Definition
A financial system refers to a complex system dealing with a vast variety of financial activities, but mainly allows the transfer of money between savers and borrowers. The systems are crucial in informing on organization’s planning and action plans and helping different players in the sector to track and manage resources necessary in successesful completion of any given or chosen activity.
Introduction
The system is made up of a number of components which comprise the following:
- Financial institutions,
- Financial markets,
- Financial instruments,
- Financial services,
- Financial practices,
- Financial transactions (Sheffrin, p. 551, 2003).
Financial markets which refer to mechanisms allowing people to trade financial securities, commodities and other fungible items, and financial institutions which refers to institutions whose primary source of profit is through financial asset transactions, collectively facilitate the functioning of the financial system through financial instruments; the former plays a very pivotal role in transfer of funds (financial assets) from surplus units to deficit units, though, the transfer which is mainly from lenders to borrowers is facilitated by banks and non banking institutions.
Financial services refer to services that ensure the smooth flow of financial activities in the economy and include banking, insurance, stock broking, investment services and other professional services. The services help in raising enough funds and assist in the deployment of the same thus ensuring efficient management.
Financial practices should be in line with business ethics since any contrast would affect the much consumer pays or whether he/she would buy all the financial services in the market, deceptive and unfair financial services practices often cause serious consumer injury thus the need for information to ensure consumer financial literacy.
Characteristics of Financial Services
Financial services play a very major role in the efficient transfer of wealth from lenders to borrowers, implying that the services have to be distinct in nature thus the following characteristics:
Financial services have to be customer specific; in order to be customer focused and remain relevant in the creation of wealth in any economy, financial firms offering these services need to study the need of their customers before deciding on their financial strategy; this ensures that the firms design only products which are tailor made to suit the needs of their customers.
Financial services have to be intangible; focus on quality and innovativeness is crucial for any firm providing financial services and products; this would ensure that, the firms uphold a good image ultimately enjoying the confidence of their customers.
Financial services have to be concomitant; production and supply of the services to customers have to be achieved simultaneously ensuring continuity in provision.
Financial services must have a tendency to perish; financial services cannot be stored otherwise their functionality would be compromised, implying that, firms rendering this kind of services have to synchronize demand and supply in order to ensure that the services are supplied as required by the customers.
The main function of financial systems is that it transfers wealth efficiently from lenders to borrowers, thus enabling great wealth creation in any economy.
Asymmetric information is concerned with decisions made when dealing with transactions whereby one party has better or more information than the other creating an imbalance of power considering the fact that knowledge in business dealings is power; this can sometimes complicate transactions involved in financial systems resulting in situations where either of the parties involved can enforce, or effectively retaliate for breaches of, certain parts of an agreement whereas the other or others cannot. Good examples of this problem include; adverse selection and moral hazard, whereby adverse selection refers to a situation whereby the ignorant party lacks information while negotiating an agreed understanding of the contract whereas in moral hazard the ignorant party lacks information about performance of the agreed upon transaction or lacks the ability to retaliate for a breach of the agreement, for example in a situation where one is negotiating for insurance, an adverse selection would occur when people who are high risk buy the insurance based on the fact that the insurance company cannot effectively discriminate against them, probably due to lack of information about the particular individual’s risk or forced by either law or other constraints (David & Baruch, pp. 2747 – 2766, 2000). The moral hazard focuses on the code of behaviour after one has been insured, and would refer to the likelihood of reckless behaviour may be due the fact that the insurer cannot observe this behaviour or cannot retaliate against it (David & Baruch, pp. 2747 – 2766, 2000). Mostly, adverse selection occurs when, the buyer of goods, services or assets has difficulty assessing the quality of these items in advance while the moral hazard comes into play after the signing of a purchase agreement between the buyer and the seller probably due to a change of behaviour or due to inaccurate monitoring by the buyer on the seller’s change of behaviour.
Asymmetric information occurs when traders on one side of the market in any market setting dealing with financial assets know things that traders on the other side of the market do not (Howells & Bain, pp. 35 – 40, 2007). This condition might not seem to be a serious problem for markets; usually it would be cheap and easy for traders who know things that others don’t know to pass this information, the problem, given experiences in real-world markets is that traders who have detailed information may benefit from concealing or misrepresenting this information; this gives brokers and other players favorable ground to exploit and close major business deals (Howells & Bain, pp. 35 – 40, 2007).
In summary asymmetric information in any market setting refers to the differences between the information available to buyers and sellers, for example in financial assets markets, asymmetry may arise between the lenders who are the buyers of the assets and borrowers who are the sellers; this ultimately may either distort or shape the observed credit – market outcomes.
Financial Markets and Institutions
Financial markets constitute a major component in financial systems; this is because it is not only through these markets that the previously issued financial assets are exchanged but also facilitation of borrowing and lending through the sale of newly issued financial assets which breaks ground for the interactive part of trading to commence in any financial system. Financial markets serve the following functions:
Borrowing and lending: It is through financial markets that the transfer of funds from one agent to another either for the purposes of investments or consumption is achieved.
