Historical Evolution of Financial Services
As soon as economic activity moved beyond barter, rudimentary financial services came into being. Banks had been established in medieval Italy as far back as the fourteenth and fifteenth centuries in response to the trade that started between Italyās different city States and financing such trade and underwriting the risks that accompanied it were the beginnings of banking as we know it today. Britain followed with similar banks in the seventeenth century. Merchants and artisans and, indeed, anyone with an excess of goods beyond their immediate needs, whether for their own consumption or for sale to others, would convert some or all of them into gold or silver, the only acceptable medium of exchange known at the time. The gold or silver would, in turn, be deposited with gold or silversmiths for safe keeping with the latter issuing receipts in lieu to the depositors. These receipts then began to be used for making payments or for settling debts rather than physically transferring any of the gold or silver for the purpose. The goldsmiths, for their part, would note the changes in ownership of the precious metals on their books. The receiptsāessentially pieces of paper backed by the deposited precious metalsāwere the forerunners of modern paper money . Over time, owners of the receipts began to lend them to friends and associates and such receipts could remain in circulation almost indefinitely being used by their holders (individuals and partnerships) for buying and selling goods and for settling debts, rarely coming back to be exchanged for the deposited gold or silver. In fact, the total of claims outstanding against the original gold or silver at any given time could be several times more than the quantities of the metals actually deposited. Thus, the banking principle was born.
Nowadays, the issuance of paper money is a monopoly of the State while lending money āgiving credit1āand the price at which it is done, the rate of interest, has become an elaborate activity not only in the variety and number of institutions involved but is governed by its own dedicated framework of practices, conventions, laws and regulations including the establishment of central banks . Economics itself has come up with a field of study called āmonetary theoryā that seeks to distinguish the different influences that affect the real and monetary parts of the economy and financial economics is an integral part of any Economics or MBA course. As with other fields of study in Economics the subject is not without its share of disagreements and controversies.
Taking a broad view of the economy all money , i.e. any instrument that allows its holder to exchange it for goods and services, is essentially a matter of credit.2 Therefore, when an institution overextends its credit, and not only to individual customers but also to sister institutions engaged in similar activities, some of the borrowers will inevitably be unable to repay. When this happens the lending institution has effectively lost a part of the money that was deposited with it. Under certain circumstances, this may cause the institution to fail and, given the interconnectedness of lending institutions and individual borrowers in the modern economy, the whole of the lending and borrowing system could be in danger of collapsing. In any modern economy, lending institutions are consequently obliged to keep a portion of the equivalent of the gold or silver (the money deposited with them), as a reserve with another institution. This institution has been called the central bank and given its vital role in maintaining the confidence of the general public its importance was quickly established. Many central banks in the developed countries have been in existence for the better part of three centuries.3 Today, it would be difficult to imagine a banking system without a central bank . Although central banks initially came into being primarily to provide confidence to depositors, they are now an integral component of the financial system and are directly responsible for maintaining adequate liquidity and price stability in the economy and, in many countries, for regulating the banking system.
It needs to be stressed that money cannot in most economies be precisely measured. The easiest definition is the quantity of money issued as ālegal tenderā by the State or central bank . However, money is an elastic entity. It is whatever society is prepared to accept and in history there have been instances of substitutes for money (cigarettes in POW camps in World War II, cowrie shells in the Pacific etc.) From a modern perspective, the simplest form of created money is any IOU that can be discounted in the market. As a result, the financial system can keep on expanding almost indefinitely, so long as confidence is maintained. Indeed, the financial system as a whole can exceed the total value of the output of goods and services in an economy many times over, as it has in a number of countries (Pettifor 2017).
