1 An introduction to the financial system in theory and in practice
Introduction
The aim of this book is to introduce and analyse the issues and debates surrounding development finance, at both a global and local level. Although the area is relatively new, at least in the form of a distinct subject in its own right, the question of the relationship between the financial sector and economic development and growth has a long and occasionally volatile history.
The development of an effective financial system has been seen as an essential prerequisite for growth at some points, and an unproductive parasite on the real economy at others. The contemporary debate, for the most part, subscribes to the first of these perspectives, though some still support the âparasitic viewâ. Those reading this book for the first time are also likely to take a relatively optimistic view of what the financial system can achieveâthere would be little point studying the subject if this were not so. Similarly, this book takes a broadly optimistic stance on the debateâthere would be little point writing it if this were not the case.
However, it is important to stress at the outset that, as with much in the fields of economics, finance and development, there is rarely only one answer to any question. The answers arrived at may owe as much to the ideological predispositions of their authors as to conclusive empirical evidence. It is important to bear this in mind as you work through this book, which is structured so as to equip you with the skills and confidence to critically analyse the issues for yourselfâultimately, to reach your own conclusions.
Having said that, whilst we do not have all the answers, it is not the case that we know nothing. Theoretical positions have evolved, changed direction, gone up blind alleys (and back again) and been informed by real-world experience for at least a hundred years. It is from this real-world experience that we have, perhaps, the most to learn: we have seen what has worked and what has not, though we may not always know exactly why these outcomes have occurred.
In this first chapter, however, we start with some financial theory and some basic facts with the aim of establishing a framework for the rest of the book. Chapter 2 considers the relationship between finance, development, growth and poverty alleviation. The third chapter reviews both the theory and practice of the trend towards financial liberalisation that began in the early 1970s, whilst Chapter 4 provides an overview of the key features of the domestic financial system in developing countries. Chapter 5 examines the debate around reform of the domestic financial system, focusing on the link between financial sector development, economic growth and poverty reduction. Chapter 6 then moves to the external financial system and compares trends and key issues in official development assistance (i.e. aid) and private sector flows. Chapter 7 considers the incidence and causes of financial crises and debt crises in developing countries, whilst Chapter 8 assesses reforms to the global system, under the aegis of the âinternational financial architectureâ. Chapter 9 examines the linkages between the domestic financial sector, private sector development and growth in developing countries. The final chapter pulls these different strands together, and considers the options facing policy-makers in developing countries, and ends with a discussion of what countries could do, and what obstacles they may face in proactively developing a financial system that can facilitate high and sustained rates of growth and, ultimately, the elimination of extreme poverty.
First, however, we must answer some basic questions, before seeing how others have answered them in the past.
The most fundamental question to answer is simply, what is the financial system actually for? In principle, the role of the financial system is largely the same as in Walter Bagehotâs description of the London money market in 1864: âIt is an organisation of credit, by which the capital of A, who does not want it, is transferred to B, who does want itâ (Bagehot, 1978: 422).
Whilst this remains the ostensible purpose of the international financial system, the reality is now very different. In particular, the scale, complexity and interrelatedness of financial markets today has created a plethora of profitable opportunities that are not a âmeans to an endâ, but have become an end in themselves. Total world economic output in 2005 was estimated at between US$55 trillion and US$60 trillion per year. These are big numbers, but they are dwarfed by turnover in the global financial marketsâthe spot foreign exchange market alone sees more than US$450 trillion in turnover per year, or almost ten times the real economic output of the global economy.
Before returning to this issue, however, the next section considers how, in principle, the financial system performs the functions described by Bagehot almost 150 years ago.
1.1 How do financial systems do this, in theory?
Bagehot described how the nineteenth-century London money market channelled surplus financial resources to capital-scarce borrowers looking to invest. The first function of the financial system is therefore:
- (a) To mobilise savings and allocate creditâbanks, as well as other financial institutions, act as intermediaries between savers and borrowers/investors. Thus households with surplus resources place these resources with banks, which in turn sift through potential borrowers and allocate credit to its most productive use. Similarly, asset management companies and âcontractual savingsâ institutions1 also mobilise savings and allocate these funds as investments, usually in public capital markets.
As well as channelling resources indirectly from the capital-rich to the capital-poor through third-party financial intermediaries, the financial system also enables the process to occur directly:
- (b) It enables individuals to directly provide surplus resources through the capital marketsâindividuals and institutions with surplus capital to invest can directly participate in the capital markets of the financial system through providing debt financing to companies by purchasing corporate bonds, or by providing equity finance to companies through the purchase of shares.
