The Role of Financial Markets and Banking systems In the Development of an Economy - Essay Example

The Role of Financial Markets and Banking systems In the Development of an Economy 0 Introduction: A well regulated financial market and an efficient banking system are the backbones of an economy, especially the one which is at a developing stage. The financial market includes the stock and bond exchanges, commodity exchanges and other financial intermediaries like investment banks. The very purpose of these organizations is to ensure that the trade and industry of the country gets the required finance at the right time at very economical interest costs so that they will be able to their financial goal of profit maximization. Without the financial markets the firms would not be able to mobilize the required capital for their existing and expansion projects. The effective functioning of the financial markets is greatly aided by the existence of an efficient banking system. The banking system encompasses a network of commercial banks and other lending institutions controlled usually by an apex body known as the central bank of the country. A purposeful coordination between these two organizational setups is absolutely essential for the financial harmony in a country. Hence it is for the government to ensure such coordination through regulatory and other reporting measures. These regulatory measures may even include provisions for the organization and structure of the capital markets and the banking system. The purpose of this paper is to bring out the role of the financial markets and the entire banking system in the development of an economy and their relationship with the financial and corporate sectors of the economy. 2.0 Economic Functions of the Financial Markets: According to Nasdaq Educational Foundation the financial markets in a country are responsible for performing a number of functions for the development of the economy. Some of these functions are: The financial markets provide with the successful companies the additional funds they need to finance their capital projects. Thus it provides further business opportunities for a growing business. They encourage the varied strata of investors to invest their surplus funds in the securities of different companies. Promotion of investments in the trade and business of a country is the primary function of the financial markets. They report on the movement of the stock prices which provides the important signals for the investors to channel their funds to those areas which are very productive and may yield additional returns for the investors. Financial markets represent efficient risk management tools by enabling the investors to transfer their risks. Through the functioning of the financial markets the investors who is averse to more risk taking can transfer the risk to those who are able to tolerate more risk. 3.0 Stock Markets: The stock markets basically being a major constituent of the financial markets of a country provide the venue and the ways for different companies to raise the required capital by way issuing shares. The stock market represents a virtual market place where the buyers and sellers of stocks and securities of different companies meet to exchange their possessions for value. The functioning of a stock market is so complex that it depends upon so many factors which are not controllable. The efficient market hypothesis states that the stock prices in the market react on the basis of the information made available to the market. However the government can form regulations to control the functioning mechanisms of the stock markets laying down the procedures for dealing in shares. Listing of the shares of a company is a prerequisite for the shares of any company to be transacted in a stock exchange. 4.0 Other financial Markets: Futures and options are known as derivative and the derivatives market also represents the financial market of a country. There are different ways in which the futures market operates like calls, options, hedging and swap. “Buyers can obtain protection against rising prices and sellers can obtain protection against declining prices through futures contracts.” (Andrew M. Cuomo) The futures carry substantial risks and trading in futures is rather a complicated system. It may cause losses even to experienced investors as it involves the prediction about the future direction in both ways of the price changes which phenomenon is highly risky. Investment banks and insurance companies also form part of the broad spectrum of the financial markets in a country. Regulating the functions of these organizations is also the responsibility of the governments to ensure a smooth functioning of the economy. 5.0 Stock Market in Hungary: As an illustration for the working of the financial market in a developing country this part of the paper analyses the stock market functioning of Hungary a fast developing East European country. The Budapest Stock exchange represents the major financial market of Hungary. This stock market has a history of getting established as back as 1864. As per the ‘History’ page of the Budapest Stock Exchange there is an active participation of this stock exchange in the European Economy and the different major stock exchanges in locations like Vienna, Frankfurt, London and Paris publish the quotes from the Budapest stock exchange. 