Financial Systems

Principles and Organization

Edwin H. Neave

• Publisher: Routledge
• Year: 2002
• ISBN:
  9781134835904
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

As the world's financial markets become increasingly integrated and competitive Financial Systems: Principals and Organization offers an explanation of how and why change occurs. Data from four major financial systems are used to highlight principal financial system features. There is also a detailed exploration of the economic principles behind financial deals. It also offers:
* Wider scope than other books on the subject making it an ideal introductory text
* More up-to-date economic explanations
* An international overview of US, Pacific and European economies
This book has already been adopted by the Canadian Institute of Bankers for its financial systems course offered worldwide. Financial Systems will be invaluable reading for students and professionals alike.

Part I
Overview

Part I is an introductory overview which examines the roles of a financial system and explains how a typical financial system is organised. Chapter 1 outlines the structure of the book. Chapter 2 examines the roles a financial system performs and the clients it serves, while Chapter 3 explains how a typical financial system is organised. Chapter 4, which contends that change is one of the most important features of a modern financial system, outlines the factors contributing to change and explains why the effects of change are registered so rapidly in a modern financial system. The last chapter of the overview, Chapter 5, examines prominent features of the financial systems of four major countries—Germany, Japan, the UK and the US—to give the reader an initial idea of some of the similarities, and some of the differences, among the world’s principal financial systems.

1 Introduction

LEARNING OBJECTIVES

After reading this chapter you will understand

• that a financial system helps savers to invest their funds
• that financial system organisation is determined according to the ways different forms of financial deals are governed
• that the kinds of financial deals done, and the ways they are done, can affect economic growth
• that financiers’ pursuit of new profit sources is the principal determinant of financial system change
• how knowledge of financial system activity can help financial managers perform their roles more effectively

This book is intended to help future managers understand the kinds of activities that take place in a financial system, and to understand why certain kinds of organisations are set up to carry out those activities. The book explains that financial systems in market-oriented economies have a typical structure that is determined by economics: the economics of governing the transactions they take on, and the operating economics of the firms effecting the transactions. The book further explains that financial system change is driven by the same economic forces that determine system organisation. As you gain an understanding of how these economics work, you will become better able to discern directions of future financial system change. This knowledge will in turn help you to deal more effectively with the opportunities that the changes will likely bring.

This book argues that the world’s financial systems are largely shaped by the same forces, and develop in quite similar ways. To be sure, there are also important differences among financial systems. But most of the differences among domestic financial systems result principally from details of an economy’s development, or even from historical accident. Moreover, the differences are continually being mitigated by the same economic forces, thus causing the world’s major financial systems to converge toward a common type. The book uses examples from financial systems throughout the world to illustrate this process of convergence, and to explain how the same kinds of changes are transmitted from one economy to another.

The study of a financial system is a more vital matter than commonly realised. A financial system’s importance is not limited to the people working in it. Rather, financial system performance can and will importantly affect business capital formation decisions, and these decisions in turn affect economic development and international competitiveness. The terms on which financing is made available affect both the amount and type of capital formation that takes place in an economy. If business cannot obtain funds as readily and as cheaply in one country as in another, it will attempt either to raise the funds where the terms are better, or may even relocate the entire business to another part of the world. Moreover, the terms on which business can obtain financing will depend on the skills and insights of financiers who must decide whether or not to put funds into different kinds of projects.

Since the mid-1970s, change has been the most prominent feature of the world’s financial systems. Change has been and continues to be driven by two principal forces: technological development and the increased competition which follows on it. In nearly all developed economies, technological change and evolving competition affect the economics of doing financial transactions, or ‘deals’ as the rest of this book usually calls them. As financiers discern these changes, they alter their ways of doing business in response. Even regulators respond to the workings of the same forces, principally by proposing legislative changes to recognise evolving forms of domestic financial business. In addition, as international finance continues to increase in importance a body of international law, and a number of international organisations, are being developed to supervise the growing international activity.

