Financial Markets and Financial Intermediaries
Financial Markets and Financial Intermediaries
Financial market makes buying and selling of financial securities, commodities, and other valuable items at low transaction costs and at prices that reflect efficient markets. Financial market is fundamentally an information-processing engine: it processes the orders that come in, it discovers a price, and it matches buyer and seller ( 2002 ). The global financial market has experienced a dramatic change since the early 1970’s (2004). Global forces for change included advances in information communication technology (ICT), making remote access to trading systems ubiquitous. The innovations in ICT and the development of new instruments in the financial market became self reinforcing. According to (2004), other significant change agents were financial deregulation and liberalization at the national level, opening up to international competition, and globalization of financial and real markets. Additionally, changes in corporate behaviour, such as growing disintermediation and increased shareholder pressure for financial performance, were the prime movers behind the transformation in the financial services sector in the emerging market economies. Advancing globalization during the 1980s and the 1990s increased trans-border capital flows and tightened the links between financial markets in the emerging markets and global
financial centers. Growth of global financial markets was further accelerated by improvements in the fundamentals, particularly by more rapid economic growth in the emerging market and matured industrial economies.
(1999), argues that financial market play an important role in an economy because they bring together parties who have surplus or excess funds available for investment and those who have shortage of funds for investment, all of which makes for a more productive and efficient use of a country’s resources. Financial institutions act in the markets to combine the savings funds of many individuals into financial products to meet the investment needs of firms. According to (2003), financial markets offer an efficient mechanism to channel savings for intangible investments. All financial markets have three dimensions: the creation of new credit, the trading of existing credit and the volume of accumulated credit.
Financial Intermediaries are institutions, firms of individuals who perform intermediation between two or more parties in a financial context. According to the (2006) the role of financial intermediaries as advisers, distributors, or broker-dealers is crucial, and in most cases, a vital link in the road to investment avenues. According to
(2007), financial intermediaries are parties that help affect a transfer of funds from providers to demanders of capital. The transfer of funds can be direct or indirect. Example of financial intermediaries are brokers, credit-rating agencies, dealers, investment banks, insurance companies, pension funds, savings banks, closed and open ended mutual funds, private banks, venture capitalists, finance houses and commercial banks. In performing their traditional roles, intermediaries gather savings deposited in small individual accounts and then lend out the funds in typically larger amounts – an activity sometimes called denomination intermediation (1998). (2000) argues that financial intermediaries act as accountants of the economy and they implement the control function of money. Financial intermediaries are institutions that intermediate in the financial process between ultimate borrowers and ultimate lenders in the economy. The ultimate borrowers include consumers who need to borrow to finance part or all of their consumption, firms that borrow to invest in physical capital and government which borrows to finance its deficits. The ultimate lenders are the economic units that serve part of their current income by spending less that their current income on their purchases of commodities and want to lend some or all of these savings to others for some duration (2000). Financial intermediaries borrow from the ultimate lenders or from other intermediaries by issuing their own liabilities in exchange and re-lend to others by accepting the latter's liabilities. In the modern economy, only a small proportion of the savings is directly transferred from the savers to the ultimate borrowers. Most of the savings are directed by the savers to financial intermediaries such as banks, mutual funds, pension funds, insurance companies etc., which re-channel the funds thus obtained to firms and the government, directly by buying their shares and bonds or indirectly through other financial intermediaries such as investment banks (2000). Since the inception of financial markets in industrial economies, savers have entrusted much of their wealth to intermediaries that, in turn, finance the projects of investors. Because of their importance, governments have long regulated the activities of these intermediaries to ensure sound financial markets (1995). Banks, savings and loans associations, credit unions, money market mutual funds, insurance companies, and brokerage firms are some of the most important financial intermediaries. Each of these business and, therefore, desires to make a profit. The profit arises from the fees the intermediaries charge and from the difference between the interest rate they pay on deposits and the interest rate they charge for loans. Financial intermediaries perform important functions that make financial markets work efficiently. Financial intermediaries provide important advantages to savers. Financial intermediaries also pool risk and create liquidity. Pooling risk means the funds provided by thousands are loaned to hundreds of individual firms. If a firm is unable to make its loan payments, that default is shared by all the depositors and no individual depositor is left with a high degree of risk. Liquidity means that an asset can be easily changed into cash (1990 ). (2003), argues that liquidity is the magic word of an exchange. Good liquidity attracts trading and new listings, poor liquidity repels them. Trade growth provides strong incentives for the growth of multinational corporations, which offer several advantages over simply exporting goods or services. Intermediaries use forward commitments to offer their clients a risk management service by guaranteeing the interest rate a client will pay on a loan. For example, if a forward commitment specifies a fixed interest rate, the issuing intermediary assumes the risk that rates might rise after giving the undertaking. The intermediary does not assume the interest rate risk if it only agrees to provide a line of credit at the market interest rate prevailing when the loan is actually drawn down, but competitive pressures might dictate prespecifying the rate. In this case, the intermediary may wish to hedge the risk in the futures markets (1998). In many cases, banks followed businesses into new markets with a view to protecting existing client connections. Once established, both the banks and the multinationals contributed to still more growth in international business, both financial and non-financial.