5.1 Strategies of Budapest Stock Exchange (BSE): Being an active player in the Hungarian capital market the BSE has the following strategic missions in its functioning: Enlarging the involvement of the investors of the country in the effective stock market functioning Enlarging the range of the financial products being dealt with by the exchange Soliciting and maintaining the cooperation of other countries of the world Consolidating the functions and services of the exchange and Ensuring effective communication with the financial community 5.2 Organisational Structure of BSE: BSE is formed as a company limited by shares in the year 1990 by a Deed of Foundation and is managed by a Board of Directors headed by a Chairman and assisted by a CEO and two Deputy CEOs. BSE is also a full member of the Federation of European Securities Exchanges (FESE) and the World Federation of Exchanges (WFE) 5.3 Functioning of the BSE: Transactions in stocks and bonds including Mortgage bonds, Corporate bonds, Government bonds and Treasury Bills as well as other derivatives are traded in the BSE. BSE operations are heavily influenced by four leading stocks which determine the index of the BSE. The BSE also operates through BUMIX. BUMIX is an exchange where the medium and small captialisation shares are listed. This exchange is for those shares which do not qualify for inclusion into the BUX shares index. However shares listed in BUMIX do not influence the index in a major way because of their relatively low rate of dealings The BSE follows Xetra Trading system with more than 300 members having trading licences from more than 16 countries. Through this system the BSE can have access to more than 8000 securities. It also provides the facility to deal in securities being traded in other European stock exchanges as well as major United States Exchanges like Nasdaq, S&P 100 etc. According to the BSE Annual Report 2006, the Stock Exchange has transacted 26.088 billion Euro worth of cash market securities and 24.357 billion Euros worth derivatives during the year 2006. Budapest Stock Exchange is the Second best stock exchange nest to the Warsaw Stock Exchange of Poland. The BSE’s highest recorded index point was 25550.68 and it has reached the lowest point of 717.75. The exchange has current transactions running with 20 stocks. 5.4 Indices of the Budapest Stock Exchange: Currently the following indices are operated in the Budapest Stock Exchange in Hungary. BUX - This is the official share index of the Budapest Stock Exchange Company Limited by shares BUMIX – This index represents the Mid and Small Cap Index of the BSE. Generally those shares which do not have the required criteria for inclusion in the BUX are included in this index CETOP20 – being the Central European Blue Chip Index RAX – this index represents the equity investment fund and portfolio index DWIX – The Daiwa-MKB Treasury Bill Yield Index dealing with the Treasury Bills. In order to get qualified to enter into the BUX index the following requirements have to be met: Minimum face value as prescribed by the exchange Minimum price of the shares should have been defined The shares should register at least a minimum number of transactions in the stock exchange The turnover on the stock exchange should be at least 10 percent of the registered capital during the period of six moths preceding to the revision of the index. 5.5 Sections of the BSE: The Budapest Stock Exchange consists of the following sections: Equities Section dealing in Equities, Compensation Notes and Investment Funds Debt Securities Section covering Treasury Bills, Government Bonds, Mortgage Bonds, Corporate Bonds and International Bonds Derivatives Section dealing in Equities and Index Futures, Equities and Index Options, Currency Futures, Currency Options, Interest Rate futures Commodities Section dealing in Grains and Gold Apart from the above sections, the BSE also operates an Exchange Traded Fund. The principal objective of this BUX Index Tracking Exchange fund is to ensure that 95 percent of the assets are invested in the equities that are being traded in the Budapest Stock Exchange and the fees and transaction costs are kept at the lowest possible level. 6.0 Banking Systems: Traditionally banks involved themselves in the process of accepting deposits from the public mobilized out of their savings in return for a nominal rate of interest. These deposits in turn were lent to other needy customers against the payment of pre-agreed rates of interest usually for fixed periods of time. The difference in the amount of interest collected from the borrowers and the amount of interest paid to the depositors represent the profits of the banking institutions. However modern day banking systems have undertaken additional functions of selling insurance products. In addition they also involve themselves in the marketing of investment products like mutual funds and also stock broking. This way these institutions have reached larger sections of the people and mobilize more investments being utilized for productive purposes. 6.1 Regulation of Banking Systems: Since the banks represent the major constituent of the large financial sector, an efficient functioning of the banking system should be ensured in order not to cause a breakdown of the financial system. It is necessary to create an apex body of authority with supervisory functions to oversee the general functioning of the overall financial system and specifically into the operations of the banking system. The functions of these apex institutions encompass the provision of regulations governing the merger of banking, insurance and securities businesses which lead to the development of the financial market. The process of controlling the overall financial markets including the banking system requires a complete monitoring of the trends of development in the financial market, critical evaluation of the inherent risks in the different sectors of the financial market and evolving a measurement of the impact of such risks on the overall developments in the financial system of the economy. Such authoritative position is usually assigned to the central bank of the country. 7.0 Banking System in Hungary: According to the Magyar Nemzeti Bank website established in the year 1924, as a company limited by shares, the National Bank of Hungary was responsible for maintaining the state’s accounts. It also took the responsibility for managing the country’s external borrowings. By the careful monitoring of the interest rates and evolving intelligent credit policies and also through efficient controlling of the bill discounting principles the National Bank of Hungary was able to control the credit flow in the country and thereby greatly influenced the operation of the banks and the system of banking in the country. The apex institution was also bestowed with the responsibility of managing the foreign exchange matters of the country. 