In conventional textbook analysis, the function of a financial system consisting of banking and the issuance and trading of financial assets is essentially to intermediate between those with surplus funds at their disposal which they have deposited with a commercial bank (or other institutions such as savings banks, building and mutual societies), i.e. savers, and those who might need them for varying periods of time, i.e. borrowers. The quantity of funds that a bank can lend is, however, constrained by two influences: one, on the demand side, the number of sound and reliable borrowers and the quality of the security that they can provide against the possibility of default. This is the bankās principal fiduciary responsibility: to assess risk objectively and to lend funds in the least risky way possible so that its legal and moral responsibilities, meaning the safety of the savings in its care, are not compromised. Two, on the supply side, it is constrained by its share of the total of societyās savings in circulation. A bank may theoretically only lend the savings that have been deposited with it but nothing stops it from borrowing from other banks, at home and abroad, to increase the size of its operations except its own creditworthiness.4
As part of the long-term evolution of the financial system it is also worth remembering that as economies began to grow and individuals and enterprises grew richer the need for longer-term funds such as equity or pre-production capital, particularly on the part of enterprises, grew in tandem. In addition to, short-term loans two types of financial instrument came into being: shares and bonds . Shares are a form of part ownership of the enterprise issuing them.5 The owners of the shares are entitled to receive a part of the profits of that enterprise and to participate in its management by electing its board of directors. Generally speaking, shares have to be held in perpetuity (i.e. till such time as the share-issuing enterprise continues to exist) but holders can sell them on and there is, in fact, an active market in the buying and selling of shares in most countries through the stock exchange. Bonds, on the other hand, are a form of debt and carry an obligation to pay a certain sum of money per annum to their holders. By and large, bonds have an end date, i.e. maturity, when they have to be āredeemedā or repaid but they, too, are traded like shares before reaching maturity.
As a result of the principle of limited liability both shares and bonds have become vehicles for absorbing the surplus funds of individual investors, whether households, firms or financial institutions and are as such a form of wealth. But the managers of the enterprises that have issued them are not in existence for satisfying the interests of the share- or bond-holders. They are there to generate a surplus over the costs of all inputs used by them in production, i.e. make profits for the enterprise, with which their own interests are aligned. The need to pay out dividends on the shares or interest on the bonds is almost identical but the enterprises will do so to the minimum extent needed, i.e. just enough for the investors to keep them interested. In practical terms, shares and bonds can be considered to be identical as far as the financial needs of an enterprise are concerned and for investors they are merely different ways of earning ārent ā. They do have a separate legal status, and often they are treated differently for tax purposes,6 but ultimately they are similar ways of raising longer-term finance by enterprises.
The total of finance available in the economy at any given time is the equivalent of all public and private wealth, also embodying physical assets like infrastructure , houses, buildings, plant and machinery. Into this pool flow day by day new surplus funds from savings and profits that are then invested in shares and bonds or are deposited in banks. These incremental flows are, however, small compared to the total stock of financial assets in the economy. Thus, it is very unlikely that the average price of shares and bonds that constitute the aggregate of the pool would be materially affected by the size of these flows. Historically, the main influence on these prices has been the state of expectations which affects not just the price of shares but, indirectly, the rate of interest as well. The latter because the price of has to be low enough, and the yield high enough, in order for them to compete with shares. New bonds can be sold only if they can promise a risk-adjusted return that is comparable to that of shares. Empirically, it has been seen that when banks make more loans they tend to reduce the demand for bonds, so pushing up interest rates.
Financialization
The financial system has evolved into playing a variety of other roles and in the past each of the roles was kept distinct with its own regulatory regime particularly after World War II. For savers, in addition to banks there are insurance companies, building societies, blind trusts, managed funds, hedge funds and pensions, all playing different roles in the economy whether to buy protection against risk or to protect the value of the assets/savings over the long term. For large or wealthy investors there were wholesale banks that primarily operated in the interbank market, dealt with enterprises and/or with large private clients, managed cross-border financial flows and assisted in new and growing avenues for providing finance, such as cross-border trade and investment that gave rise to a separate class of risks, such as exchange rates and political developments. Since the 19...