Three Main Dimensions of Financial Institutions - Essay Example

Three Main Dimensions of Financial Institutions Conceptual framework for the process and measurement of Financial Development, within a two-dimensional matrix of (a) sectors, namely institutions and markets, and (b) three main dimensions of Financial institutions Introduction In the wake of the recent global economic crisis, there has been renewed interest in examining the role of financial development. It has become a source of interest to many researchers, in the context of the economic growth and infrastructural development in a country. The global economic recession that originated from the US mortgage market sector, few years back, has expressed itself in the form of ‘sovereign debt,’ within the countries that fall under the ‘Euro zone’ (Eichengreen, Mody, Nedeljkovic, and Sarno, 2009). Even in 2011, we find that the markets continue to struggle with the question of economic reforms, in association with other basic questions, like how to develop sustained and enduring financial growth while also elevating fiscal responsibility. The development of financial systems are affected by various factors, which are, financial institutions risk management policies, ‘indebtedness’ of both individuals and sovereign elements, the banking system, regulatory delinquencies, and exports via the ‘exchange rate policy.’ Some modern researches claim that the chief cause of the current economic recession is mainly owing to certain socio-economic queries, pertinent to a much broader context, like the enduring presence of income inequality, through the investments made in the line of education and human capital (Rajan, 2010). The World Economic Forum has defined financial development “as the factors, policies, and institutions that lead to effective financial intermediation and markets, as well as deep and broad access to capital and financial services” (The Financial Development Report 2010, 2010, 4). Financial development, is the trajectory through which the states can work towards elevating the efficacies of their economic system (markets and resources), the banking sector, the monitoring of various investment projects, and overall strengthen the position of the financial system. Thus, one can view financial development as a major aspect in affecting a country’s economic growth and welfare (Huang, 2006, 2). Strong factual evidences uphold the notion that finance is at the base of a state’s developmental process. Modern academic scholars in the line of economics increasingly believe that efficient, smoothly running financial systems are essential for processing funds for use in various generative purposes, and in apportioning risks measures to those that can bear it, thus fostering economic development, enhancing infrastructural growth chances, balanced income distribution, and alleviating poverty (Aghion,  Howitt, & Mayer-Foulkes,  2005; World Bank 2001). While assessing the objectives of the financial structures and analysing the process and measurement of financial development in a country, focus must be on certain factors. These are the present terms of the financial services (like the various financial institutions and markets); analyzing the factors behind the underdeveloped and overlooked market sectors; and identifying the various barriers within the present range of financial services (Rajan and Zingales, 1998). The dimensions along with the provisions made for the financial developments of a country are assessed are efficiency; size; and reach; along with the quality and cost of the provided financial services for the economic growth of the country (ibid). Thus, the ideal conditions for a good financial developmental system in a country will make provisions for a safe and low cost transfer of money within the state, access to remote locations, and also to the socially and economically weak homes. There will be facilities benefitting monetary deposit and other investment contingencies that will make provisions for good ‘risk-return’ trade-off values, and high liquidity gains. Various entrepreneurs will have a wide variety of funding sources for their effective functioning while affordable consumer finance and mortgaging facilities will accessible to all members of the society. A strong financial development will also reflect a system where “the credit renewal decisions of banks and the market signals coming from organized markets in traded securities will help ensure that good use continues to be made of investable funds”( World Bank and IMF, 2005, 70). Thus, we find that the scope of analysing the process and measure of financial development structure is fairly wide, and it is impossible to break the entire process into self-contained compartments that are in accordance to the existing markets and institutions, and all the sectors must be viewed as a part of one process. In this context, we will examine the various indicators of financial development in order to create a conceptual framework for the process and measurement of financial development, within a two-dimensional matrix of the sectors, like institutions and markets, and the three main dimensions of the financial institutions, that is, efficiency; size; and reach. Discussion Assessment of the measures and processes of financial development- a general overview: The most significant characteristic in the analysis of the financial structures and development is the creating a locus on the financial service users and on the effectiveness of the system in catering to the needs and demands of the user. Analysis of financial structure and potential developments often make studies of the various policies and reforms that are specially created for the user benefit and that promote financial development are generally favoured in such analysis and assessments (Skeel, 2003). The proposed conceptual framework for process and measurement is based on the assumption, from a considerable amount of empirical evidences (from World Bank and IMF sources) that an effective financial development is best accessible from market oriented financial sources, while the state’s role being limited to regulating and creating the infrastructure for a strong financial development. In accordance with the definition of the term financial development as provided by The Financial