Essay on a Financial System | Financial Management

Here is an essay on a ‘Financial System’ for class 11 and 12. Find paragraphs, long and short essays on ‘Financial System’ especially written for school and college students.

Essay # 1. Introduction to Financial System:

A financial system enables the transfer of purchasing power within an economy. The cost and efficiency with which they function distinguish developed financial markets from underdeveloped ones. Financial integration and financial innovation have made the regulation of financial markets extremely challenging. This article describes the formal financial system, its products, and its regulation.

Financial markets are critical to development. The structure of a financial market determines orderly flow and how information is reflected in prices. Inspite of financial integration, there are differences in inter-country and intra-country regulation, regulatory regimes with varying levels of effectiveness across countries (in terms of laws and their implementation), different reporting norms, differences in the levels of legal protection available to investors and creditors, tax structures, financial systems and financial market structures.

Liberalization and Financial Markets:

Stock market liberalization allows overseas investors to hold equity shares in a country’s domestic stock markets. Empirical evidence finds an association between stock market liberalization on the one hand and a reduction in cost of equity (because risk is shared by domestic and overseas investors), increase in private investment, increase in stock price correlations across countries and greater financial integration across countries. However, there are also ‘spill over’ effects between markets across countries and a greater risk of financial contagion. The evidence on return on equity though is mixed. Some research points to lower ROE in emerging markets than in developed markets, while some find that the reverse is true.

Essay # 2. Functions of a Financial System:

The most important functions of a financial system are:

i. Resource allocation,

ii. Risk pricing,

iii. Asset pricing and

iv. Providing the mechanism for making payments.

Savers may directly lend to borrowers, or use financial intermediaries to perform the investment management function. A financial system permits multiple payment mechanisms, and encourages savings through financial products with differing risk-return characteristics to suit the needs of different individuals.

Financial markets provide the crucial function of financial asset pricing ensure periodic disclosure of information, transparency and adherence to corporate governance norms. Investors are able to buy and sell securities (liquidity) at market clearing prices, hold a wide portfolio of securities (diversification) and profit from price differentials in financial markets in several different geographical locations (spatial arbitrage). In an ‘open’ financial system, information efficiency and the invisible hand of market forces ensure ‘risk-appropriate’ asset prices.

Financial intermediation allocates resources, moving savings from millions of savers to borrowers, via financial intermediaries such as commercial banks which take on the responsibility of making lending decisions. Financial intermediaries enable pooling of funds and diversification of risk. Intermediation permits risk diversification in a number of ways. Since the savings of hundreds of investors are pooled by financial intermediaries and lent to a variety of borrowers (household, corporate and government), risk gets diversified.

Financial intermediaries possess the expertise to perform their duties, the capacity to demand tailor-made periodical reports from each lender, and can renegotiate lending arrangements. Large financial intermediaries reduce the cost of services through scale economies. Intermediation gives rise to a host of auxiliary services such as credit rating (corporate and sovereign) and purchase of non-performing assets.

The financial system provides a mechanism to price risk, and allows the transfer of risk through hedging and speculation. It permits price discovery through organized markets (stock exchanges, and derivatives exchanges). It ensures efficient resource allocation in accordance with the risk-return characteristics of each borrowing. The depth of a financial system is measured by the ratio of liquid liabilities to GNP. A deep and efficient financial system ensures higher investment productivity (measured as the ratio of change in GDP to investment) and attracts overseas investors.

Countries with rudimentary formal financial systems are unable to meet corporate borrowing needs because most savings do not flow through it, while the scale of lending by the informal financial sector is small. An autonomous and efficient financial system encourages stable and prudent macroeconomic policies by enforcing market discipline on the government—the largest of all borrowers.

The financial system is a barometer of economic development, its sophistication being adjudged by the number of financial institutions, the depth of the various financial sub-markets, the variety of financial instruments, the degree of freedom accorded to market participants, the types of financial services available, their quality and cost. Countries with stable, well-developed and competitive financial systems are not coincidentally also developed economies. The depth and width of a financial system are influenced by the variety and number of financial intermediaries—both domestic and foreign, and the services they offer.

The financial system plays a critical role in securing funding for overseas investment and expansion, and attracting foreign direct investment (FDI) and portfolio investment into an economy.

The structural soundness of financial institutions is of critical importance, along with their assessment of and attitude to risk, their capital adequacy and asset-liability management (ALM) practices. Many developing countries continue to have bank-based financial systems. Adverse selection by banks and moral hazard issues adversely affect resource allocation, and substantially increase the banking system’s non-performing assets.

