Unit: 1 Nature and Role of Financial Institutions in the Economy

1. Nature of financial institutions Financial institutions are the organizations which perform the essential functions of channeling funds from those with surplus funds(suppliers of funds) to those with shortages of funds(user of funds).Financial institutions are active in todays global markets include commercial banks, insurance companies credit unions, finance companies, savings and loan associations, saving banks, pension funds, mutual funds, and similar organization. Their fundamental role in the financial system is to serve both ultimate lenders and borrowers but in a much more complete way than brokers and dealers do. Financial institutions issue securities of their own-often called secondary securities to ultimate lenders and at the same time primary securities from borrowers. The secondary securities issued by financial intermediaries include such familiar financial intermediaries include such familiar financial instruments as checking and savings accounts, life insurance policies, annuities and shares in mutual fund. For the most part, these securities share several common characteristics. They generally carry low risk of default. Financial institutions are accept primary securities from those who need credit and in doing so, take on financial assets that many savers, especially those with limited funds and limited knowledge of the market, would find unacceptable. One of the benefits of the development of efficient financial intermediations has been to smooth out consumption spending by households and investment spending by businesses over time, despite variations in income , because intermediation makes saving and borrowing easier and safer. Financial intermediaries overcome inefficiencies or frictions in the financial market place and reduce the cost to society of moving information and wealth among households, business and governments, providing access to economies of scale( information cost savings) that would otherwise not be available to many (mostly smaller) units in the economy. Financial intermediaries improve the real world efficiency of the money and capital markets in allocating the daily flow of capital through the global market place toward its best possible uses. 2. The Global Economy and Financial System The basic function of the economic system is to allocate scarce resource- land, labor, management skill and capital to produce the goods and services needed by society. The high standard of living most of us enjoy today depends on the ability of the global economy to turn out each day and enormous volume of food, shelter and other essential of modern living. This is an exceedingly complex task because scarce resources must be produced in just the right amounts to provide the raw materials of production and combined adjust the right time with labor, management and capital to generate the products and services demanded by customers. In short, any economic system must combine inputs- land and others natural resources, labor and management skill, and 1

capital equipment- to produce output- goods and services. The global economy generates a flow of production in return for a flow of payments. The Global Economic System Flow of production Flow of payments Land and other natural resources Labour and managerial skills Capital equipment Goods and services sold to public

We may also depict the flows of payments and production within the global economic system as a circular flow between producing units (mainly business and governments) and consuming units (principally households). In the modern economy, households provide labour, management skill, and natural resources to business firms and governments in return for income in the form of wages and other payments. Most of the income received by households is spent to purchase goods and services from business and governments. The circular flow of production and income is interdependent and never ending. The circular flow of income, payments and production in the Global Economic Systems:-

Producing units (Mainly business firms and governments)

Consuming units (Mainly households)

3. The Role of Markets in the Global Economic System In most economies around the world. Markets are used to carry out this complex task of allocating resources and producing goods and services. Market in an institution set up by society to allocate resources that ate scarce relative to the demand for them. Markets are the channel through which buyers and sellers meet to exchange goods, services and productive resources. The marketplace determines what goods and services will be produced and in what quantity. This is accomplished through changes in the price of goods and services offered in the market. If the price of an item rises, this sumulates business firms to produce and supply more of it to customers. In the long run, new firms may enter the market to produce those goods and services in experiencing increased demand and rising prices. A decline in price, usually leads to reduce productions of a goods and services, and in the long run some suppliers may leave the market place. Markets also distribute income. In a pure market systems, the income of an individual or business firm is determined solely by the contributions is makes to producing goods and services demanded by the market place. Markets reward superior productivity and the sensitivity to consumer demands with increased profits, higher wages, and other economic benefits. Of course, in economic systems where governments play major roles, government policies also affect the distribution of income and other benefits. There are essentially three types of markets at work within the global economic system:1) Factor Market:- in factor markets consuming units sell their labor and other resources to those producing units offering the highest prices. The factor market 3