In addition to these key functions, the financial sector also organises and implements various aspects of the âplumbingâ of the national economic system. Perhaps the most important of these is:
- (c) The provision of clearing and settlement servicesâif the national economic system is seen in terms of an engine, then clearing and settlement systems can be viewed as the fuel that enables the machine to function. Specifically, businesses and individuals are able to settle financial balances, whether they be cheques or credit and debit cards for smaller balances usually associated with individuals or small businesses or large value payments between financial institutions, which are generally settled centrally within the national central bank.
As well as providing these vital functions for the private sector, the financial system is both overseen and used by national governments in a variety of ways.
- (d) Governments regulate the activities of the financial systemâthe government has an indispensable role in terms of setting and enforcing the regulation of financial institutions, whether directly or through specialist agencies set up by government to undertake this role. The international system, in contrast, does not have one regulator, but relies on coordinating the activities of national regulators.
- (e) Governments also borrow from the financial systemâthe government issues sovereign bonds, which are purchased by the financial system (both nationally and internationally), thereby providing the funds needed to finance government expenditure (i.e. to finance fiscal deficits).
- (f) Governments may also take a more direct role in the financial systemâboth historically and today, many governments have sought to intervene directly in the functioning of domestic financial systems. Examples of such activities include directing the allocation of credit through development banks and/or directly owning or controlling a section of the commercial banking sector.
Ultimately, therefore, the ostensible purpose of the financial system remains as described by Bagehot above, and the system performs these functions within a regulatory framework implemented and enforced by national governments. However, it is important to reiterate that, at least in principle, the system does not simply allocate surplus capital to any borrower, but to the most productive possible use. In theory, this efficient allocation therefore maximises the productive use of capital.
Later we will consider the theoretical principles and assumptions behind this perspective in some detail. Before this, however, the next section highlights the key features of the financial systemâs infrastructure, before discussing the most important financial institutions that operate within this framework.
1.2 What are the key features of the financial system?
1.2.1 Capital markets
- (a) Bond markets (or âfixed incomeâ markets) enable corporations and governments to borrow directly from investors in the capital markets through the issuance of bonds. Bonds are issued in the âprimary marketâ, and then traded in the âsecondary marketâ. The resultant debt provides investors that purchase the bonds with a regular stream of income payments through âcouponsâ (i.e. interest payments) for the life of the debt, as well as the payment of the debtâs âprincipalâ upon maturity. The magnitude of the coupon is set at the time of issuance, hence the term âfixed-interestâ. In the secondary markets, a fall in the price of the bond therefore results in an increase in the rate of interest, or âyieldâ paid, as the fixed coupon payment becomes a larger percentage of the price of the bond. The reverse is obviously true of a rise in the price of a bond. In terms of the pricing of risk, therefore, falling demand for a bondâperhaps due to market perceptions of deteriorating credit quality of the issuerâleads to falling prices and higher interest rates. The higher interest rate therefore reflects the perceived increase in the risk attached to the bond. Bonds may have any maturity, and in general terms the shorter the maturity the lower the rate of interest. Other factors that influence the level of interest attached to a bond are (a) the creditworthiness of the issuer (be it corporate or sovereign), and (b) specific features that may be attached to the bond to alter its nature (more will be said of these features below, but a bond without such additions is known as âvanillaâ)
- (b) Equity markets enable investors to obtain a percentage of the ownership of the company in question. There are two forms of equity market: (1) âpublic equity marketsâ (share markets/stock exchanges) are where companies âlistâ their shares for trading purposes, with the total value of the companyâs outstanding shares termed âmarket capitalisationâ. Investors that purchase a companyâs shares are entitled to a share of the companyâs profits in proportion to their stake in the form of âdividendsâ, which are usually paid annually. Although in many marketsâparticularly developed onesâanyone can invest in public equity markets, in practice major institutional investors play a dominant role. In the UK, for example, just 14% of the total market capitalisation of the London Stock Exchange is held by private individuals (i.e. âretail investorsâ), with the remainder being held by financial institutions (i.e. âinstitutional investorsâ). (2) The second form of equity market is âprivate equityâ, where shares are not listed on a public market, but are sold directly to investors.
In terms of pricing, the value of both bonds and equities can be described as the present value of future revenues derived from the financial instrument. For bonds: âThe value of a bond is the present value of the promised cash flows on the bond, discounted at an interest rate that reflects the default risk in these cash flowsâ (Damodaran, 2002: 887). For equities, value can be determined either âintrinsicallyâ or âextrinsicallyâ. Intrinsic valuation refers to the fundamental value of the equities, which is usually determined in a similar way to that described for bonds above: future (net) revenues of the company in question are discounted back to arrive at a ânet present valueâ (NPV) today, which is then simply divided by the number of shares issues to produce the âfair valueâ of each share today. There are a variety of models that have been designed to perform this function, but the most commonly used are some variant on the standard discounted cash flow (DCF) model.