Development Report 2010, the various measures of financial development is distinguishable by seven primary aspects. These are: 1. Environment of the financial institutions 2. Environment of the business sector 3. Financial durability 4. Banking services 5. Non-banking services 6. The markets 7. The access to the entire set of financial services provided (The Financial Development Report 2010, 2010, xiii). Thus, we find that the indicators for a country’s financial development takes into account an overall view of all the factors that aim at a long-term development of a state’s financial systems, and encompass a much broader scope than simply taking into account the measures of the present or short-term financial stabilities. Owing to the broad scope of the definition, we find that the top pointers in the FDI list, US and UK, have poor scores in the context of financial stability that are compensated by compelling strengths within their intermediate financial processes that help to elevate their positions within the FDI ranking list. UK and US show advantages in the various nonbanking sectors and the markets, while United Kingdom also demonstrates strength in banking sectors based on the measures of the institutions efficiency and size. In the 2010 Financial Development report, however, both the countries show signs of overall economic deterioration, particularly in the area of taxation. Fig 1: Top 10 countries in the overall Financial Index ranking. Here we find that the countries with smaller economies (as per their GDP) are more predominant amongst the top 10 list (like Hong Kong SAR Singapore and Australia), when compared to the member countries of the G-8 (The Financial Development Report 2010, 2010, xiii). Fig 2: Absolute GDP growth vs. Financial Development Index 2010 score (source: The Financial Development Report 2010, 2010, xiv). From the figures obtained in the 2010 Index results (fig 1) when viewed in the context the present economic situation shows that some of the developing countries are now the major players in global market arena. They are also the primary drivers behind the present world economic growth, while predictions show that at the present rate of growth the developing countries would generate the majority of absolute GDP growth over the next five years (The Financial Development Report 2010; Rajan and Zingales, 2003). At an average estimate, the rising economies with high GD rates, however, show 1.3 points less in the FDI rates the economies of the developed nations in the Index (Figure 2). This observation reveals that financial stability, though a significant feature of the rising economies, while accounting for performance in other areas of the FDI, may work towards restricting economic growth at both the national and global levels. Here, before we take a closer look at the various financial development indicators we will first examine the theories that conceptualise on financial development of a country. Economic theories pertaining to financial development: A significant body of literature backs the notion that like various other important elements, there are strong relations between the achievement of a long-term economic growth and development and the extent of financial development. Financial development is assessed by considering certain factors like efficiency, size, access, depth, effectiveness, and security of the financial system, which is comprised of the institutions, markets, intermediates, resources and assets, and the various associated regulations. The greater the levels of financial development in the country, the wider are the provisions of financial services that allow risk diversifications. This in turn increases the growth curve of a nation and allows a greater scope for the consumers to access a range of financial services. Joseph Schumpeter first proposed the link between economic growth and financial development in the early 20th century, where he claimed that the financial intermediaries advocated technological modifications by providing economic resources for the invention of new products (Schumpeter, 1912). However, the technological inventions alone could not bring about the economic growth that was noticed in 18th century UK, and a significant amount of financial investments also helped in the initiated the Industrial Revolution in UK and later in Europe (Hicks, [1969], 2001). In this context, Levine commented, “If the financial system does not augment the liquidity of long-term investments, less investment is likely to occur in the high return projects…. Because the industrial revolution required large commitments of capital for long periods, the industrial revolution may not have occurred without this liquidity transformation” (Levine, 1997, 692). The Keynesian Liquidity Preference Theory promoted the non-neutral role of money processes, and shifted the focus away from the role of credits with a financial system. The theory stated that “if part of the monetary income received by the operators is accumulated rather than spent, the effective demand will not be able to absorb all the production and this will fuel unemployment”( Keynes, 1933, 408-11). In the ‘Liquidity Trap Model,’ Keynes stated that “if the liquidity trap sets a floor to the interest rate at the rate (i ) greater than the level of interest rate consistent with full employment, it triggers a disequilibrium in the market of loanable funds with planned saving exceeding planned investment” (Keynes, 1936, 235). This would in turn lead to large-scale fall in expenditure compared to production levels and a subsequent accumulation of undesired inventory and involuntary unemployment. Gurley and Shaw in their ‘Debt Intermediation theory’ focus on the role of the financial intermediaries present within the credit supply, instead of the money supply process, where they define the scope of external financing, in the process of financial development. Gurley and Shaw’s theory claim that “Economic development is retarded if only self-finance and direct finance are accessible, if financial intermediaries do not involve…Institutionalisation of saving and investment quickens the growth rate of debt relative to the growth rates of income and wealth” (Gurley and Shaw, 1955, 518). In their papers, they distinguished three steps in the process of financial