Importance and Role of the Financial Sector - Assignment Example

Importance and Role of the Financial Sector The financial sector can be defined as an industry which provides financial services to both commercial and retail consumers. The key players in this sector from are banks, insurance companies, stock exchanges, insurance companies and non banking financial institutions.i The importance of the financial sector can be highlighted by its impact on the micro and macro economy indicators. These are interest rates, inflation rates, balance of payments deficit/surplus, exchange rate and growth rate. The demand and supply of money in the economy is controlled by the financial sector. This affects the interest rates. An interest rate is at the very basic the cost money. It’s how much you pay to receive money and how much you earn to sell money. Banks basically help determine the interest rate. While each bank may offer different interest rates to customers, the basic rate or the discount rate is determined by the Central Bank (Mathieu, 1995, p. 64). This is the rate at which the central bank lends to all other banks. And the central bank sets this rate by considering factors such as the demand and supply of money, interest rates, exchange rates, balance of payments and the growth rate. The financial sectors set the interest rate which affects the exchange rate of a currency. A high interest rate means that the currency essentially “costs” more. It also means that if foreign investors put their money in local accounts they will get higher returns. This is known as hot money inflow. As more investors buy the local currency, the currency appreciates. While high interest rates lead to hot money inflows it also means that the country’s exports are now more expensive for foreigners. This means that if previously an American had to pay $1 for PKR 80, now they might have to pay $80/70 since $1 is now equal to PKR 70 and not PKR 80. This means that if previously an item in Pakistan cost PKR 800, the American had to pay $800/80=$10. But now since PKR has appreciated he has to pay $800/70=$11.43. So it costs him more now and depending on the elasticity of demand, he might buy less or not buy at all. So an appreciation of currency is not necessarily a good thing. On the other hand imports become cheaper. E.g. if a barrel of oil cost $100, a Pakistani importer had to pay PKR 100x80=PKR 8000 per barrel. But now he has to pay PKR 100x70= PKR 7000 per barrel. However as imports increase this can create inflationary pressures in the economy and on the balance of payments. If exports are greater than imports, all things held constant, the balance of payments is positive. However if exports are less than imports, the balance of payment is negative which means the country has to find alternative sources of funding to bridge the gap (Sametz, 1993, p.16). Finally studies have shown that historically there is a strong correlation between high economic growth and high financial sector growth in countries. The key roles of a modern financial sector can be broadly classified into five categories.ii First is strong public finance i.e. the ability to raise revenues, control expenditures and service public debts. Without the ability to accurately forecast future expenditures and revenues, many countries would have to resort to debt borrowing or sale of national assets. Second, stable money, this can mean one of two things. One is to keep the supply of money in the economy stable. This consists of M1 and M2 money usually. These terms signify the liquidity of the money in the economy ranging from very liquid to highly illiquid. At any given point in time the demand and supply gap of money in the economy should not be too large. If supply is less than demand this will create a liquidity crunch in the economy causing interest rates to rise to incentivize people to save. It can also however lead to higher costs of borrowing. On the other hand if supply exceeds demand, people will spend their excess money, interest rates will fall and a higher demand for products will be created leading to inflationary pressures on the economy. The banking system offers people the chance to save excess money or get access to more money. Both come at a cost of interest. In the first case the bank gives the depositor a premium to save and invests the money elsewhere to earn higher rates of interest. This is usually lending the depositors money to someone else like the second case. The difference between the lending and depositing rates of banks is known as the spread and the larger the spread, the more inefficient the banking system is. Like any sector, the financial sector is also regulated by the government. The key bodies governing the financial sector are the central bank and the securities and exchange commissions. The central bank performs the fourth role of the financial sector i.e. it acts as the official bank for the government. It works by supervising and regulating the financial system of a given country. It also acts by creating and enforcing monetary and financial policies