Essay # 3. Systemic Risk in Financial System:

The term ‘systemic risk’ has been defined by Schwartz (2008) as ‘the risk that an economic shock such as a market or institutional failure triggers either a failure of a chain of markets and institutions or causes significant losses to financial institutions, resulting in increase of cost of capital, or decreasing its availability, often evidenced by substantial financial market price volatility. This definition includes both the cause (an economic shock), and the effects (institutional losses, institutional failure, and stock market volatility).

Systemic risk is considered to be the cause of, as well as the consequence of, a massive derailing of the financial system. It can lead to a collapse of financial markets, disruption of the financial system, the domino effect of a default by one financial institution or market participant, and a shock to the economic system due to the disruption and/or failure of the financial system. Systemic risk affects financial markets—either originating in them or causing them to fail.

The failure of financial institutions is a key aspect of systemic risk. Their collapse causes the loss of depositor wealth, a steep decline of investor faith in the formal financial system, and a severe dent in the credibility of financial market regulators. Since financial institutions are participants in the financial markets (both as sellers and buyers), preserving them is central to financial regulation.

Does systemic risk occur within a financial system or is it a blow from outside? If it is an external shock, financial regulators are not capable of addressing systemic risk. Financial regulation is designed to deal with risks within a financial system. It is essentially structured according to the domestic financial system. At best financial regulation should ensure institutional strength, adherence to more than the minimum capital adequacy norms, robust asset-liability management, ex-ante prevention of systemic risk, and an effective ex-post response to it. Maintaining financial stability and averting panic are the primary goals.

Constant monitoring and using the signaling effect of penalizing defaulters is the foundation of effective regulation.

According to Schwartz’s definition, institutional failure or market failure is the triggering external event. A banking failure, for example, is a failure within the financial system. Banking regulators reduce the probability of bank failures by monitoring compliance with capital adequacy norms, the expansion of the deposit insurance program (Indonesia), capital infusion (Chile, India), writing off of and/or transfer of non-performing assets (India, Finland, Japan, Malaysia, Mexico, Philippines, Spain, Sweden, Thailand, UK, USA), forced mergers with healthy banks (Brazil, Chile, Ghana, Norway), creditor-led restructuring (Argentina, Chile, Norway, Poland) and in extreme cases, resorting to bank closure (Guinea, Ghana and Czech Republic).

There is also an implicit government guarantee against individual bank failures—ABN Amro, Citibank, Credit Suisse, Fortis, ING, RBS, Macquarie Bank and UBS are a few internationally known banks that were bailed out by their respective governments during the global financial crisis of 2007. The crisis demonstrated that systemic risk does not originate solely in banks. Non-bank originators within the financial system include institutions (mortgage companies in the US subprime crisis), processes (securitization), financial derivatives (ABSs and CDOs) and their trading (over-the-counter trades). Gorton and Metrick (2010) term the non-bank originators as shadow banking.

Financial systems often have multiple regulators—the capital market, corporate bond market, sovereign debt market, foreign exchange market, currency derivatives market each has separate regulators, as do insurance companies, pension funds and the banking system. The absence of a regulatory authority for the entire financial system and the lack of coordination between multiple regulators pose unique challenges to maintaining financial stability. But financial institutions with a global presence such as AIG, Citigroup and Goldman Sachs transcend an overarching single national regulator. How best to deal with them as financial market integration gathers pace is a dilemma occupying the minds of regulators around the world.

Financial regulation is further complicated by the fact that regulations themselves—and in certain cases the repeal of legislation—provide the trigger for financial engineering. For example, the adjustable rate mortgage was a financial innovation in USA that was spawned by the restrictions removed on the types of housing loans that could be offered by mortgage companies. The spread of the subprime crisis in USA to the global banking system is a graphic illustration of the difficulties faced by national regulators.

As financial markets open up, a local problem is transmitted to overseas investors, through traditional as well as complex financial products. One of the confessions of the US Federal Reserve was its inability to understand the structure of and the risks associated with OTC structured products. As a response to the difficulty of national regulation, the need for an international body to monitor financial systems has been strongly advocated.

The Financial Stability Board (FSB), located in Basel (Switzerland) is an international body that was set up in April 2009. It replaced the Financial Stability Forum, which was set up by the G7 countries in 1999. As its name indicates, the FSB’s objective is to ensure financial stability by coordinating national regulatory activities at the international level, and collaborating with international financial institutions to develop appropriate responses to deal with financial vulnerabilities. It encourages greater inter-country communication among regulatory agencies. The FSB identifies vulnerabilities in financial systems, prescribes actions and provides advice on benchmarking of regulatory standards.