development process: Introduction of external money (public fund in form of cash balances) that exerts restrictions on the efficient appropriation of saving towards financial investment, thus, retarding growth. Introduction of direct (bonds/ equities) and indirect (bank debts) forms of financing that elevates the overall financial scope and capacity of the national economy. The financial system starts to evolve and becomes more advanced, providing for a large variety of financial mechanisms, both for the lenders and the borrowers (Gurley and Shaw, 1955). Modigliani- Miller’s theory frames that in reality the economic decisions are free of the financial structure, (under certain assumptions), and the firm value remains uninfluenced by the financial structure, thus remaining unaffected by the fact whether the investment spending is resourced through the processes of debt issuing or equity raising. In this theory, there are no considerations for indirect financing through the process of bank credit, while there are no significant roles for financial intermediaries within the scope of financial development. Another famous theory that connected economic growth with financial development is the McKinnon-Shaw approach where the relationship between financial and economic development is based on Gurley and Shaw's ‘debt-intermediation hypothesis.’ As per this hypothesis, an increase in monetary stock as regards the degree of actual economic activity tends to increase the levels of intermediation within the financial arena, which further acts by increasing the ‘productive investment’ and the ‘per-capita income.’ It further adds that the “nominal interest rate controls inhibit capital accumulation because they reduce the real rate of return on bank deposits, thereby discouraging financial saving” (Demetriades and Luintelb, 2001, 465). The McKinnon-Shaw approach also shows that the greater ‘real’ interest rates have an elevating effect on the “average productivity of the aggregate capital stock” by discouraging the investors on putting their money on projects with low returns (Fry 1997; World Bank, 1993). After examining the theories that examine the processes of financial development and subsequent economic growth of the country we will now examine the various indicators of financial development as outlined by the World Bank in their latest indicator publication of 2009 (Beck, & Demirgüç-Kunt, 2009). Indicators of financial growth: To measure the levels of financial development, one must take into accounts all the different factors that as a whole contribute to the Fig 3: The Composition of the Financial Development Index (the seven pillars as denoted by the The Financial Development Report 2010, 2010, 5). to the degree of effectiveness of the provision found with the present financial services. To create a conceptual framework index that measures the levels of financial development, its various aspects of can be characterised as seven “pillars,” that are classified into three main classes (Figure 3): 1. Factors, policies, and institutions: these are the basic characteristics that assist in the development of markets, financial intermediaries, instruments, and financial services. 2.Financial intermediation: the efficiency, size, reach, and variety of the markets and financial intermediaries that give access to financial services. 3.Financial access: access to different forms of financial services and capital for individual citizens and business enterprises. To complement the above stated set of diverse indicators for assessing an overall finance development, as per the guidelines set by the World Bank and IMF publications, the assessors must also converge on the ‘sectoral indicators’ of financial development. Table 4 displays some of the sub-sectors of a financial system and show the relevant indicators of their ‘size and development.’ Here the breadth of the financial system can be interpreted in terms of the reach and accessibility of the existing financial institutions, as for example, the outreach of a banking system, seen in terms of the “total number of branches and the number of branches per thousand inhabitants” (World Bank and IMF, 2005, 17). Owing to the limited scope of this paper, instead of analysing the ‘sectoral indicators’ it will focus only on the primary indicators of financial development, like, institutions, markets and the efficiency, size, and reach, of the financial institutions. Fig 4: Sectoral Indicators of Financial Development (Source, ibid, 18). Institutional indicators: “The institutional environment encompasses the laws and regulations that allow the development of deep and efficient financial intermediaries, markets, and services as well as the macroprudential oversight of financial systems”(The Financial Development Report 2010, 2010, 5). This encompasses all laws that regulate and monitor the financial sector, the quality of corporate governance and contractual enforcement. As per the economic theories, a strong and stable institutional environment is necessary for decreasing the transaction and information charges (Levine, 2004). Legal institutions are also an essential part of the financial development, since it works towards protecting the investor interests (Barth, J., Caprio, G., and Levine, R., 1999). Thus, reforms that aim to boost the nation’s legal entities and overall environment along with safeguarding the investor are likely to create a more effective financial sector (Bekaert, and Harvey, 2005). Good corporate governance within business institutions encourages financial development, which in turn positively affects growth (La Porta, Lopez-de-Silanes, and Shleifer, 2000). ‘Contract enforcement’ is another important aspect in financial development since it restraints the chances for evasion among the debtors, which leads to greater compliance (Shleifer and Vishny, 1997). If the investor safeguarding is inadequate it creates a number of negative effects, which in turn proves to be harmful for the external financing, and ultimately moves towards the formation of strong capital markets (Tavares, J. 2002). Overall, observations reveal that inadequate enforcement of financial contracts help in boosting credit rationing, thus working as a barrier in the overall financial development and economic growth (Galor, and Zeira, 1993). Role of