allocate factors of production- labor, managerial skills and capital- and distribute income- wages, rental payment, and so on to the owners of productive resources. 2) Product Markets:- consuming units uses most of their income from factor markets to purchase goods and services in product markets. Food, shelter, automobiles, theater tickets and clothing are among the many goods and services sold in product markets. 3) The financial markets and the financial system:- it is here that the third kind of market, the financial market performs a vital function within the global economic system. The major function of financial market is to attract and allocate savings and setting interest rates and the prices of financial assets ( stocks, bonds etc ) Most of the funds set aside as savings flow through the global financial markets to support investment by business firms, governments, and households. Investment generally refers to acquisitions of capital goods, such as buildings and equipment, and purchase of inventories of raw materials and goods to sell. The make up of investment varies with the particular unit doing the investing. For a business firm, expenditure on capital goods and inventories are investment expenditure. Households invest when they buy a new home, furniture, automobile and other durable goods. Government spending to build and maintain public facilities is another form of investment. Modern economies require enormous amount of investment to the goods and services demanded by customers. Investment increases the productivity of labor and leads to higher standard of living. However, investment often requires huge amount of capital and it is collected from sale of financial assets in financial markets. Indeed, the money and capital markets operating with the financial system make possible the exchange of current income for the future income and the transformation of savings into investments so that population, employment, income, and the living standards can grow. Those who supplies funds to the financial markets receive only promises in return for the loan of their money. These promises are packages in form of attractive financial claims and financial services such as stocks, bonds, deposits and insurance policies. Financial claims provide dividends, interests, or other returns to the supplier of funds. The role of financial markets in channeling savings into investment is absolutely essential to the health and vitality of the economy.

The Global Financial System Flow of loan able funds (saving) Flow of financial services, Suppliers of funds (Mainly households)

Demands of funds (Mainly business firms and governments)

incomes and financial claims 4) Functions of financial system: The importance of the financial system in our daily lives can be illustrated by reviewing its different functions. The global financial system has seven basic functions: a) Savings function: - as we noted earlier, the global system of financial markets and institutions provides a conduit for the publics savings. Bonds, stocks and other financial claims sold in the money and capital markets provide a profitable, relatively low risk outlet for the publics savings, which flow through the financial markets into investments so that more goods and services can be produced, increasing the worlds standard of living. b) Wealth Function:- for those individuals and business choosing to save, the financial instruments sold in the money and capital markets provide an excellent way to store wealth(i.e. preserve the value of assets we hold) until funds are needed for spending. Bonds stocks, and other financial instruments do not wear out overtime and usually generate income, moreover their risk of loss often is much less than for many other forms of stored wealth. Financial system helps in increment of wealth providing the facility of holding financial instruments. c) Liquidity function:- for wealth stored in financial instruments, the global financial market place provides a means of converting those instruments into cash with little risk of loss. Thus, the worlds financial markets provide liquidity(immediately spend able cash) for savers who holds financial instruments but are in need of money. d) Credit function:- in addition to providing liquidity and facilitating the flow of savings into investment to build wealth, the global financial markets furnish credit to financial consumption and investment spending. Credit consist of a loan of funds in return for a promise of future payments. Consumers, business and government need credit for capital expenditure and consuming expenses. The capital market and money market provides credit to users. The volume of credit extended by the money and capital market today is huge and growing.