1.1 THE BOOK’S PURPOSES

Today’s financial managers find it more urgent than ever to understand the basic forces driving financial system change. As the world’s financial markets increasingly become more competitive, and more closely integrated, new profit opportunities need to be exploited quickly if they are not to be lost to competitors. Indeed, new products may need to be introduced with speed just to ensure that existing business can be retained. In such an environment the manager without an understanding of how and why change occurs is a manager who will quickly become outdated, and therefore one who will likely fail to prosper. For example, during the 1980s management personnel in some of the larger securities firms earned much of their companies’ revenue by arranging mergers and acquisitions. During the later 1980s and early 1990s the pace of this activity tailed off, and earnings declined commensurately. At the present time, the later 1990s, interest in merger activity is again increasing. This book will explain why such cycles in financial activity occur. It will also discuss the potential for profiting from cycles, as well as some of the dangers to be encountered along the way.

Understanding how and why change occurs is not simply a matter of describing what is happening today: description is not explanation. Explanation demands a more organised picture of the forces driving change, and of how those forces influence financial activity. This book uses the economics of financial transactions to develop such a picture. It explains why financial systems take their manifest forms, and why these forms change over time. For example, readers of this book will learn why there was a virtual explosion in derivatives trading over the 1970s and 1980s,¹ and will therefore come to understand the reasons for this immense increase in derivatives’ popularity. While some press accounts suggest that the growth of derivatives trading is largely due to a willingness to speculate, the real reasons are to be found in the changing risks within the financial system and the corresponding changes in the economics of their management.

To help the reader apply its theory, the book refers to activities in a number of financial systems, especially those of Germany, Japan, the UK and the US. Examples from these and other countries show how profit opportunities arise as financial systems change, and how managers interested in setting up and operating financial firms can take advantage of these opportunities. By understanding how the forces of change operate, readers planning private sector careers can learn to profit from them. Equally, readers whose careers are likely to be in the public service can use the same knowledge to devise and implement better, more effective ways of supervising financial activity. For example, the book will show that the rapid increases in the size of the Japanese banking system, and the more recent increases in its loan losses, are not unique events. Rather, they are examples of a recurring form of crisis that recurs regularly, to greater or lesser degrees, in most economies’ banking systems. The book will show that some of the difficulties currently facing Japanese banks are explained by the same factors that led to difficulties encountered previously in other banking systems.

The book begins by explaining how individual financial transactions or deals differ, and what this means for the ways in which deals can be structured. Second, the book explains the basic ideas underlying the use of derivative securities, and shows why their importance for risk management has grown so rapidly since the early 1970s. Third, the book explains why it is so important for financiers to have different kinds of deal-making capabilities. An understanding of these issues helps the reader appreciate how financial system development occurs and where profit opportunities are likely to arise as the changes take place.

Even though many examples are used, the book’s explanations emphasise principles rather than descriptive detail. Many readers will probably agree that explanations can convey a more powerful understanding than descriptions, but some may object that analysing a financial system in terms of principles omits so many practical details that it cannot be of much help to the everyday manager. Yet, practical details must be omitted if the reader is to make real headway in understanding financial systems. First, in today’s rapidly changing financial environment descriptions become dated so quickly that it is almost impossible to keep them current. Second, even if it were possible to keep descriptions current, they are not enough. Every analyst needs to have a theory (road map) to understand the broad outlines of, and the major forces at work within, a financial system. Without the organisation provided by theory, an analyst can assemble a mass of detail but still fail to understand either how the details relate to each other or what causes them to keep changing. Finally, the reader who has learned to apply the theory has a set of ideas that remain valid for a much longer time than does current description.

1.2 THE BOOK’S ORGANISATION

This book consists of five parts. The first, overview part describes the users of a financial system, how the system is organised, and how that organisation changes over time. Selected data from four major systems—Germany, Japan, the US and the UK—are used to identify the principal financial system features examined in the rest of the book. The second part of the book is an examination of the economic principles according to which deals are done and financial firms are organised.

The remaining three parts of the book apply the theory. The third part, financial markets, examines markets for raising funds and for managing risks, as well as some of the financial firms trading in these markets. The fourth part examines financial intermediaries. Intermediaries are often active in many financial markets, but much of their importance is attributable to their non-market negotiations with clients. Intermediaries administer, or govern, deals differently than do market agents. These differences mean intermediaries actually agree to different kinds of deals than do market agents, and hence their activities are complementary to market trading. The book’s fifth and final part examines the questions of assessing and improving financial system performance.