International banking activity can be divided into three principal types— offshore banking, arm’s length banking and host country banking. Offshore banking is like an assembly plant in a low wage country: it represents an economically advantageous means of carrying out the banking. Offshore banks thus carry out business for their domestic customers in a low cost jurisdiction. The jurisdiction’s tax laws are often the source of the cost advantages, but labor and other resource costs also play a role. Arm’s length banking is based on comparative advantage, and means that international banks can profitably make loans or investments which domestic banks are less qualified or too small to offer. As one example, US banks familiar with making relatively risky cash flow loans were able to do so profitably in small markets like Canada’s before an indigenous capability developed. To the extent this kind of activity occurs, the average costs of the international bank are lower than the average costs of the indigenous bank, principally because the international bank has a larger volume of business over which to spread the fixed costs of originally entering the business. Host country banking is full fledged foreign direct investment whereby banks accompany their
countries’ investors to provide financing for the capital projects in the foreign country. Now, many of the world’s largest banks have full-fledged operations in a number of countries. These operations are largely international in character, but can also include retail operations in host countries (1998). Financial intermediaries are important because they can help in solving problems that transfer of funds from providers to demanders of capital entails.
Financial intermediaries avoid duplication and permit specialization. They serve to economize on search, evaluation and monitoring costs. Some of the desired change in asset quality through pooling and diversification are made possible by intermediaries. The issuance of senior, information-insensitive claims makes the intermediary the primary residual claimant to the quality of services it provides and diminishes the extent to which the intermediary needs to be evaluated by investors.
Characteristics and Developments of India’s Financial Market
The financial sector in India is consisted by commercial banks, non-bank financial institutions (NBFIs) and the capital market. India’s financial markets and financial intermediaries have two important characteristics:
1. The credit markets in India are highly segmented with commercial banks being the dominant players in the short-term credit market (credit for less than a year, mainly used to finance inventories), and NBFIs are the dominant players in the long-term credit market (mainly used to finance investments in plant and machinery).
2. Stock markets in India are relatively well developed compared with other developing countries.
According to (2003), the evolution of the financial sector policies in India that started from 1969 can be divided into three distinct sub-periods:
1. Early 1970s – mid 1980s – a period of increasing financial repression
2. Late 1980s – 1991 – a period of mild reforms
3. From 1991 – a period of increasingly liberalized financial sector
In the two decades since independence, banks in India operated in a relatively liberal environment. The nationalization of 14 banks in 1969 was a turning point in the evolution of banking sector policies in India. In 1991, as a part of the economic reform package, there was a considerable relaxation on the entry of new private banks and existing public sector banks were allowed to issue fresh capital to the public through the capital market. However, the ownership of the dominant commercial banks in the Indian financial sector remained in government hands. Mandatory requirements to invest in government securities and hold cash were scaled down drastically. This increased the ability of banks to lend, but there was very little change in the restrictive environment with regard to the deployment of credit; that is, there was no reduction in the priority sector lending requirements. With respect to regulations on the pricing of credit, most of the interest rate controls were lifted by 1994 in a gradual manner. The most significant change in the banking environment from the viewpoint of the private corporate sector was the interest rate deregulation. Banks were now allowed to charge differential interest rates for firms based on the risk perceptions, which was not the case prior to the deregulation. Lending decisions now rest with the banks themselves and political and administrative interventions have dramatically reduced.
Non-Bank Financial Institutions
Non-bank financial institutions in India can be classified into three groups, namely the insurance sector, mutual funds and development finance institutions (also known as term lending institutions in India) (2003 ). Traditionally the Development Finance Institutions (DFIs) have been the most important source of long-term borrowings for private corporate firms. Financial liberalization has brought about three important changes to the operations of DFIs. DFIs have increasingly raised funds through the cpiatl market by issuing new shares, bonds, debentures and fixed deposits. The government permitted all DFIs to charge interest rates in accordance with the perceived risks inherent in the projects funded subject to a minimum lending rate in August 1991. With the abolition of industrial licensing and re-orientation of the economy away from planning industry specific capacity targets to markets driven allocation of resources, long-term credit provided by the DFIs is no more directed by the government. The DFIs are key financial intermediaries who would channelise investments based on market signals and as a result of their screening function.
Unlike other developing countries, India has had fairly well-developed stock markets and their role in the overall financial system has dramatically increased since the 1980s (2003 ). In 1992, there was a substantial deregulation of the stock market especially with the respect to the new issues market, with the abolition of the Office of the Controller of Capital Issues. Price controls on the issue of new shares were lifted and new guidelines that were less restrictive than those in the in the pre-1991 period were put in place. In September 1992, the Government of India allowed unrestricted entry in terms of volumes of investments in both primary and secondary markets to reputed Foreign Institutional Investors such as pension funds, mutual funds, investment trusts and asset management companies. Following these reforms, the three years from 1992 to 1995 saw a boom in the primary market.
Characteristics and Developments of China’s Financial Market
As the country moved away from a centrally planned economy, the Chinese financial structure was gradually reformed so that the needs of the economy could be satisfied. Between 1978 and 1984, various financial institutions were established. Since 1986, share-holding company-based commercial banks have been established at both national and regional levels. Non-bank financial institutions have also grown very fast. Investment trust companies, security firms, insurance companies, leasing companies, finance companies, and closed-end mutual funds have all been set up. In 1994, state owned commercial banks ceased to be required to carry out policy loans to state owned enterprises. China is a developing country as well as a transitional market economy. Financial development in China proceeds in a context that reflects both these long-term processes (2000). Although there are overshooting cases of market liberalization, China seems to remain in the category of compatible opening, if not over cautious (2003). Despite the negative impacts of market liberalization, these have been so far contained at a manageable level, as most economic, social and political problems have been mainly caused by domestic structural adjustment. China benefits a great deal from foreign investment, especially foreign direct investment. It has been the largest recipient developing country of foreign investment since 1993 (2003).