e) Payments function:- the global financial institution also provides a mechanism for making payments for goods and services. Certain financial assets including checking accounts and negotiable order of withdrawal(NOW) accounts, serve as a medium of exchange in making payments. Plastic credit cards issued by banks, credit unions, and retail stores give the customer instant excess to short term credit but are also widely accepted as a convenient means of payments electronic means of payments are in wide spread use today and are growing rapidly. f) Risk protection function:- the financial markets around the world offer business, consumers and government protection against life, health, property, and income risk. This is accomplished, first of all, by the sale of insurance policies. Life insurance, property casualty insurance etc protect us from different risk. In addition to making possible the sale of insurance policies, the money and capital markets have been used by business and consumers to self-insurance against risk; that is, holding of wealth are built up as protection against future losses. g) Policy Function:- finally, in recent decades, the financial markets have been the principal channel through which government has carried out its policy of attempting to stabilize the economy and avoid inflation. By manipulating interest rates and availability of credit, government can affect the borrowing and spending plans of the public, which, in turn influence the growth of jobs, production, and prices. Methods of Moving Loan able fund in the Financial System Whether simple or complex, all financial systems perform at least on basic function i.e. movement of fund. They move scarce funds from those who save and lend to those who wish to borrow and invest. In the process, money is exchanged for financial assets. However, the transfer of funds from savers to borrowers can be accomplished in at least three different ways. The methods of funds transfer are: 1. Direct Finance 2. Semi-direct Finance 3. Indirect Finance Direct finance: With the direct financing technique, borrower and lender meet each other and exchange funds in return for financial assets without the help of third party to bring them together. You engage in direct finance when you borrow money from a friend and give him or her IOU, or when you purchase stock or bonds directly from the company is issuing them. We usually call the claims arising from direct finance primary securities because they flow directly from the borrower to the ultimate lender of funds. Direct finance is the simplest method of carrying out financial transactions and most financial systems in history started out using direct finance. Semi direct finance

In the semi direct finance, there is three parties- borrower, lender and broker or dealer. Brokers and dealers bring surplus-budget units together, thereby reducing information cost. A broker is merely an individual or financial institution who provides information concerning possible purchases and sales of securities. Either a buyer or seller of securities contacts a broker, whose job is simply to bring buyers and sellers together. a dealer also serves as an intermediary between buyers and sellers, but the dealers actually acquires the sellers securities in the hope of marketing them at a later time at a favorable price. Simi direct finance is an improvement over direct finance in a number of ways. It lowers the search(information) cost for participants in the financial markets. Frequently, a dealer will split up large issue of primary securities into smaller units affordable by every buyers of modest means and, thereby, expand the flow of savings into investment. In addition, brokers and dealers facilitate the development of secondary markets in which securities can be offered for resale. Indirect finance The limitations of both direct and indirect finance simulated the development of indirect finance carried out with the help of financial intermediaries. Financial intermediaries active in todays global markets include commercial banks, insurance companies, credit unions, finance companies, savings & loan associations, savings banks, pension funds, mutual funds, and similar organizations. Their fundamental role in the financial system is to serve both ultimate lenders and borrowers but in a much more complete way than brokers and dealers do. Financial intermediaries issue securities of their own-often called secondary securities to ultimate lenders and at the same time accept IOUs from borrowers primary securities. The secondary securities issued by financial intermediaries include such familiar financial instrument as checking and savings accounts, life insurance policies, annuities, and shares in a mutual fund. Financial intermediaries accept primary securities from those who need credit and, in doing so, take on financial assets that many savers, especially those with limited funds and limited funds and limited knowledge of the market, would find unacceptable. Indirect finance: Primary securities (direct claims against ultimate borrowers in the form of loan contracts, stocks, bonds etc.) Secondary securities

Ultimate borrowers (deficit-budget units)

Financial intermediaries(ban ks, savings & loans associations

Ultimate lenders (surplus budgets)

Flow of funds (Loans of spending power)

flow of funds (loans & spending power)

Types of financial intermediation: Financial intermediation is performed by financial intermediaries in different way according to their working nature. The types of financial intermediation depend on the types of financial intermediaries. So the different ways of financial intermediation can be described on the discussion of the different types of financial intermediaries. Financial intermediaries are: 1. depository institutions: a. commercial banks b. Non bank thrift Savings and loan associations Savings banks Credit unions Money market funds 2. Other Financial Institutions: a. Financial companies b. Government credit agencies c. Mortgage companies 3. Contractual Institutions: a. Life insurance companies b. Property casualty insurers c. Pension funds 4. Investment Institutions: a. Investment companies (mutual funds) b. Real estate investment trusts. 5. Other financial institutions: a. Investment bankers. b. Security brokers. c. Security dealers.

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By nabaraj