Price determination: financial markets enable or provide a platform from which prices for either newly issued financial assets or even the existing stock can be determined, this can easily be drawn from the history of related assets for the new issued financial assets or changes adopted for the existing stocks to maintain their demand.
Information aggregation and coordination: financial markets provide a platform from which useful information can be collected and aggregated about financial assets and the flow of funds from lenders to borrowers making it easy to assess the level of success or failure and ultimately based on the information remedial actions can be drawn to guarantee growth and expansion of economies through efficient flow of wealth.
Risk sharing: in every business dealing, the more people are involved, the higher is the spread and the weaker is the effect of risks on the individuals, financial markets allow transfer of risks from those who undertake the investments to those who provide funds for the same thus reducing the effect on each party involved.
Liquidity: a vibrant financial market guarantees holders of financial assets with easier and prompt means of conversion in cases where one would wish to liquidate or even resell their interests.
Efficiency: vibrant financial markets consolidate activities together reducing transaction costs and information costs.
Financial Institutions
Financial institutions refer to institutions taking part in the creation and/ or in exchange of financial assets, they are classified into four categories which include the following:
- Brokers,
- Dealers,
- Investment banks,
- Financial intermediaries (Mishkin, p. 3, 2006).
Broker refers to a commissioned agent of the buyer or seller whose duty is to locate a seller or a buyer of the financial assets to complete the transaction. Brokers benefit through commissions they charge on any completed transaction; the major examples are the real estate brokers or stock brokers.
Dealers serve the same function as the brokers by matching buyers with sellers, only that they don’t benefit through commission as with brokers but rather through profits accrued from sales since they buy assets at a relatively low price and sell them at a relatively higher price, examples include car dealers, dealers in the US. Government bonds and so on. Contrary to the brokers, Dealers also keep inventories and have a duty to ensure quality provision to the consumers, otherwise take up responsibilities.
Investment Banks assist in the initial sale of newly issued securities like the Initial Public Offers (IPO’s) through offering advice, underwriting or sales assistance to the involved parties to ensure that they act on reliable and sufficient information.
Financial Intermediaries engage in financial assets transformation in that they purchase one kind of financial asset from a large number of agents using debt contracts and lend to large numbers of consumers and firms using debt contracts as well, a significant portion of the borrowing on the liability side is in the form of demand deposits, securities that have the important property of being a medium of exchange (Gorton & Winton, p. 2, 2002).
Financial Institutions and Moral Hazard
Every financial institution aims to be a leader in the transfer of wealth from lenders to borrowers in order to sufficiently contribute to wealth creation in any economy, however, aspects of moral hazard could creep in allowing one of the involved parties to take advantage of the other party’s lack of knowledge. Examples include:
Financial bail outs of lending institutions by governments would mostly encourage risky lending in future activities, due to the fact that, some may feel justified to take up risks since they believe they may not have to carry the full burden incase of losses. This happens most with big institutions which have built their reputations so strong that they can engage in risky loans which would probably pay handsomely incases where the deal turns out well, but in cases where the investment turns sour and there are losses to be suffered, the tax payer comes in to rescue the situation, though sometimes it may for the future benefit of the economy. These big institutions going into huge investments involving lenders and borrowers contribute immensely to wealth creation in any economy and thus being bailed out incases where the investments turn bad would ensure steady economic growth though small businesses which wouldn’t enjoy the same favor may deem it unfair.
Moral hazard can also occur with borrowers, mostly, credit companies in most economies regulate or limit the much a card holder can spend, purposely to rule out or minimize reckless spending of borrowed funds; the companies understand the kind of enticement these cards present and thus act to prevent losses which may arise as a result of failure by the holders to honor or any other irregularity which may disrupt the adopted payback procedures. An example, is “a case of brokers, who do not lend their own money, would push risk onto the lenders, Lenders, who would sell mortgages soon after underwriting them, then push the risk onto investors, investment banks would then buy mortgages and chop up mortgage-backed securities into slices, some riskier than others, then finally investors buy securities and hedge against the risk of default and prepayment, pushing those risks further along” (Summers, financial times, 2007). “In a purely capitalist scenario, the last one holding the risk is the one who faces the potential losses; in the 2007–2008 subprime crisis, however, national credit authorities in the U.S., the Federal Reserve assumed the ultimate risk on behalf of the citizenry at large” (Summers, financial times, 2007). The bailing out completes the moral hazard because it covers a default caused by an individual or an institution that does not take full responsibility for their doings.
Adverse Selection
The term derives its meaning from insurance industry in which it would be used to refer to a situation whereby someone’s demand for insurance would be positively correlated to his or her risk of loss, higher risks buy more insurance, and the insurer would be unable to allow for this correlation in the price of insurance probably due to private information only known to the individual (Polborn, pp. 327 – 354). The lack of information to some parties involved in the deal, say insurance, causes a state of imbalance in the trading and to counter its effects insurance companies ask a range of questions and may even ask for medical reports on people applying to buy insurance in order to vary prices accordingly and also to reject any elevated risks. “Studies show that some adverse selection can be advantageous considering the fact that, it may lead to a higher fraction of total losses for the whole population being covered by insurance than if there was no adverse selection” (Akerlof, p. 488 – 500, 1970). This means with adverse selection some people would invest in ground breaking fields, which otherwisely they would not, expanding levels of trading in these areas and strengthening the economies.