1.3 SUMMARY OF APPROACH

This book develops a theory of how financial deals differ, and of how different deals are structured. The theory explains how the size and nature of the financial firms doing the deals are determined, and thus shows how the financial system emerges as an aggregate of these firms’ activities. The theory also explains why financial system change occurs, and discusses some of the reasons why many forms of financial activity are cyclical in nature. These explanations can help future managers to function effectively in a financial environment, whether they intend to work in profit-making firms or as public servants.

REVIEW QUESTIONS

Exercise 1 Suppose you can make a loan to an impeccable credit risk for one year at a rate of 7 percent. Would the rate you charge on a higher risk loan be less, the same, or more?

Exercise 2 Why do you suppose banks are so eager to sell insurance in their branches nowadays?

Exercise 3 The huge growth in risk management instruments (swaps, options, futures) has almost all taken place since the early 1970s. Try to list some of the reasons why there would be an increased demand for risk management since the early 1970s.

Exercise 4 Some of the following activities are mainly fund raising, while others are mainly aimed at risk management. Try to classify them accordingly: buying insurance; selling bonds to fund the purchase of a new computer system; buying an option; borrowing to finance a new venture; arranging an interest rate swap. (If you don’t know exactly what’s involved in some of these transactions, you will be learning more about each at a later point in the book.)

Exercise 5 Suppose a bank buys some treasury bills that it intends to hold until maturity, and that it also makes a long term loan to a fairly risky new business. Would the second deal require more continuing attention than the first? Why?

Exercise 6 If you invest in government bonds and hold them to maturity, they represent a relatively low risk investment. Stocks typically represent a higher risk investment, because the returns on them usually fluctuate over a wider range than do the returns on bonds. Suppose you are considering putting your money either into a five year US Savings Bond currently offering an 8 percent return, or a bank equity fund that has a historical return of 8 percent. Which do you think is the better deal, and why?

Exercise 7 Give an example of some kind of financial deal to which a bank would typically pay little continuing attention. Do you think the same would be true of a venture capital investment in a new company? Why or why not?

Exercise 8 What are the major forces contributing to financial system change? Why do these forces contribute to change?

Exercise 9 Why are these forces having similar impacts on most market economies’ financial systems?

Exercise 10 Why has the pace of change increased within the world’s financial systems?

Exercise 11 Find at least one article on changing financial regulation in the United States or the United Kingdom. Who wants these regulatory changes? Why do you think they are wanted?

2 Roles and clients

LEARNING OBJECTIVES

After reading this chapter, you will understand

• that the financial system serves several different types of clients consumers, business and governments
• how the financial system serves to effect payments
• how the financial system facilitates risk management
• how the financial system serves as a store of value
• some of the ways in which finance affects economic activity

The workings of a country’s financial system are not readily apparent to casual observers. Readers of the financial press probably think of a financial system as a set of markets in which shares and exotic instruments such as financial derivatives are traded. They are less likely to think about the importance of the financial system for providing new funding of projects, and about whether that funding comes mainly through financial markets or financial intermediaries. They are also less likely to realise that the financial system helps an economy to run smoothly, and is a vital contributor to the economy’s development.

2.1 WHAT ROLES DOES A FINANCIAL SYSTEM PERFORM?

Financial systems perform most of their everyday operations so quickly and smoothly that their importance is not always well readily recognised. Few observers notice how easily a well functioning financial system performs its principal roles: effecting payments, facilitating the investment of accumulated wealth, making funds available to finance viable new projects, and providing risk management facilities.¹ Yet, when you begin to consider how important each of these functions is, the vital roles played by the financial system start to become apparent. When in addition you realise that the financial system can contribute to economic growth, the importance of its functioning becomes still more evident.²

2.1.1 Payments system

The financial system effects payments by responding to the instructions of individuals, businesses and governments to transfer funds to other parties. When a traveller uses a credit card to obtain cash in a foreign country, or when a firm pays for imports from abroad, the financial system completes the transaction. The financial system also makes it possible fo...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Figures
• Tables
• Preface
• Part I Overview
• Part II Concepts
• Part III Financial markets
• Part IV Financial intermediaries
• Part V Assessing and improving performance
• Appendix Solutions to exercises
• Glossary
• Notes
• References