Financial Markets and Institutions - Term Paper Example

INTRODUCTION Economic growth gearing in later half of the 18th and beginning of 19th Century (Illinois Labor History Society, directed policy makers and economist into debate about exploring the most beneficial financial system for the economy. The stated benefit refers to the economic growth being the parameter of contribution level by financial system while the debate accounted for the comparison of two systems of bank-based versus market-based financial system. However, it is also an accepted fact for economic growth that the debate shall be oriented towards extracting factors that provide greater efficiency in services to economic growth and the source (financial system) of efficiency gets shall be given secondary position (Levine, 2002). Underlying discussion attempts to draft the fact that both systems have their own domain to lead the economy and hence, contributing to the economic growth. Consequently, discussion is laid to explore factors that are drivers of each system; their respective contribution in making system is markedly different in different environments and finally, developing combination of growth driving factors together for economic growth. This also leads to establishing fact that it is not necessary that factors only play role within the single financial system being employed but effective and real economic growth lies in the sound balance among both systems. DISCUSSION Financial systems under debate include bank-based and market-based financial systems. Former system has bank’ supremacy with no or least regulations implemented and has been advocated for providing mobility in early economic development era while corporate’ were still to develop governance system. The management referred is in terms of mobility, liquidity and risk management factors including sound saving and investments decisions mainly for corporations with controlled information resulting from long term tie between the bank and the corporate manager. This system is considered to be advantageous for countries where institutions where sound banking system forcing repayment reduces risk (Santomero, 1989). Japan and German noted mainly for their bank – based system. On the other hand, the latter financial system of market-based financial systems is one governed by capital markets. It provides market with solution to capital investment within market along with risk management aspects of control etc. Investment decisions being directed by availability of information to all lenders (investors). Hence, forcing businesses to perform in interest of shareholders or otherwise other options are open for investors. For instance, linking management compensation with firm’s performance or selection of management team based on firm’s performance etc. This latter format had US and UK noted for being directed by this system (Levine, 2002). Both systems’ advocates while presenting benefits it offer to economy, have also pointed to issues of the other system. Such as bank based system points to benefit that investor could reap by making efforts to explore information that in case of market based system is already open to all. Further, it points that in market based system liquidity situation forces low priced trading of shares of firm that can have detrimental effects on overall corporate performance. One most important aspect that bank based system refers as its merit and missing component of market based system is strong control over corporate management ensuring repayment of loans or investment etc. This control levels ground for FDI that would not land in the country unless repayment is assured; hence affecting economic growth. Contrary to this market based systems also asserts its benefits and identifies the lacking aspects in the banking based system. For instance, highlighting the dark side of the case when banks are given extended power to hold control of economic growth driving avenues; market system questions fate of those debtors that are interested in entering the business but not at the dominant terms of banking that are expected to rule in such case. Thereby market based systems lead the economic growth with information transmitted to all and projects with true value gets financing while projects with less value are ignored by lenders (Madura, 2012). Hence, overcoming inefficiencies characterizing the banking based system with sometime mutual consent of business as well as organization. Financial system that leads to growth are dependent in the one umbrella factor of legal strength in term o f investors’ rights safeguarded and increasing efficiency in the contract system. The aforementioned factors are in line with the financial services view that point primary importance shall be given to the underlying factors driving economy in both systems and not the systems themselves. Hence the role of both systems, in fact components of the system are complimentary than substitutes. On developing the acceptance of the systems being complimentary to each other mainly for the services that both systems lend to the economic growth, the discussion herein follows analysis of components of both systems. Furthermore, it is important for the policy maker to indentify the required contribution of both systems in case as the stated contribution and size of each system determines the role of economic growth. Moreover the development of financial system leads to the fact increased savings and investments resulting in marginal productivity of capital also benefitting society with investment in various avenues (Thakor, 1996). Hence, without distinction of role of system the role of banks and capital markets are explored. Banking sectors maintains to poses an important position in the financial system. The basic function of banking according to theory of finance is to serve as financial intermediaries receiving deposits; investing proceeds from deposits in securities and generating competitive return (Fama, 1980). In competitive environment where banking industry if given freedom to generate deposits leading to investment in securities generating returns that are competitive to average market returns (incorporating in it competitively determined market charges for channeling fund process). This case can take place when regulator allows banking sector to develop its own code of conduct and policy. Unregulated competitive banking industry would self direct to avenues that generate competitive returns. Self determined market would also self determine equilibrium in terms of price and real economic activity based on the very economic principle of demand and supply. Moreover, the unregulated banking industry would also share with investor level of risks that an investor faces in case of directly investing in capital markets. Therefore, unlike the current case where banking is driven by regulators such as restriction to invest in certain avenues to safeguard public interest (money) from defaults and managing portfolio activities with limitation; the efficiency factor that is the essence of contract management is maintained with more considerate resource allocation. Another aspect of the banking based system is exchange system. Considering the financial innovation in which banking industry has nothing to do with currency and all transactions are based on the accounting system of exchange. This accounting system of wealth transfer, for any purpose such as investing in securities etc, would only requires