It is believed that adverse selection occurs when buyers or sellers would, on average, be better off trading with someone selected at random from the population than those who volunteer to trade, take an example of used car markets wherein equilibrium it could be that, the used cars that come into the market are not a random selection from the population of used cars but just the worst ones, with this a used car buyer who thinks that the used cars for sale are of average quality will be sadly mistaken and would be highly exploited simply because they lacked prior information on the conditions of the cars (Howells & Bain, pp. 35 – 40, 2007).
Financial Market Structures
“Financial markets structures take four basic forms which include: Auction markets, over the counter markets, organized exchanges and intermediation financial markets” (Mishkin, p.3, 2006).
Auction market refers to a public clearing house in which buyers and sellers through their commissioned brokers execute trades in an open and competitive bidding process, the process is not limited to physical meetings but rather any arrangement that gives access to the bidding process both to the seller and the buyer; it could be through interactive websites which facilitate auctions via a networked system of computers.
“Over the counter markets lack centralized mechanism or facility for trading but instead it is a public market consisting of a number of dealers spread across a region, country or even world over who make the market in some type of asset, the dealers post bid, ask prices for this asset and then stand ready to buy or sell units of this asset with anyone who chooses to trade at these posted prices” (Mishkin, p.3, 2006).
Intermediation financial market is a financial market assisted by financial intermediaries who help transfer funds from savers to borrowers by issuing certain types of financial assets to savers and receiving other types of financial assets from borrowers, this kind of market structure derives its name from the view that, the markets mediate trading between the savers and the borrowers (Mishkin, p.4, 2006). “The financial assets issued to savers are claims against the financial intermediaries implying that they are liabilities to the financial intermediaries, whereas the financial assets received from borrowers are claims against the borrowers, hence assets of the financial intermediaries” (Mishkin, p.4, 2006).
Financial market structures explained above expose the financial assets to the markets thus facilitating trade.
Criticisms
Asymmetric information and moral hazard contribution in financial systems has been immense as these systems go about fulfilling their main function of transferring wealth from lenders to borrowers, however, there are criticisms associated with focusing most on the role and extend of information in credit markets, and thus the feeling, that the following dimensions have been neglected;
Focuses attention only on standard credit market with no regard to non standard credit markets; credit demand, implying that the disparate composition of this demand has been neglected.
Focuses most on provision of credit neglecting the liquidity provision role of these financial institutions.
Disregard to institutions strategy especially strategies of major financial institutions contributing to expansion and growth of global economies.
Conclusion
Financial systems play a major and significant role in any country’s economy in the sense that; “they channel household savings to the corporate sector and allocate investment funds among firms, allow intertemporal smoothing of consumption by household and expenditures by firms and also enable households and firms to share risks” (Douglas, p. 520, 2001), through which the systems contribute to the growth and expansion of any economy.
Transaction mechanism is highly critical in a global economy, especially for the lower income households and smaller businesses which are key in development policies, implying that arrangements should be put in place to encourage savings for lower income households and to make room for easy access to credit facilities.
Technology advancement has led to and continues to influence the decline of asymmetric information due to easier and more efficient provision of all types of information.
References
Akerlof, G. A., 1970. The market for lemons: quality uncertainty and the market mechanism. The Quarterly Journal of Economics, 84 (3), pp. 488 – 500.
David, A., Baruch, L., 2000. Information Asymmetry, R & D, and Insider Gains. Journal of Finance 55 (6). PP. 2747 – 2766.
Douglas, G., 2001. Comparing financial systems. 55 Hayward Street, Cambridge, USA: MIT press. P. 520.
Gorton, G & Winton, A. 2002. Wharton: Financial Institutions center. Financial intermediation, Wharton school, University of Pennsylvania, USA. P. 2.
Howells, P & Bain, K., 2007. Financial Markets and Institutions, Financial Times/ prentice Hall, London, UK. 5th Ed. pp. 35 – 40.
Mishkin, F. S., 2006. The economics of money, Banking and Financial Markets, 7th ed. Addison-Wesley, Boston, MA, USA. P. 3.
Polborn, M. K., Hoy, M. & Sadanand, A. Advantageous effects of regulatory adverse selection in the life insurance market, Economic Journal, 116, 508: pp. 327 – 354.
Sheffrin, S. M., 2003, Economics: principles in action. Upper Saddle River, New Jersey: Pearson Prentice Hall, USA. P. 551.
Summers, L., 2007 – 09 – 23, Beware moral hazard fundamentalists. Financial Times, New York, USA, retrieved on 2008 – 01 – 15.