which need to be implemented keeping in mind the economic stability and growth of the country. The Securities and Exchange Commission performs the fifth role of the financial sector i.e. well-functioning securities market. Well functioning securities markets ensure that avenues of investment are open for both large and small investors. This prevents money from being idle. At any given point if money is not invested or kept in an interest earning bank account, it is losing value as per the time value of money concept. BFIs and NBFIs and their roles Any financial sector can be categorized into BFIs and NBFIs. Banking financial institutes can be further divided into merchant banks, commercial banks and finance companies. Non-bank financial intermediaries (NBFIs) include many different activities such as factoring, venture capital companies, leasing, contractual savings and various fund for example insurance companies, pension funds, mutual funds etc (Sundararajan, 2002, p.23; Haggard, Lim & Kim, 2003, p.87) Commercial banks usually form the largest chunk of the banking sectors activities. Finance companies offer services that centre on hire purchase financing type of activities, this would also include house loans, personal loans, leasing and block discounting. Merchant banks are more focused on complex banking i.e. derivatives and bulk financing. The work done through merchant banks in the money market is mostly of a short term nature. Their focus is to raise capital through a variety of activities such as syndicating, corporate financing etc. Any institution which is not a bank but is involved in financial services like investment, building societies etc can be classified as a NBFI. Non-bank financial institutions (NBFIs) are important for two main reason i.e. the financial stability of a country and economic development First, banks offer a very limited range of services. They accept deposits and give out loans. NBFIs however are able to offer a wider range of financial services which ensures that customers with different preferences for risk have a wider portfolio to choose from. Second, since banks provide a limited range of financial services, all the risks are bundled up together. Also since banks are much more developed than NBFIs this degree of concentration of risk is much higher than those of NBFIs. Thus it becomes necessary to have NBFIs to channel some of this risk away from banks (Vane & Thompson, 1993, p.60). The main role of any NBF entity is to invest and make use of savings and to act as a catalyst for different investments, they do not however, deal with the public or accept deports from them directly. NBF banks can be seen as a buffer system in a way because they create a balance in the market by acting and providing services as an alternative to those already being given forth by a commercial bank. This becomes a direct competition for commercial banks and forces them to perform at better efficiency levels and become more consumer focused to retain their competitive advantage. Many NBFIs are also centered more around securities and in the recruitment and allotment of long term financial reserves. Transaction Costs and Roles of Financial Intermediaries in Minimizing them A transaction cost is the cost of making an economic exchange. These costs can range from search and information costs to bargaining costs to contract costs and policy and reinforcement costs. It is a widely held belief that financial intermediaries exist to minimize transaction costs and we will determine how that happens (Groenewegen, 1996, p.151). For starters, financial intermediaries enjoy economies of scale. This is because their scale of operations is so large that their costs are spread over many transactions. Hence transaction cost per activity is quite small. This is probably why banks can process loans quickly because of pre existing legal departments, diversifies portfolios etc. Even if they make a loss, the loss is covered by a profit in another transaction (Dietrich, 1994, p62). Financial intermediaries are experts in their fields. This means if there is a financial transaction to be made they know the best way to do it and at the cheapest costs. They can offer diversified risks and more liquidity. References Sundararajan, V. 2002. Financial soundness indicators: analytical aspects and country practices: International Monetary Fund Haggard, S., Lim, W., Kim, E. 2003. Economic crisis and corporate restructuring in Korea: reforming the chaebol: Cambridge University Press Mathieu, N. 1998. Financial sector reform: a review of World Bank assistance: World Bank Publications, Sametz, A W. 1993. The role of the financial sector in the reform and reconstruction of Eastern European economies: New York University Salomon Center, Leonard N. Stern School of Business Vane, H, Thompson, J.L. 1993, An introduction to macroeconomic policy: Harvester Wheatsheaf, Groenewegen, J. 1996. Transaction cost economics and beyond: Springer Dietrich, M. 1994. Transaction cost economics and beyond: towards a new economics of the firm: Routledge, Read More