it enables the financial intermediaries cope with deviations from the normal cash flow that may be as a result of economic turbulence and other factors. Given the dynamism of the financial market and the economic environments, it is obvious that cash flow is subject to numerous changes that may result in reduction or increase of flow. A financial system that is not able to cushion itself from this dynamism cannot survive for a long time in the economic environment. It is, therefore, evident that capital adequacy is a component that exists because of the various risks faced by intermediaries in the financial system (Gallati, 2003). These risks are as a result of numerous adjustments in the financial sector and, therefore, capital adequacy ensures that in either way, the intermediaries such as banks and other financial institutions are able to cater for the risks posed to them by such adjustments. The investors in the financial market are also assured of their investments. References Amoako-Adu, B. and smith, B., 2002. Analysis of P/E ratios and interest rates. Managerial Finance, 28 (4), pp. 48-59. Brigo, D. and Mercurio, F., 2006. Interest rate models - Theory and practice: with smile, inflation and credit. London: Springer Publishers Burton, M. and Brown, B., 2009. The financial system and the economy: principles of money and banking. New York: M.E Sharpe Publishers. Cebula, R., 2011. Current issues in financial economics: an overview. Atlantic Economic Journal, 39 (1), pp. 1-5. Gallati, R., 2003. Risk management and capital adequacy. London: McGraw Hill Publishers. Harker, P. and Zenios, S., 2000. Performance of financial institutions: efficiency, innovation, regulation. Cambridge: Cambridge University Press. Mayo, H., 2007. Investments: an introduction. London: Cengage Learning Publishers. McEachern, W., 2011. Economics: a contemporary introduction. London: Cengage Learning Publishers. Mishra, R. K., 2005. Regulation of financial intermediaries in emerging markets. South Asian Journal of Management, 12 (3), pp. 96-97. Neville, P., 2002. Implications for financial intermediaries in attacking money laundering through enhancing tax law enforcement. Journal of Financial Crime, 10 (1), pp. 73-75. Read More