The Role of Financial Institutions and Markets

Technology, globalization, competition, and deregulation all have contributed to the revolution of worldwide financial markets and the creation of an efficient, internationally linked market. However, these developments have created potential problems (Brigham 1995: 111). As the
worldwide financial crisis, which started in the early summer of 2007 in America and spread globally, still shapes the headlines of newspapers and the political agenda of developed countries. These recent economic developments drew back societies’ attention to the importance of the world economy and financial markets. A financial market is considered as “a market in which financial assets [..] can be purchased or sold” (Madura 2012: 3).

Here, any kind of marketplace, where buyers and sellers participate in the trade of financial assets such as equities, bonds, currencies and derivatives, is meant. Mostly financial markets have transparent pricing, basic regulations on trading, costs and fees, and market forces that determine prices of securities that are traded. There are three relevant classifications of financial markets in the context of the financial crisis: money versus capital markets, primary versus secondary markets, and organized versus over-the counter markets (Madura 2012). The money versus capital market distinguishes in various points: The money market is only short- term oriented, a maturity of less than one year, and the trading objects are referred to as money market securities, which are debt securities.

These have a “high degree of liquidity” and therefore offer a low return; however, they are less risky (Madura 2012: 5). In contrast, capital markets promote the sale of long-term securities, called capital market securities, which are most often bonds, mortgages and stocks. These are often bought with the intention of financing the purchase of capital assets such as buildings, equipment, or machinery. Capital market is composed of primary markets and secondary markets: In the primary market only the trade of newly issues securities occurs, whereas in the secondary market previously issued – so existing – securities are traded (Madura 2012). The organized versus over-the counter markets differentiate in the location factor.

Whereas the organized markets represent true visible marketplaces, where member meet to trade and securities are listed like the New York Stock Exchange, the over-the-counter markets are a wired network of dealer, which do not need a central and physical location to trade, because it is a direct trade between the two participants (Madura 2012). Telecommunication and Internet allowed businesses to trade all over the world in every financial market. However, this global interconnection of financial markets also has its side effects as the fall of the Lehmann Brothers and following economic developments have shown.

In 2008 and 2009 there has been a worldwide crisis in the international financial markets, which has lead to an extreme high number of credit defaults and amortizations on speculative assets of banks and financial institutions. The financial crisis has been triggered by the lending practice, the insufficient collateralisation of mortgages and securitization of credits in the real estate market in the United States of America. The speculation on rising real estate prices bursted and risky bonds lost their value dramatically.

The financial crisis developed to a liquidity crisis, because the credit lending of banks, which are equipped with liquidity, to banks, which need cash and cash equivalents in form of credits, stopped despite the fact that the most important national banks decreased the discount rate under 1 %. Due to lack of trust between the banks, the interbank credit lending decreased dramatically, so that the liquidity crisis turned to a bank crisis. Henceforth, this crisis covered the goods market, in result unemployment rates increased, international trade decreased and the recession settled. Due to the dimensions the economic slump took it is considered as the new world economic crisis (bpb 2013).

2. Financial Institutions

Financial Institutions are firms that provide access to the financial markets, both to savers, who wish to purchase financial instruments directly, and to borrowers, who want to issue them (Cecchetti/ Schoenholtz 2010). In fact, financial institutions – also referred to as financial intermediaries – are like most other businesses: the primary business is to generate profit by minimizing the costs and maximizing the revenues. Additionally, financial intermediaries design and sell financial products and services in accordance to customers demand at a reasonable profit level (Pilbeam 2010: 46). A financial intermediary interacts with savers or lenders and borrowers simultaneously; thereby it produces a set of services, which facilitate the transformation of its liabilities into assets such as loans, which is referred to as intermediation (Madura 2012: 12).

2.1 Types of Financial Institutions

Generally, there are three classifications of financial institutions: depository institutions, contractual saving institutions, and investment institutions. Firstly, depository institutions such as commercial banks and savings banks accept and manage cash deposits as well as make loans (Pilbeam 2010: 46). Furthermore, deposit-taking institutions strive to make a profit in the way of ‘spread income’ between the cost of the deposits that they accept and other sources of funding, and the return that they receive on their investment portfolio in the way of loans, equity stakes and other investments (Pilbeam 2010: 46).

Depository institutions underlie default risks, regulatory risks as well as liquidity risks (Pilbeam 2010: 46). Secondly, contractual savings Institutions attain funds under long-term contractual arrangements and invest them largely in the capital market especially in long-term equity and debt instruments such as life insurances, private pension funds, and funded social pension insurance systems. Due to the agreement’s requirement of regular payments from for example policyholder and pension fund participant, contractual savings institutions have relatively stable inflows of funds.