banks: The recent economic crisis has brought into focus the necessity of regulations attached at the institutional level, as it is associated with financial stability. As observed in the recent financial crisis, the central banks have an important role within the functioning of financial systems (Siklos, 2010). Various studies also reveal that, well-established banks tend to have strong bonds with the private sector, which enables them get back their debts from the various business firms in time (Rajan, and Zingales, 2001). Supporters of the bank-based system claim that banks reaming unaffected by regulations thus have a tendency to benefit from the economic scale through information collection that in tur4n leads to greater industrial growth. Banks are perceived as primary players in removing the risk of liquidity, which assists in increasing high-return investments, illiquid assets and fastens the process of a country’s economic growth (Levine, 1997). One of the primary measures of the effectiveness of a nation’s banking system is through the factor of size; and larger the banking system, greater the possibilities of channelling the amount of financial capital from accumulators to the investors. This helps to boost the process of financial development, and subsequent better economic growth, and “these measures of size span deposit money bank assets to GDP, M2 to GDP, and private credit to GDP” (The Financial Development Report 2010, 2010, 8). Another important feature of the banking system is its efficiency, and “direct measures of efficiency captured in the Index are aggregate operating ratios, such as bank operating cost to assets and the ratio of nonperforming loans to total loans” (ibid); while indirect measure of efficiency is through the process of public ownership. Observations reveal that public banks tend to be ineffective and incompetent, thus, creating a barrier in the processes of capital channelling and credit allocation, which in turn slows down the ways of financial intermediation. Financial markets: The four major financial markets include bond markets (that includes government and corporate bonds), foreign exchange markets, stock markets (for equity trading), and derivatives markets. Stock market liquidity is significant in the context of financial development as it tends show a positive effect on productivity growth, capital accumulation, and current and future economic growth (Levine, and Zervos, 1996). The economic theories studied previously in the paper suggested that the stock markets foster long-term growth by collecting and disseminating information, advocating specialization, and mobilizing savings in a manner that promotes increased investments (Arestis, Demetriades, and Luintel. 2001). Further researches also reveal that as countries become wealthier, stock markets tend to turn more active and effective when compared to banks (Demirgüç-Kunt, and Levine, 2001). Recent researches have also shown that bond markets have a significant part to play role in financial development and the appropriate distribution of capital (Fink, Haiss, and Hristoforova, 2003). Derivatives markets also play a significantly role by improving risk diversification and management. By effective development of the derivative market, it is possible to increase the level of confidence of the global investors and financial institutions, while encouraging greater participation from these agents. Derivatives markets are generally seen to be small in the emerging market economies and the strengthening of the regulatory and legal institutions in such developing countries can increase the chances of development within a rising market scenario. Financial access or reach: this indicator covers the access to financial capital through both the retail and commercial channels. Statistical figures show that greater reach of the provided financial services within a country has always been associated with the positive financial development and the high economic growth (Beck, Feyen, Ize, and Moizeszowicz, 2008). The measure of the provided financial services, as shown by their size and depth does not always reveal their actual nature of accessibility to all users within an economy. Thus, the access indicators become an integral part in measuring financial development, besides the factors of size and efficiency. Commercial reach or accessibility means access to commercial loans, venture capitals, and the equity markets. Retail access refers to the accessibility of bank accounts and ATMs, and availability of micro-financing. Easy accessibility, along with an efficient financial system having large size and depth (as seen here in the banking sectors), has a significant influence on a country’s financial development, and economic growth; and thus as a sum total works towards the improving the country’s economic conditions, and the general well being of the nation. Conclusion Given the nature of the recent economic crisis, there is rising tendency amongst the experts to view financial development in terms of preventing the harmful effects of financial instability. However, financial development must be reviewed from a broader aspect in order to distinguish and address the faults and loopholes within the financial systems that could prove to be a threat to the future economic growth of a country. Creating a process that would lead to a strong financial development must provide for a long-term infrastructural development, in order to improve the local bond markets that form the chief capital source for the various economic segments, while also providing for improving the retail financial access as per the consumer needs. Thus, while one cannot deny the necessity of financial development for a sustained worldwide economic growth, the basic improvisation must necessarily come from the national and local levels through the appropriate creation and implementation of financial reforms. Bibliography Aghion, P., Howitt, P., & Mayer-Foulkes, D., 2005. The effect of financial development on convergence: Theory and evidence. Quarterly Journal of Economics, 120(1), 173–222. Arestis, P., Demetriades, O., and Luintel, K., 2001. Financial Development and Economic Growth: The Role of Stock Markets. Journal of Money, Credit, and Banking 33 (1): 16–41. 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