7.1 Single-tier Banking System: The new national currency of Hungary ‘Forint’ was introduced in the year 1946. In accordance with the nationalization of the stocks of all banks including the central bank that was brought into operation in the year 1947, there was a complete restructuring of the banking system With this the government liquidated all the existing commercial and savings banks in the country and introduced a single-tier banking system. The National Bank of Hungary was also allowed to enter into commercial banking services in addition to its function as the central bank of the country. However the country witnessed the return of the two tier banking system in the year 1987. According to the Bank’s website “With a few exceptions most of the system, branch offices and clients of the new commercial banks which were established were drawn from the National Bank of Hungary.” The National Bank of Hungary Act passed in the year 1991 with its various amendments has ensured that the bank is entrusted again with all the usual responsibilities of a central bank. 7.2 Organisation structure of the National Bank of Hungary: The National Bank of Hungary is being managed by a Governor, a Deputy Governor, Board of Directors, Monetary Council and a Supervisory Board. Management of the Foreign Exchange Rates: The responsibility of fixing and maintaining the foreign exchange rates are vested jointly with the government and the National Bank of Hungary. The Bank is given a fluctuation band within which the market exchange rate is maintained by the bank. This is known as central parity and it was 276.1 Forint/Euro between the periods from May 2001 to June 2003. 7.3 Responsibilities of the National Bank of Hungary: The fiscal policies of any nation evolved to regulate the financial markets are translated into various regulatory provisions to be implemented through the apex banking institution usually known as the central bank of the country. In most of the major countries in the world the central bank is usually owned by the state. The National Bank of Hungary being a nationalized central bank it is being managed by the government and by this way the government ensures that it has more control over the institution so that it can enforce its fiscal policies freely through the medium of the National Bank of Hungary. National Bank of Hungary bank being the regulatory authority has the following responsibilities: Acting as the institution for implementation of the fiscal policies of the government Acting as the banker for the government as well as the custodian and banker for all other banking institutions in the country Managing the foreign exchange transactions and gold reserves of the country including the maintenance of the government stock register Acting as the regulatory authority supervising the functions of the commercial and other banking institutions in the country Managing the inflationary tendencies as well as foreign exchange rates through an efficient setting and control of the interest rates; it has also to ensure that different policy mechanisms are adopted to ensure that the interest rates take effect Acting as the sole authority for the issue of currencies and bank notes (Wikipedia) 8.0 Central Banks and Monetary Policies: According to the Bank of England Home page “Interest rates influence spending and saving in the economy and the prices we pay for goods and services. Low inflation helps to maintain a stable economy and the value of our money”. One of the core functions of any central bank is to ensure ‘monetary stability’. Monetary stability implies stability of prices, lower inflationary trends and maintenance of the confidence in the country’s currency. Usually the monetary committee decides on the interest rates to be applied. The interest rates are fixed in such a way that they restrict the inflationary tendencies and stabilize or lower the prices of commodities according to the boundaries of inflation set by the government. Another principal function of the central banks is to maintain the purchasing power of the currency of the country. Spiraling prices tend to reduce the value of money. By suitably changing the monetary policies through altering the interest rates, the central bank will be able to achieve the objective of non-inflationary economic growth of the nation. By maintaining the inflation at a lower rate the central banks can ensure a long-term economic growth. Similarly by achieving stability in prices the central banks can ensure a sustained economic growth coupled with increase in the employment potential. 9.0 Conclusion: In order to ensure a balanced development of their economies, almost all major countries of the world are resorting to financial market reform which is a key element in restructuring the prevalent financial systems. In spite of such concerted efforts the world had witnessed several banking and financial crises not only in developing and transition countries but also in industrially advanced countries like Japan. Such incidents have demonstrated the havoc that can be created when the financial systems fail. The result would be severe economic contractions which will tell upon the social well being of the people of the country by imposing unnecessary additional cost burdens on the common man. Thus the avoidance of the recurrence of the worst business cycle contractions is at the root of any financial market reform, which if attempted properly will result in a sustainable growth of any economy. References: 1. Andrew M. Cuomo How Financial Markets Work New York State Attorney General http://www.oag.state.ny.us/investors/invest_2.html 2. Bank of England Home page http://www.bankofengland.co.uk/ 3. History’ page of the Budapest Stock Exchange Web page http://www.bse.hu/onlinesz/10003243.html?uio=4LONGO8FDYYE2007903U22AP18Z55Z12SMIH92705guest 4. Magyar Nemzeti Bank website http://english.mnb.hu/Engine.aspx?page=mnben_1_jegybankrol&ContentID=2326 5. Nasdaq Educational Foundation Market Mechanis: A guide to U.S. Stock Markets release 1.2 http://www.nasdaq.com/about/market_mechanics.pdf 6. Wikipedia http://en.wikipedia.org/wiki/Central_bank Read More