The stable cash flows – both inflows and outflows – are relatively stable as well as predictable, so that liquidity is not a predominant factor in the asset management of these institutions (Impavido/ Musalem 2000: 3-5). Thirdly, investment institutions are commonly known as investment companies, corporations, or trusts. An investment company issues securities and is predominantly engaged in the business of investing in securities.

Hereby, it aggregates funds of a large number of investors into a specific investment in compliance with the objectives of the investors. Individuals invest in diversified, professionally managed portfolios of securities, whereby they have access to a wider range of securities and a guaranteed spread of risk than without the investing company as intermediary (Pilbeam 2010: 53-54).

2. 2 Role of Financial Institutions in the Financial Market

As previously described in reference to the financial crisis, financial markets are imperfect; participants in the market do not have full access to information (Madura 2012: 10). For example, an investor is not able to verify the creditworthiness of potential borrowers and there is a lack of expertise to assess this creditworthiness. Here financial institutions’ function is to resolve the limitations caused by market imperfections.

Therefore, financial institutions are involved in the information processing (Madura 2012). Thereby, they investigate the financial conditions of the potential customers to figure out which have the best investment opportunities (Cecchetti/ Schoenholtz 2010). Consequently, financial intermediaries are saving information costs as well as transaction costs, because financial institutions “assist in the transfer of funds from surplus to deficit units in the economy” (Pilbeam 2010: 63). For example, there are many lenders/ surplus units, who all strive to lend various low value money market securities for different periods of time, or there few borrowers/ deficit units, who wish to borrow capital market securities for a fixed period of time – here financial institutions are useful as an intermediary.

Lenders do not have to search the markets for suitable borrowers and vice versa. Financial institutions borrow various amounts of money from surplus units, reform these into an amount suitable for the final deficit unit, and transform them into a maturity suitable for the final borrower. Thereby financial institutions serve the special needs of the deficit units and surplus units (Madura 2012: 10-11). Overall, flexibility is existent for all participants, because lenders can change the terms and conditions of lending to the intermediary without the intermediary or final borrower being at disadvantage.

While financial institution act as intermediary, they bear the risk and in result, the risk is reduced. By diversification meaning offering various bundles of financial assets, financial intermediaries spread the risk and thereby, transform risky assets to less risky ones (Madura 2012: 10-11). In fact, individual investors are capable of diversification, however, they may not do it as cost efficient as financial institutions and therefore, they possess a crucial role in financial markets.

In conclusion, financial institutions “ensure that the costs and risk are lower than if the surplus and deficit agents dealt directly with each other, and thereby ensure that there is greater flow than in the absence of financial intermediaries” (Pilbeam 2010: 63). Pilbeam means with greater flow that intermediaries increase investment as well as economic growth (Cecchetti/ Schoenholtz 2010).

2.3 Role of Financial Institutions in the Financial Crisis

Financial crises mainly manifest themselves at the level of financial institutions; especially, the role of banking institutions in the occurrence and transmitting of financial crises is a deciding one for the recent financial crisis (Andries 2009: 151). Financial Institution such as banks can facilitate the financial crises through their activities in the financial markets. Their activities can influence the interest rates, the uncertainty on the market and the price of assets (Andries 2009: 152).

The worldwide financial crisis of 2008 was subject to several developments of banks’ practices: Financial innovations and risky speculations such as in subprime mortgages and collateralized debt obligations have been practiced, loans have been expanded and the prices of assets increased without economic basis and unexpectedly decreased, so the orientation changed towards liquidity (Andries 2009: 149). Overall, banking institutions have overdone diversification and practiced financial innovations meaning structured finance, which were new complex products, whose risk could not be assessed by the rating agencies (Fratianni/ Marchionne 2009: 8-9).

While the crisis there has been uncertainty among market participants and default risk increased, so that borrowers increased the interest rates to all borrowers (Fratianni/ Marchionne 2009: 13). Simultaneously, “banks reacted by selling assets to reduce leverage, setting in motion a vicious circle of asset liquidation and price declines across a vast range of assets. Financial integration and made possible for the crisis to spread virtually worldwide“(Fratianni/ Marchionne 2009: 21).

3. Conclusion

In conclusion, financial institutions possess a vibrant role in the financial markets and accelerate the development of financial crises, because of their activities. Furthermore, financial institutions act as an intermediary, thereby they decrease transaction costs and risk, and simultaneously increase efficiency through information processing. However, besides economic growth financial institutions encourage side effects: Especially the banking institutions’ practices are responsible for the development of the recent financial crisis. Their striving for more profit with practices under the theme of no risk, no reward lead to the downturn of the worldwide economy. In the future, governments and international institutions meet certain requirements and establish regulations, in order that such practices and activities are restrained.

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