transferring the payment in an economic unit stated in prescribed pattern and hence has no involvement of physical medium. The system with stated kind of financial innovation would gear up the economy activity with greater magnitude resulting banking system to concentrate only on the supply of money for generating return giving particular bank lead among competitors. The consequential would be an un-controlled price count (based on supply rule of the economics) as it would not require payment in physical terms. However, considering this aspect unregulated banking system would finally result to spiral effect in inflation and providing no efficiency in contract management. Distinguished nature of the baking product i.e. money doesn’t allow such financial innovation as the aim is to control efficiency in the contract system and overall impact. Regulations have also facilitated banking system with accounting exchange system in form of cheques that doesn’t require cash but this innovation also has some restrictions to control inflation that is expected to take place in case of unregulated environment. Moreover, giving strength to banking system would also lead to extended control of banks on entire economic system. Increased control over asset allocation decision will then make entrepreneurs dependent on the discretion of banks than project’s feasibility. Unlike the stated financial innovation regulated banking industry is driven by tools such as reserve requirement ratio or regular open market operations to control the money supply etc thereby, balancing liquidity in the market to maintain the efficiency of the banking system. Banking system also share the risk under portfolio management activities but limited with regulations unlike capital markets that are open to all risk appetite investments. Scope of banking has been limited under regulations defining level of exposure banks can undertake under any form of investment against the deposit ratio. Moreover, banks are required to provide certain return within range and still serve as the facilitator of risk transfer. Banks portfolio investment with limitations has explored more avenues for investment; for instance, markets of futures and options have provided banks more areas to channelize the funds. The role of bank related to incorporating efficiency in contract management appears to be more strengthened under regulated market leading to balance economic growth than simple application of banking based system. This role of banks as discussed above also is not dependent on the form of financial system employed but mainly stresses on employing the factors that gear up the economy while harnessing it to maintain the growth at optimum level than producing negative returns. The established fact is also supported by the evidences that develop cross functional analysis of the countries being attributed to employ certain system. For the financial system to be successful role of capital markets is also equally important along with the role of banks. The role of capital markets alike with the role of banking sector has to coordinative substitute. Capital markets mainly depend on the information transfer and without information transfer market performance would be poor. For instance, information of poor projects if not transferred than lender would place greater value to project. Such practice would result in low quality projects to reach market in greater number and entrepreneurs would fetch sure profits from uninformed investors. On contrary to this good projects’ all information must be available to all investors in market based model leaving no room for an investor to generate extra (abnormal returns with excess information available). In both cases investors’ rights are exploited. In practice, such things do not happen instead projects’ information is resisted to be presented openly for moral hazards. Moreover, information is signaled from various factors such as management practices, willingness to investment own money (company gains) in projects etc. Market equilibrium under such signals-financed projects with information asymmetries has different features than financing gained from either no or all information transferred to investors (Leyland and Pyle, 1977). Hence, efficiency and safeguard of investors’ rights has to be derived from underlying factor of information transfer for the economic growth. Furthermore, newer capital markets such of options and financial futures being more suitable investment avenues for banking portfolio investment activities than individual investors (Allen, and Santomero, 1997). Various researches have evidenced the performance of both systems. Evidence of German firms’ performance refers to improvement in overall firm’s performance with controlling rights resting with banks than with non-bank shareholder’s block (Gorton, and Schmid, 2000). Comparative study challenging the source of finance mainly in countries attributed with certain set pattern of financing for example U.S. pattern of market-based finance has no evidence. The study also concluded that except Japan most of countries are heading to internal source of finance than external market based financing (Corbett, and Jenkinson, 1996). CONCLUSION Economic policy makers for deriving an economic system most beneficial has been involved in debate related to suitability of either of bank based or market based financial system. The discussion upon introducing the merits and demerits of each system stressed financial system that incorporates basic aim of each system i.e. efficiency from banking based system of contract management and safeguarding shareholder’s right in information transmission based system of market. Hence, role of banks and markets in a system than bank based and market based systems. The discussion also develops combination of economic gearing elements of each system that play complimentary to each other than substituting. In the end, the study has also referred to examples what advocate the support from these systems but at the same time challenging traditional view of attributing of entire economic growth to systems. References Allen, F. and Santomero, A. (1997) The theory of financial intermediation, Journal of Banking and Finance, 21, 1461-1486. Corbett, J. and T. Jenkinson (1996) The Financing of Industry, 1970-1989: An International Comparison, Journal of the Japanese & International Economies 10, 71-96. Fama, E. (1980) Banking in the theory of finance, Journal of Monetary Economics 6, 39-58. Gorton, G. and F. Schmid (2000) Universal Banking and the Performance of German Firms, Journal of Financial Economics 58, 29-80 Illinois Labor History Society. (2010) The industrial revolution and the progressive era 1877-1913. Available from http://www.illinoislaborhistory.org/education/curriculum/the-industrial-revolution-and-the-progressive-era-1877-1913.html [Accessed 23 December 2012] Levine, R. (2002). “Bank-Based or Market-Based Financial Systems: Which is Better?” Journal of Financial Intermediation, 11, 398-428. Leyland H. and Pyle, D. (1977) Information asymmetries, financial structure and financial intermediation, Journal of Finance 32, 97-112. Madura, J. (2012) Financial Markets and Institutions (10th ed), Thomson. Santomero, A. (1989) The changing structure of financial institutions: a review essay”, Journal of Monetary Economics 4(5), 1-14. Thakor, A. (1996) The Design of Financial Systems: An Overview, Journal of Banking and Finance 20, 917-948. Read More