A key distinction between bond and equity markets relates to the nature of risk. In bond markets, it is the issuer who carries the primary risk, since payments must be met regardless of the financial circumstances of the company. In equity markets, however, the risk is primarily held by the investor, since dividend payments will be linked to the financial performance of the company so that in a bad year no payment will be made. Put another way, if a company raises finance in the bond market debt accrues, but if it raises finance in the equity markets it does not.
1.2.2 Other financial markets
- (a) Money markets provide a market for short-term debt securities, such as bankersâ acceptances, commercial paper and government bills with short maturities. Money market securities are generally used to provide liquidity to companies and banksâincluding overnight loans to meet their reserve requirements as usually determined by the central bank. As such, they are associated with low rates of interest, which reflect the very short maturities involved, and the low credit risk (zero in the face of government) of the participants in the market.
- (b) Derivatives markets provide instruments for the handling of financial risks, where participants in the derivatives markets purchase instruments that enable themselves to âhedgeâ themselves against future movements in asset prices. A derivative is therefore a financial contract whose value is derived from a financial instrument such as a stock or bond, an asset (such as a commodity), a currency or a market index (such as the FTSE 100, for example). Derivatives may be traded on market exchanges, such as the Mercantile Exchange in Chicago (CME), the Chicago Board of Trade (CBOT) or the London International Financial Futures and Options Exchange (LIFFE). Derivatives may also be bought or sold privately on an âover-the-counterâ (OTC) basis between major financial institutions. By 2004, average daily turnover in the global derivatives market was estimated at $2.4 trillion, with the largest form of contract relating to interest rates, followed by foreign exchange (FX), equities and commodity-related contracts.
- (c) FX markets trade currencies internationally. By 2004, global FX markets saw average daily turnover of US$1.8 trillion, which is broadly equivalent to the annual GDP of the United Kingdom. Historically, the FX market has been rather an ad hoc affair, with no central market. However, since 2002 an increasing proportion of global FX trades have been transacted and settled through the Continuous-Linked-Settlement (CLS) Bank, which by 2006 processed more than half of all global FX trades. CLS Bank was established to reduce settlement risk in international FX transactions, which is particularly problematic given that such trades often involve more than one time-zone. That is, as both sides of an FX trade have to be settled for the transaction to be complete, it is possible for an institution in one time-zone to settle its side of the trade, only for its counterparty in another time-zone subsequently to default on its side of the trade. Settlement risk of this kind in FX markets is often described as Herstatt Risk after a German bank in the early 1970s.2
From a national/international perspective, capital and money markets are almost entirely national, whereas derivatives and FX markets are more international in nature. In terms of participants, âretailâ investors (i.e. the general investing public, as opposed to financial institutions) may provide financing directly to borrowers through any of these markets (though in practice they tend to focus on equity markets). Alternatively, however, they may provide funds indirectly through financial institutions, which may operate on a national or international basis depending on the scope and scale of their activities:
1.2.3 Commercial financial institutions
- (a) Commercial banks take deposits from the public and lend money on a short- to medium-term commercial basis to individual and corporate borrowers. The difference between the interest rate paid to savers and that charged to borrowers is called the âspreadâ. Crucially, commercial banks transform short-term liabilities (i.e. current account deposits that can be withdrawn on demand) into long-term assets (i.e. loans of longer maturity).
- (b) Investment banks/merchant banks undertake a broader range of financial services, which are generally related to the business and financial institutions sectors. These forms of banks assist businesses in finding and structuring various forms of finance, including the issuance of corporate bonds and the âunderwritingâ these issues (i.e. they agree to purchase any unsold bonds). Investment banks also arrange mergers and acquisitions (M&A) and may invest their own capital by taking equity positions (public or private) in selected businesses.
- (c) Universal banks perform all the functions of commercial banks, combined with the services offered by investment banks.
- (d) Mortgage banks/building societies specialise in providing finance for the purchase of property, both residential and commercial. (Although these distinctions between types of banks remain, the last two decades have seen considerable erosion of the âfunctional boundariesâ between the different types of bank and non-bank financial institutions.)
- (e) âContractual savingsâ institutions such as pension funds and insurance companies pool and invest the savings of their members to generate sufficient funds to meet their liabilities (i.e. pension liabilities and paying insurance claims). The investment and asset management activities involved in this function may be performed âin-houseâ or may be outsourced to a third-party asset management company.
- (f) Asset management companies provide âpo...
