Wednesday, February 4, 2009

The global financial system (GFS)

Financial system - Introduction
Recent changes in the global financial markets:
• Globalisation of financial markets.
• Increase in the amount of money involved in financial transactions.
• Increasing domination of institutional investors.
• Increase of new financial instruments and products.
• Increase use and importance of technology.
• Impact of the internet (online banking online dealing).
• Increase competition between banks (corporate banking decline).
• Trend towards deregulation of the financial sector.
• Emergence of EU and Euro.
• Increasing importance of emerging markets.

Financial system – Introduction
Financial System is the group of individuals, intermediaries and
institutions that can potentially interact or participate in transactions
that involve real or financial assets.
The financial assets are instruments that facilitate transactions in
real assets or constitute the subject of a transaction between market
The financial markets facilitate the trading of financial assets
between market participants and
The financial intermediaries facilitate the financial transactions of
market participants.

The role of a financial system – Principles
The Financial System provides the environment in which the
individual investors and companies operate.
Financial system participants:
– Individuals.
– Companies.
– Financial institutions, private and public organisations.
– Governments.
Functions of the financial system:
– Facilitations of transfer of money.
– Primary and secondary security markets.
– Financial services.

The role of a financial system – Principles 2
In a financial system different parties participate in or perform
different functions but the common feature of all those functions is
The transfer of money from surplus to deficit economic agents.
– Bank deposits.
– Use of means of payments (cheques or electronically).
– Managing risk through investing in pensions or using insurance.
– Direct investment through buying and selling equities and bonds.
Transfer of funds from ultimate Lenders to ultimate borrowers can
Be made through direct lending; through trading in organised
securities markets or indirectly through financial intermediaries.

Lenders and borrowers in a financial system
• End users:
– Ultimate Lenders.
– Ultimate Borrowers.
• Intermediate Lenders and borrowers
– Financial institutions.
– Dealers.
– Market makers.
• Financial intermediaries
– Brokers.
– Banks, Clearing houses.
1. Motivation and interests of the end users.
2. Motivation and interests of financial intermediaries.
3. Function of financial intermediaries.

Saving and Lending
Savings is the surplus of the income over expenditure.
In most developed economies, the majority of the individuals and
households are net savers, i.e. surplus economic agents.
Investment is the acquisition of real assets that are used in the
production of goods or services by companies (the original term
used by the economists).
Financial Investment is a term used by financial press for
acquisition of financial assets by individuals.
Individuals has less investment opportunities than companies.

The deficit economic agents have current consumption higher than
their current income.
Borrowers are deficit economic agents such as:
– Companies.
– Government or local government authorities.
– Individuals and households.
Deficit economic agents have to liquidate existing financial assets to
finance their investments or incur financial liabilities, i.e. debts.
• Borrowers are interested at:
1. Minimising the cost of borrowing.
2. Maximising the length of time of the loan.

Lenders, borrowers and Financial assets
In a transaction, the financial asset of one party is liability for the
other party.
In aggregate, the financial surpluses and deficits must be equal.
Sectors in a closed economy:
– Households or private sector.
– Companies or corporate sector.
– Government.
Assuming that households have a financial surplus and companies
have financial deficit.
If government runs a deficit, the private sector surplus has to be
equal to the sum of the government and corporate sector deficit.

Financial Institutions
Financial institutions (FI) are companies that act as mediators
between surplus and deficit economic agents.
Financial Institutions:
– Deposit takers (banks).
– Non-deposit takers.
Functions of financial institutions:
– provision of payment mechanism.
– facilitation of lending and borrowing.
– provision of insurance, foreign exchange and other services.
• Liabilities of the banks are used as money.
• Banks are increase and facilitate money supply.
• Banks are closely regulated.

FIs as companies
Financial institutions are companies and use labour and capital to
provide efficient services.
• Financial crises, economic recession periods or industry
consolidation forces FI to become more efficient.
– High street premises vs. internet banking.
– Labour efficiency.
FI use capital (input) and provide loans (output) that generates
economic rents.
• Deposit-taking FI:
– Input: customer deposits.
– Output: loans.
• Non-deposit-taking FI:
– Input: funds from savers (for insurance, pensions, unit trusts, mutual funds).
– Output: investments in FA and deposits/loans to other FI.

FIs as Intermediaries - Functions
Financial institutions mainly receive deposit from surplus
economic agents and provide loans to deficit economic
agents but also provide a range of other services.
• Intermediation by FI also involves offering services not
only to ultimate lenders and borrowers but also to other
transacting parties .
• The role/functions of FI as intermediaries are:
– Provision of payment mechanism
– Creation of desirable assets and liabilities
– Maturity transformation
– Risk transformation/management
– Liquidity provision
– Cost efficiency (transaction, information and search costs)
– Provision of efficient monitoring mechanism.

