Financial Institutions' Role in Integrating Economics - Essay Example

?Introduction Financial s have played a significant role in integrating the different economics of the world. A brief analysis of the global economic scenario can highlight the fact that the financial industry has always been that sector which has either strengthen or uplifted the economic outlook of a particular region, or has caused turmoil. (Morawski, 2012) Nevertheless, for a progressive and thriving economy, it is imperative for the financial institution to equip them with the awareness regarding the various risks and benefits that prevails in the market. This report elaborates on the characteristics of a financial intermediary and how the consumers derive benefits from it. An understanding of Financial Institution A financial intermediary can be defined as an institution that acts as the middleman between investors and firms raising funds. (Investopedia, 2012) Several types of financial intermediaries such as Banks, Insurance companies, building societies, pension funds, credit unions etc functions in an economy. The function of a financial intermediary is of prime importance in economic growth as it brings in contact two parties i.e. one having a surplus of funds who is looking for a venture to invest in so to earn a return on the money, and the second type which is looking to borrow funds. Since in the real world, it is rare that the demand of lender and borrower reconcile and thus a financial intermediary comes into play. A financial intermediary, such as banks, acquires funds from the lenders and subsequently lends them to the borrowers according to their desire rates. In this particular exercise the financial intermediary takes into consideration various needs of the lender and borrower such as maturity (which means the duration or term for which the lender wants to lend and the borrower wants to acquire) and rate of return/cost of debt (the lender wants to maximize the return, whereas the borrower wants to minimize the cost). The financial intermediary also aligns the information available, between lenders and borrowers, without which the parties would not be able to achieve their desired outcome. Since a financial intermediary enjoys economies of scale and has greater expertise in managing the risk and rewards, it offers considerable cost savings to the lender and borrowers over direct lending and borrowing. In addition, the financial intermediary also offers risk aversion which assists the parties involved in spreading out and reducing the risk. Common Functions of Financial Institutions There are three main ways in which capital is transferred between savers and the one who needs it. In the first procedure, the saver directly receives stocks or bonds which a business sells. This transaction is done in the absence of any financial institution. The business in order to get the money it needs, provide savers with its securities. The second way is indirect way, which includes an investment banking house such as Merill Lynch, which underwrites the issue. Underwriter here plays the role of a middleman and guarantees the issuance of securities. The stocks or bonds of the company are sold to the investment bank, which in turn sells these same securities to the savers. In such transaction, the business’s securities and the savers money is only passing through the investment banking house. It should be noted that in this particular transaction that the investment bank buys the securities and held them for a particular period of time. By doing so the investment bank is taking a risk that it may not be able to resale these securities in the future for as much amount as it paid. This transaction is termed as a primary market transaction. The third way is an indirect way in which transfer is made through a financial intermediary such as bank or mutual fund. In this case, by exchanging its own security, the intermediary obtains funds from the saver. After acquiring the funds, the intermediary purchases businesses’ security with the money it obtained from the saver. For example, a bank might get dollars from a saver, delivering him a certificate of deposit, and then in form of mortgage loan the bank might lend the money to a smaller business. In this way, the intermediaries literally create new capital in the market. The certificate of deposit which the bank offers to the deposit holders is both safer and more liquid than mortgages and is the best security for the savers to hold. The following figure by as presented by Eugene F. Bringham (2000, p 16) illustrates the various modes of transfer as elaborated above. Retail banking System and its advantages Retail banking is that particular types of banking institution in which the bank interact directly with the individual customer apart from dealing with giant corporations. (Investopedia, 2012) Major retail banks of the world such as HSBC, Citibank and Deutsche Bank have been operating successfully from the past many years and have now successfully transformed the banking industry through which it is now available to the masses. (Ranker,2011) These banks deals with a wide spectrum of customers both individuals and corporate and fulfill their various financing needs. In addition to catering the needs of the