Advanced Finance, Banking and Insurance
Lecture 1 – Functions of the Financial System
Working of the financial system: allocation
Main function of the financial system is to allocate resources.
Distinguish between bank-based (intermediaries) and market based (intermediaries through
markets by e.g. buying bonds or shares and allowing borrowers to get funding).
Financial and economic development:
- Functioning of financial systems is vitally linked to economic growth: a well-
functioning financial system allocates funds to their most productive uses. Also
market failures, which are underlined since the crisis (e.g. banks with too much credit
and too small buffer and go bankrupt after a shock).
- Some recent studies conclude that at intermediate levels of financial depth, there is
a positive relationship between the size of the financial system and economic
growth.
- But at high levels of financial depth (private credit ≥ 100% GDP), more finance is
associated with a higher likelihood of financial crises and less growth.
- Begs the question whether market based or bank based system is better.
Banks have the advantage that because of monitoring they keep information
and often have long-term relationships with clients and both bank and client
can benefit from keeping the information.
Markets have free-rider problem: when you make a purchase, you reveal
your preferences so there is less of an incentive to invest in information.
Because of this, banks may be better, but market based is more resilient.
,Main functions of financial systems:
1. Reducing information costs: overcome an information asymmetry (as borrowers
have more information about projects) between borrowers and lenders which can
occur ex ante (adverse selection, beforehand) and ex post (monitoring, during).
E.g. banks, credit rating agencies.
To prevent information asymmetry. Usually, borrowers have much more
information about a project than lenders do. Now, there can be more deals.
2. Reducing transaction costs, e.g. by pooling funds. E.g. financing big loans by many
small depositors. E.g. banks, investment funds do this.
3. Facilitating the trading, diversification, and management of risk: e.g. by providing
liquidity and through securitisation. With a well-developed financial system, you have
a broad range of products (deep and liquid markets), everybody can pick own
combination of risk and return. Another role is banks providing liquidity: they have
illiquid loans on the asset side, but depositors are liquid (can get their money back
immediately). Liquidity, maturity and credit transformation.
Example: functions of credit rating agencies:
- A credit rating is a forward-looking opinion on credit risk.
- CRAs perform two key functions:
Offer an independent assessment of the ability of issuers to meet their debt
obligations.
Offer ‘monitoring services’ through which they influence issuers to take
corrective actions to avert downgrades.
- Concentrated market: the three largest CRAs share roughly 95 per cent of the
market.
Interpretation of credit ratings:
Regulation of credit rating agencies:
- Discussion on the role of CRAs:
Conflicts of interests inherent to their business model: CRAs are mainly
financed on the basis of an issuer-based compensation scheme, meaning that
the agencies are paid by the issuers of these instruments to publish a rating.
, Underestimation of credit risk associated with structured credit products.
Condemned for exacerbating the recent European debt crisis when they
downgraded various countries in the midst of the financial turmoil (when it
should have been in advance).
- A regulatory framework for CRAs has been introduced, focusing on registration,
enhanced oversight, and transparency.
Role of government:
Government intervention (regulation, policy) is needed:
- To protect property rights and to enforce contracts.
- To encourage proper information provision (transparency) (e.g. accounting).
- In order to ensure soundness of financial institutions (not too much
interconnectedness, which could cause a snowball effect after a bankruptcy).
- In order to ensure competition (no abuse of market power).
Financial (de)liberalisation:
- Financial liberalisation: opening up of domestic financial markets to foreign capital
and foreign financial intermediaries.
- Allowing foreign capital to freely enter domestic markets:
Increases the availability of funds, stimulating investment and economic
growth.
Enhances competition in the financial system.
May lead to institutional reforms that stimulate financial development.
Also a backside of increased interconnectedness. After the crisis there was
more deliberalisation.
Bank-based versus market-based
- Direct finance: sector in need of funds borrows from another sector via a financial
market (rare).
- Indirect finance: a financial intermediary obtains funds from savers and uses these
savings to make loans to a sector in need of finance (most common route).
In most countries, indirect finance is the main route for moving funds from
lenders to borrowers; these countries have a bank-based system.
While countries that rely more on
financial markets (i.e. both
direct/indirect) have a market-
based system (e.g. through
investment funds).
, Arguments in debate:
- Atomistic markets face a free-rider problem: when an investor acquires information
about an investment project and behaves accordingly, he reveals this information to
all investors. Banks, however, may keep the information they acquire.
- Corporate governance, i.e. the set of mechanisms arranging the relationship
between stakeholders of a firm, notably holders of equity, and the management of
the firm.
- Banks have the advantage that because of monitoring they keep information and
often have long-term relationships with clients and both bank and client can benefit
from keeping the information.
Corporate governance:
Investors can use several tools to ensure that management of a firm acts in their interest;
the most important tools are:
- Appointment of the board of directors.
- Executive compensation.
- The market for corporate control: proxy contests (where to persuade other
shareholders to together pressure the management), friendly mergers and takeovers,
and hostile takeovers.
- Concentrated holdings. The more concentrated the holdings, the more influence one
specific shareholder can exert.
- Monitoring by financial intermediaries.
Complements:
- Some authors argue that financial markets and financial intermediaries may provide
complementary growth-enhancing financial services to the economy. Official policy
for capital markets union to have a mixed financial system.
- For instance: Allen and Santomero (1997): intermediaries reduce participation costs,
i.e. the costs of learning about effectively using financial markets as well as
participating in them on a day-to-day basis.
Type of activity:
Investing in equity, you benefit
from risk (higher return on
equity) while providing debt,
you just get your debt and
some interest repaid.
Law and finance:
- Financial system is a set of contracts that is defined and made more or less effective
by legal rights and enforcement mechanisms.
- A well-functioning legal system facilitates the operation of both financial markets
and intermediaries.
- La Porta et al. (1997): financial systems offer different levels of creditor and
shareholder protection depending on the origin of the legal rules in place, i.e. English,
French, German, or Scandinavian origin.
