For any financial market in an economy to function efficiently, it must have an effective

financial system.

The financial resources of any economy are unlikely to match the trade and exchange
needs of every person. Some people (savers) have current incomes exceeds their
expenditures while the other group (borrowers) face a problem that their expenditures
are more than their current incomes. The mismatch between income and expenditures
creates an opportunity for a mutually advantageous exchange so that those who have
surplus are willing to lend their savings if they are compensated and those deficits are
willing to pay for the funds they need. (R. Glenn Hubbard)

In an economy, the three groups of potential savers and borrowers are households,
business firms and government. They can be domestic or foreign. The function of a
financial system is to provide channels and links to transfer funds from the groups who
have saved money to the groups who want to borrow money. Savers are suppliers who
provide funds to the borrowers in return for financial assets which will be better store of
value in the future. Borrowers are demanders who need funds for consumer durables or
to finance an investment project, issuing financial liabilities against themselves for their
future income. For example, if I want to buy a new flat but do not have enough money, I
can borrow money from a bank to make a mortgage. The mortgage is my liability which I
need to repay the loan and interests and at the same time, the mortgage is the asset of
the bank who is able to enjoy the benefit of receiving extra income - interests every
month.

To maintain an efficient financial system is of vital importance to the healthy growth and
development of an economy. It can allocate the scarce and idle financial resources from
being underutilized by the surplus group to the deficit group. From the productive use of
the funds, entrepreneur can invest in new project venture which in turn create new jobs
and produce goods and services for the society. Individual consumer is able to finance
their consumer durables according to their needs and desires which consequently
expand the consumer market. Having an effective functioning financial system is one of
the key factors in securing economic growth and improves people’s economic welfare.

In addition to the basic function of matching individuals who has excess funds with those
who need them, the financial system also provide three key services for savers and
borrowers. These services include risk sharing, liquidity and information services. By
providing these three services in different ways, financial markets and intermediaries
make various financial assets and liabilities more attractive and convenient to savers
and borrowers.

Risk Sharing
Risk is the degree of uncertainty of a financial asset’s return. From the experience of
financial tsunami happened in 2008, there is always a chance that the value and price of
financial asset will fluctuate and drops to zero due to default. Most individual savers are
not gamblers and they are looking for a stable return on the assets they are holding.
The financial system offers savers different types of financial claims with various risk
level. For example, the government bonds have less risk when compare to the higher
risk associated with equity investments. Financial market can create financial instrument
to transfer risk from savers to borrowers who do not like uncertainty to those who are
willing to bear higher risks. By this way, individual savers are able to reduce their risks
by diversification their wealth into a portfolio of assets with different risk level they can
accept. The ability of financial system to provide risk sharing will encourage savers more
willingness to buy borrower’s financial liabilities and provide borrowers with a greater
range of possibilities to raise funds in the financial system.

Liquidity
Liquidity is a measure of the ease, speed and safety with which an asset can be
exchanged for money to purchase another asset. In general, the more liquid the asset,
the easier it is to exchange. Asset in the form of cash is most liquid. From the view of the
savers, liquidity of financial assets is very important and crucial to their investment
decisions. It is because liquid assets allow them to respond quickly to new investment
opportunities or unexpected market events. By holding financial claims such as stock or
bond issued by the entrepreneur, individual savers have more liquid assets than they
would if they directly owned the actual business equipment. The reason is that there is a
more accessible and marketplace for selling the financial claims than there is for selling
the second hand business equipment. Financial claims such as stock, bonds, and
treasury bills are more liquid than machinery, equipment or real estate property.

In addition to creating financial securities, the financial markets in the financial system
also provide trading system through which those financial assets are traded. This
mechanism much increases the liquidity of financial assets. Investors can easily sell their
holdings of stocks and bonds of large corporations through an exchange where equities
and bonds are traded. As a result, it is much more attractive to saver to release their
funds and encourage more lending in the economy. With greater liquidity, savers are
willing to accept a lower return as the risks involved is reduced. It therefore reduces the
costs of borrowing for less well-known firms which has promoted a more efficient
allocation of financial resources in the economy.

Information Services
The third service of the financial system is the collection and communication of
information services. To gather information about the background about borrowers and
the intention they will do with the borrowed funds are necessary information required by
the savers. It will be costly and waste a lot of time for the savers to obtain such
information by itself. A financial system must be able to access information about
borrower’s circumstances for individual saver to make prudent investing decisions.
Private firms have organized to collect and provide information on the quality of the
financial claims. Moody’s Investor Service and Standard and Poor’s Corporation are
leading information providers. In this way, the financial system allocates funds efficiently
because it reduces the cost of information in matching savers and borrowers.

The financial system also needs to provide a monitoring system for solving the problems
of asymmetric information. This refers to a situation where borrowers possess
information about their opportunities or activities that they do not disclose to lenders so
that they can take unfair advantage of the lenders. Such kind of behavior must be
regulated.