borrowers, the retail banks are also serve the individual savers who want to earn income on their savings. Retail banks accept deposits from the individual customer as well and provide fixed or variable return on them. The importance of retail banks cannot be ignored in this dynamic and fast paced global economic environment where the financing needs of the corporations are changing every now and then rapidly. (Economist, 2012) In the absence of the retail banking system, the companies would have to resort to the traditional way of raising funds. One of the traditional ways of raising funds for the company would be to generate enough profit for the year in a financial year so that the company is able to save a certain percentage of it to be utilized for new projects and investment opportunities. The drawback of raising funds through this method is that it would take a significant amount of time for any company to raise enough funds for any investment opportunity. Thus it is likely that the company will miss out on the opportunity. The other traditional method of raising funds would be through issuing fresh equity in the stock market. This method is mostly applied by large corporations who are already listed on the stock exchange and their shares are actively traded on the stock market. The downside of acquiring financing through issuance of equity is that the procedure is quite complicated as compared to acquiring funds by approaching any bank. In most cases, a loan is acquired from any bank o financial institution by filing an application for the sanctioning of the loan. The bank or any other financial institution, after evaluating the necessary details such as credit history, financial outlook for assessing the ability of the entity to repay the loans in future, and the purpose of the project for which the loan application was filed, sanctions the loan. Whereas in the case of raising finances through issuance of equity shares, the company has to fulfill several requirements such as issuing a pre defined number of shares, issuing shares to the existing shareholder in proportion to their existing shares and appointing a financial advisor for conducting a due diligence of the entity’s operations. Although these statutory rules and requirements are enforced by the relevant authorities in order to safeguard the interest of the organization and general public, complying with them can be quite troublesome when the requirement of the fund is urgent. Apart from the corporations, retail banks especially cater the needs of individual consumers. Consumers can easily obtain loans from these for their household needs and these loans are available at various rates depending on the term and the financing need. The retail banking system also offers deposit facility where the money of the individual investors is secure and on top of it these investors can earn markup on them. Retail banking usually focuses on individuals and smaller businesses. In retail banking system, products can be designed, developed and marketed according to the specific needs of the consumers. These banks mainly rely to operate through branch banking system in which a bank has several branches in the form of small outlets and the people can visit these branches for the sanctioning a loan, obtaining a overdraft facility or for depositing a balance with the bank. (Navigant, 2012) Based on the above analysis it is quite evident that the banks assist the corporations and individuals in fulfilling their financing needs. In addition to that, the concept and function of retail banking system is also very beneficial for the economy as a whole. The easy availability of the capital increases the production activity in an economy and thus increases the Gross Domestic Product (GDP). The availability of funds at smaller level helps the development of smaller businesses and from individual perspective it increases standard of living. The operation of the retail banking system is fruitful for the bank itself as through offering loans and advances to wide variety of consumers, the risk of the bank is spread and chances of losses due to default decreases. References Economist.com (2012) Retail banks: In vogue | The Economist. [online] Available at: http://www.economist.com/node/18654578 [Accessed: 26 Oct 2012]. Investopedia.com (2012) Financial Intermediary Definition | Investopedia. [online] Available at: http://www.investopedia.com/terms/f/financialintermediary.asp [Accessed: 26 Oct 2012]. Investopedia.com (2012) Retail Banking Definition | Investopedia. [online] Available at: http://www.investopedia.com/terms/r/retailbanking.asp [Accessed: 26 Oct 2012]. Morawski, A. (2012) The Role of Financial Intermediaries and the Increased Need for Regulation of Financial Markets. p.2. Navigant.com (2012) Trends in Retail Banking and Increasing Competition | Advantage 2012 | Navigant. [online] Available at: http://www.navigant.com/insights/library/financial_services/advantage/retail_banking_competition/ [Accessed: 26 Oct 2012]. Ranker.com (2011) Retail banking Companies; List of Top Retail banking Firms. [online] Available at: http://www.ranker.com/list/retail-banking-companies/reference [Accessed: 26 Oct 2012]. Eugene F. Bringham (2012) Financial Management. 11th ed. Florida: p.16-17. Read More