Home Business & Finance Financial System
Allied with the efficient allocation of funds is money creation. This function may also be termed the bank loan / credit function, because it is this action of banks that creates money in the form of new deposits. Not only are existing funds allocated efficiently, but new loans are allocated efficiently by the banking sector (usually). They have the unique ability to create money literally "with the stroke of a pen", provided of course that the central bank assists in the process through the supply of borrowed cash reserves to the banks, which they willingly do at their KIR.
The banks may thus also be seen as the intermediaries that ease the constraint of income on expenditure, thereby enabling the consumer to spend in anticipation of income and the entrepreneur to easily acquire physical capital (assuming the project is feasible). These activities are crucial in terms of output and employment growth. Money creation is covered more fully later.
Enhanced liquidity for lender
Enhanced liquidity is created for the lender to a financial intermediary. If an individual purchases the securities of the ultimate lenders (such as making a loan to a company), liquidity (explained in detail below) is zero until maturity of the loan. Intermediaries are in the business of purchasing less (or non-) marketable primary securities, and offering liquid investments to the ultimate borrowers.
A good example is the banking sector that makes non-marketable securities such as mortgages, leases and installment credit contracts, and finances these by offering products that are immediately "encashable" such as call deposit accounts, current accounts and savings accounts.
Similarly, money market funds (also called money market unit trusts or money market securities collective investment schemes) aggregate small amounts of funds for on-lending in larger packages in the form of the purchase of non-negotiable certificates of deposit (NNCDs). The latter are not marketable but the units of the unit trusts are (back to the issuer). Also, individuals may borrow against certain products of financial intermediaries, such as the life policies of long-term insurers.
Price risk lessened for the ultimate lender
Flowing from the above is that financial intermediaries take on price risk and offer products that have little or zero price risk. An example is a long-term insurer that has a portfolio mainly of shares and bonds (about 80% in many cases - the other investments being property and money market investments) that involve substantial price risk at times, but offers products that have zero price risk, such as guaranteed annuities.
Another fine example is banks that have a diverse portfolio that includes price-sensitive bonds, loans and share / equity investments, and offer products that have zero price risk such as fixed deposits.
Improved diversification for lender
Allied to the lessening of price risk is the benefit of diversification. Flush members of the household sector (i.e. ultimate lenders) usually have a smaller wealth size and can therefore only achieve limited diversification compared to a financial intermediary that aggregates small amounts for investment in the securities of the ultimate borrowers. Thus, an individual has limited diversification possibilities and therefore carries a higher risk level than financial intermediaries, which are able to hold a wide variety of investments.
The central doctrine of portfolio theory (and practice) is that risk, defined as variability of return around mean return, is reduced as the number of securities in a portfolio is increased, provided that the returns are not perfectly positively correlated. It may be said that part of the investment risk is "diversified away".7 This concept is illustrated in Figure 3. It shows there are two types of risk: specific risk (the risk that applies to specific securities (assume shares), such as poor business decisions and the taking on of too much debt), and market risk (risk that applies to all securities such as a war of an increase in interest rates).
Figure 3: risk and diversification
Economies of scale
Because of the sheer scale of financial intermediaries compared with individual participants, a number of economies are achieved. Two main economies are realized:
• Transactions costs.
• Research costs.
The largest benefit of financial intermediation is the reduction in transactions costs; in fact some intermediaries have been formed specifically because of transactions costs (e.g. securities unit trusts). The obvious example is that the (transaction) cost involved in purchasing a small number of shares in a company via a broker-dealer is similar to the cost of purchasing a large number of shares. Even more important is payment system costs. The banking system, through the use of sophisticated technology, provides an efficient payments service (coequal clearing, EFTs, ATM withdrawals, etc.) that is relatively inexpensive. Individual participants in the financial system cannot achieve this reduction in transactions costs.
Another benefit is in terms of research costs. An individual holder of a diversified portfolio of shares has the task of monitoring the performance of each company, which involves economic analysis, industry analysis, ratio analysis, etc. Financial intermediaries do have the resources to carry out research, which essentially benefits the holders of its products (liabilities). A good example is the retirement fund. The retirement fund member has a "share" or "participation interest" in the portfolio of the fund (liability of the fund), and the fund has the resources to research the investments (assets) on behalf of the many members.
The financial system (specifically the banking sector) provides the mechanism for the making of payments for anything that is purchased (goods, services, securities). Certain financial assets serve as a means of payment and purchases are settled efficiently (assuming an efficient clearing and settlement system). The financial assets that are accepted as a means of payment (i.e. money) are:
• Bank notes and coins (issued by the central bank in most cases)
• Bank deposits [transferred by cheques, credit ("straight" purchases) cards, debit cards, EFTs etc.].
Certain financial intermediaries are in the business of offering protection against adverse occurrences such as untimely death, health problems, damage to property and loss of income. In addition, the financial system allows for self-insurance, i.e. the storage and building of wealth in order to protect against adverse life, property and income occurrences.
Monetary policy function
The financial system provides the ideal mechanism for the implementation of government policy in terms of economic growth, stable employment, balance of payments equilibrium and low inflation. The monetary authorities are able, through various means, to exert a powerful influence on interest rates, in turn influencing consumption and investment spending, the demand for loans / credit and so on.
|< Prev||CONTENTS||Next >|