FIs as Intermed. – Provision of Payment Mechanism.
• Most payments do not involve exchange of cash
• Many FI such as commercial banks offer options to pay by:
– Cheques
– Credit cards
– Electronic transfers
– Debit cards etc.
• Opportunities to use non-cash payments are also offered by
other non-bank financial intermediaries.
• Competition in prices and quality of services provide wide
choice to market participants.
• Electronic transactions in fund transfers are increasingly
common between domestic and foreign residents.
• The efficiency of system of payments facilitates economic

FIs as Intermediaries – Asset & Liability creation
• Creation of financial assets and liabilities:
• Examples:
– A bank attracts deposits of customers with surplus funds by creating a
number of different deposit and savings accounts (current accounts,
savings accounts etc).
– A bank offers a number of different loans to individuals and companies
(mortgages, short-term loans, consumer loans etc).
– A financial company raises equity capital and loans to provide lease
services to corporate clients.
– An insurance company provides insurance services to households and
– A mutual funds company offers investment opportunities.

Financial Markets
Financial markets (FMs) are organised and highly regulated
mechanisms that facilitate the transactions between investors
and companies or other market participants that act as investors
or intermediaries.
• No need to be in a specific physical location.
• Financial claims or financial instruments that represent
investors’ assets and liabilities are traded in the FMs.
1. Financial instruments that can be traded directly:
Shares, corporate and government bonds, treasury bills.
2. Financial instruments that cannot be traded directly:
Life assurance benefits, pension benefits, bank or savings deposits.

Financial Markets & Financial Instruments
• Classification of FM by the type of interest rate that the traded
financial instruments offer:
1. Instruments that pay fixed rate of interest (bonds, some mortgages).
2. Instruments that pay variable rate of interest (bank deposits, equities).
• Classification of FM by the time to the residual maturity of the
traded financial instruments:
1. Money markets: where the maturity is less than a year.
2. Capital markets: where the maturity is higher than one year.
• Classification of FM by the type of issue:
1. Primary markets.
2. Secondary markets.

The global financial system (GFS)

The global financial system (GFS) is a financial system consisting of institutions and regulations that act on the international level, as opposed to those that act on a national or regional level. The main players are the global institutions, such as International Monetary Fund and Bank for International Settlements, national agencies and government departments, e.g., central banks and finance ministries, and private institutions acting on the global scale, e.g., banks and hedge funds

1 History
2 Institutions
2.1 International institutions
2.2 Government institutions
2.3 Private participants
2.4 Legal frameworks and treatises
3 Perspectives 4 Criticism, discussions and reform

The history of financial institutions must be differentiated from economic history and history of money. In Europe, it may have started with the first commodity exchange, the Bruges Bourse in 1309 and the first financiers and banks in the 1400–1600s in central and western Europe. The first global financiers the Fuggers (1487) in Germany; the first stock company in England (Russia Company 1553); the first foreign exchange market (The Royal Exchange 1566, England); the first stock exchange {the Amsterdam Stock Exchange 1602).Milestones in the history of financial institutions are the Gold Standard (1871–1932), the founding of International Monetary Fund (IMF), World Bank at Bretton Woods, and the abolishment of fixed exchange rates in 1973.

International institutions
The most prominent international institutions are the IMF, the World Bank and the WTO:
1.)The International Monetary Fund ( keeps account of international balance of payments accounts of member states. The IMF acts as a lender of last resort for members in financial distress, e.g., currency crisis, problems meeting balance of payment when in deficit and debt default. Membership is based on quotas, or the amount of money a country provides to the fund relative to the size of its role in the international trading system.
2)The World Bank ( aims to provide funding, take up credit risk or offer favorable terms to development projects mostly in developing countries that couldn't be obtained by the private sector. The other multilateral development banks and other international financial institutions also play specific regional or functional roles.
3)The World Trade Organization ( settles trade disputes and negotiates international trade agreements in its rounds of talks (currently the Doha Round)

Government institutions
Governments act in various ways as actors in the GFS: they pass the laws and regulations for financial markets and set the tax burden for private players, e.g., banks, funds and exchanges. They also participate actively through discretionary spending. They are closely tied (though in most countries independent of) to central banks that issue government debt, set interest rates and deposit requirements, and intervene in the foreign exchange market.

Private participants
Players acting in the stock-, bond-, foreign exchange-, derivatives- and commodities-markets and investment banking are
Commercial banks
Pension funds
Hedge funds and Private Equity
Legal frameworks and treatises
North American Free Trade Agreement (NAFTA)
Commonwealth of Independent States (CIS)
There are three primary approaches to viewing and understanding the global financial system.
The liberal view holds that the exchange of currencies should be determined not by state institutions but instead individual players at a market level. This view has been labelled as the Washington Consensus. This view is challenged by a social democratic front which advocates the tempering of market mechanisms, and instituting economic safeguards in an attempt to ensure financial stability and redistribution. Examples include slowing down the rate of financial transactions, or enforcing regulations on the behaviour of private firms. Outside of this contention of authority and the individual, neoMarxists are highly critical of the modern financial system in that it promotes inequality between state players, particularly holding the view that the political North abuse the financial system to exercise control of developing countries' economies.

Criticism, discussions and reform
Among the many critics of the GFS are:
The ATTAC network
Joseph Stiglitz
George Soros
Stefan G. Dunbar
Pope Benedict has urged a major overhaul of the global financial system

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