Another informational role is the communication of information. Financial markets can

function this efficiently by incorporating information into the prices of the financial
securities. As long as information is communicated to the economic agents, savers and
borrowers can receive the benefits of information from the financial system by looking at
the asset returns.
Globalization
The globalization of financial markets improves the ability of the financial system to
channel savers’ fund to borrowers wherever they are. Moving capital between countries
becomes increasing important since the breakdown of fixed exchange rate in the 1970s.
Over the past recent decades, many countries had deregulated their policies on the
financial sector and abolished capital controls that kept their citizens from exporting their
savings. The rapid postwar economic growth of Japan and in Europe increased the pool
of savings available to the borrowers. The easy flows of capital across national
boundaries help corporate lack of resources to finance their productive opportunities.
Corporate can access to national markets to raise IPO funds through the primary equity
market. Secondary markets provide liquidity to those financial claims that have
previously been issued. This is what the financial market is supposed to do. The Russian
aluminum giant United Company Rusal Ltd. will be ready to receive net proceeds from
the global offering of HK$16,790 millions in Hong Kong is a good example.
(http://www.hkexnews.hk/listedco/listconews/advancedsearch/search_active_main_c.as
p)

Eurocurrency Market
The growth and development of the eurocurrency market since the Second World War
plays an important role to enable international financial market to be more efficient
because it created a short-term money market to manage the short-term liquidity
imbalances of lenders and borrowers. In this market, short-term funds in a given
currency are intermediated in a location outside the jurisdiction of the domestic monetary
authority of the currency of denomination. This eurocurrency market enjoys a
comparative advantage over the domestic local banking operation for they are not
subject to the same level of supervision and regulation as the domestic local bank must
comply with. It will be beneficial to both the lender and the borrower as they can get a
better interest rate than each would get in their domestic local bank. In addition, an
exporter can also protect the profit margin of his receivable against the exchange rate
risk by borrowing the importer country’s currency from this market.

Syndicated Bank Loan

In terms of long-term finance, borrowers can meet their needs by arranging syndicated
bank loans in which a syndicate of banks are grouped together to provide a single loan
to the borrower who is either a big international enterprise or a notional government. The
loan amount is often large for billions of dollars that any single individual bank cannot
afford the default risk of the borrower. Therefore the primary motivation for such a loan is
a risk sharing as each individual bank is holding a fraction of the loan. Efficiency is also
gained from specialization from which the various tasks involved are divided according
to their abilities and expertise. Smaller banks are given the opportunities to participate
and obtain the benefits of information services with low information costs, paying the
lead manager a small fee for assessing borrowers’ creditworthiness, pricing the risk and
arranging the syndication.

Derivative
Derivative markets add value in the financial system by providing valuable risk sharing,
liquidity and information services for savers and borrowers. Derivatives are financial
securities whose value is derived from another "underlying" asset, reference rate or
index. For example, the value of an option on HSBC depends on the share price of
HSBC. By using derivative, risk sharing is facilitated by bringing hedgers and
speculators together. In future and option contracts, hedgers can reduce their exposure
to fluctuations in the price of the underlying asset whereas speculators have a chance to
make a profit from the anticipated fluctuations in the price of the underlying asset. So the
risk is transferred to the speculators. Active speculation in derivative market not only
increases liquidity but also help to incorporate information into market prices which in
turn increases the efficiency of the market of the underlying financial securities. When
derivative instrument is traded in organized exchange, the contract size and
specifications are standardized. This enhances their liquidity and make more efficient to
the economic agents. The clearing house at the exchange reduces the information costs
by guaranteeing performance between the trades of the buyer and the selling. It
removes the default risks of the loser and guarantees the contracts will be honored.

Securitisation
Securitisation removes the need for lenders to be in close physical proximity to
borrowers. That is, someone wanting a mortgage need not seek out a local bank with
local depositors to finance it. In addition to divorcing the physical location of the lender
from that of the borrower, securitisation separates the origination of credit from the
bearing of risk. Actors along the securitisation chain can make use of their comparative
strengths in processing information or managing various types of risks. All of this should
improve efficiency.
(Mr Stephen G Cecchetti, Economic Adviser and Head of Monetary and Economic
Department of the BIS, at the Eighth BIS Annual Conference, Basel, 25-26 June 2009)

Securitisation is the transformation of illiquid financial assets into marketable securities

for trade on the capital markets. It is a method of funding various types of receivables
such as mortgage loans, credit card receivables, car loans and commercial corporate
loans. Banks can bundle portfolios of their loans into different levels of ratings and shift
the default risks associated with the loans by selling the rights to receive the future
income stream from the loan to other investors who are willing to accept it. The investors
buy the securities that are backed up by the income stream of the loans. Being removing
the assets from the balance sheet and freed of the need to hold capital against the
default risk loss, the bank can make more off-balance-sheet lending.

The characteristics and functions of the above economic activities enable the financial
market to be more efficient.

------END OF COURSEWORK-----
Bibliography

A. Jackson & Y Bai (2009), Edinburgh Napier University, Global Financial Markets
Module Text Unit 1, 3, 4, 6, 7

R. Glenn Hubbard (2005), “Money, the Financial System and the Economy”, Fifth
Edition,
Pearson Education, Inc. Chapter 1 (p.3-7), Chapter 3 (p.31-53), Chapter 9 (p.195-198),
Chapter 14 (p.327)

Philip Coggan (2002), “The Money Machine How the City Works”, Fifth Edition, Penguin
Books, Chapter 7 (p.59-65), Chapter 10 (p.102-106)

Marc Levinson (2005), “Guide to Financial Market”, Fourth Edition, Profile Book Ltd.
Chapter 3 (p.37-41), Chapter 9 (p.167-171)

Website

http://business.mapsofindia.com/globalization/impact.html (assessed on 23.10.2010)

http://www.finpipe.com/derivatives.htm (assessed on 24.1.2010)

http://www.bis.org/speeches/sp090710.htm (assessed on 24.1.2010)