The Importance of money, Financial Markets and Financial Institutions
A Brief note on the Development and importance of money and credit is relevant to the proper understanding of financial markets and financial institutions.
In any discussion on the importance of money the first question which comes to our mind is what are the real uses of money? Money in its modern from at least, is not anything that we can eat or wear, nor does it provide shelter or entertainment in any direct manner. Similarly, do banks and other lending institutions contribute in any real way to our well-being? The short answer to these questions is that money, credit or the whole structure of financial institutions, can contribute greatly to the standard of living in society, but it does so only indirectly, by helping man to become much more productive. Money in the modern economy is viewed as lubricant that greases the wheel of economic activity. Without money, the transactions that make up our daily economic routine would be extremely difficult and so is saving and investment. Money also plays a key role in influencing the behavior of the economy as a whole and the performance of financial institutions and markets. More specifically, charges in the supply of money and credit can affect how rapidly the economy grows, the level of employment, and the rate of inflation and these in turn can affect the value of financial assets held by individuals and financial institutions.
If we contrast a subsistence economy with highly industrialized economy, we find great differences in material well-being. The standard of living of any community is basically determined by productivity of its people, and the high standard of living of an advanced industrialized country reflects the high level of productivity which has been achieved. This hes been largely the result of specialization. Specialization means that each worker devotes himself to a single occupation such as factory work, farming, teaching or government service, and usually to a specialized task within that occupation. As adam smith long ago demonstrated, such division of labour is a remendous boost to productivity because it makes it possible for each person to concentrate on what he is most fitted for, it encourages the development of a high degree of skill, it saves the waste of time and effort of constantly moving from one job to another, and it stimulates mechanization of tasks and improvement in work methods. But specialization is only possible if each worker can readily exchange his specialized service for the goods and services which he and his family actually need. And the development of specialization is made possible by the parallel development of money, credit and financial institutions.\
As a matter of fact, to appreciate the importance of money in an economic system, it is instructive to speculate on what the economy might be like without money (i.e., a barter economy). For one thing, without money individuals in the economy would have to devote more time to buying what they want and selling what they do not want. They will have less time to work and play. The introduction of money has simplified matters. Workers are paid in money which they can use to pay for their goods and services. Money becomes a medium of exchange. But the most important thing about the medium of exchange is that everyone must be confident that it can be passed on, that it is generally acceptable in trade and other transactions. It is important to emphasize, however, that people use the medium of exchange money not because it has any intrinsic value, but because it can exchange for things to eat, to drink, to wear, and play with.
• Money is the raw material in banking;
• In any industry a good manager will start by starting with the raw material;
• If we do not appreciate the raw material, we will never master its transformation and the end product [Chorafas, 1999]
A person, who is unable to understand the raw material used by his company, will never be able to understand the products which he handles. If he does not know and appreciates the input, he will never learn much about the output. Therefore, he will not be able to sell his products and services to his clients. This is true of banking as of any other industry.
The role played by money in modern society may be summed up as follows:
• A medium of exchange: Money is a means of exchange because it is generally acceptable. Money is a substitute for barter economy. People who trade in goods and services, and financial assets nowadays are willing to accept money in exchange for these items. Barter is a costly activity, because it requires a double coincidence of wants: two individuals must simultaneously be willing and able to make a trade.
• A unit of measurement: Money functions as a unit of account, which means that people maintain their financial accounts by using money to value goods, services and financial assets. Money makes possible matrices and provides a frame of reference. It also constitutes the basic for double-entry accounting as well as for keeping accounts, profit and loss statements and balance sheets.
• Raw materials for the banking industry: Without it banks cannot deposits and give loans, hence they cannot act intermediaries.
• A store of value: Money serves as a store of value. An individual can set money aside today with an intent to purchase items at a later date. Many commodities represent wealth, but the practice is to translate them into a common denominator which is money. The value of money comes with the fact that it is limited in supply. As a store of value and of wealth, money is a key ingredient of capital. Money constitutes the raw material for both the capital market and the money market.
• Standard of deferred payment: Money serves as a standard of deferred payment. People agree to loan contracts that call for future repayments in terms of money. These contracts defer repayment of a loan until a later date. Parties to the contract agree to meet financial terms specified in terms of money.
The object of government controls: Central banks may regulate money supply and also try to influence interest rates and exchange rates.
• Money makes it feasible to move remittances from one place to another through networks.
• Banks do so without transporting bulky commodities or valuable metals over long distance.
Every branch of knowledge has its fundamental discoveries. For example in physics, fire is a fundamental discovery, in politics it is vote and as far as commercial and economic existence of man is concerned, money is the most important discovery.
In modern day context, Money and technology have a common ground, such as plastic money. Similarly, technology is inseparable from modern banking and vice ver. Today or tomorrow a bank must be ready to trade any product from any place, in any exchange and over the counter (OTC). Technology takes the credit for this globalization. We shall elaborate on this point in a different section.
Financial Markets and institutions
The importance of money becomes more obvious in its relevance to Financial Institutions and markets. Money contributes to economic development and growth by stimulating both saving and investment and facilitating transfer of funds from savers to borrowers, who want to undertake investment projects but do not have enough of their own money to do so. Financial Markets give savers variety of ways to lend to borrowers, thereby increasing the volume of both saving and investment and encouraging economic growth. People who save are not often the same people who can see and exploit profitable investment opportunities. The introduction of money, however, permits the separation of the act of investment from the act of saving. Money makes it possible for a person to invest without first refraining from consumption (Saving) and likewise makes it possible for a person to save without also investing. People who are not fortunate enough to have their own savings now can invest.
In a monetary economy, a person simply accumulates in cash because money is a store of value. Through Financial Markets, this surplus fund can be lent to a business firm to invest in new equipment, the equipment it might not have been able to buy if it did not have accesss to borrow funds. Both the saver and Business firm are now better off; the saver receives interest payments, and the business firm expects to get a return over and above the interest cost. And the economy is also better off because the only way an economy can grow is by allocating part of its resources to the creation of new and more productive facilities.
In an advanced economy, this challenging of funds from savers to borrowers through financial markets reaches highly complex dimension. A wide variety of Financial Instruments such as stocks, bonds and mortgages are utilized as devices through which borrowers can gain accesss to the surplus funds of savers. Various markets specialize in trading one or another of these financial instruments.
And Financial Institutions have sprung up such as commercial banks, saving banks, saving and loan associations, credit unions, insurance companies, mutual funds and pension funds that act as intermediaries in transferring funds from ultimate lenders to ultimate borrowers. Such financial intermediaries themselves borrow from saver-lenders and borrower-spenders gain. Savers have the added option of acquiring saving deposits or pension rights which are less risky than individual stocks or bonds, and business firm borrower can tap large sums of money from a single source. None of this would be possible were it not for the existence of money, the one financial asset that lie at the foundation of the whole super structure.
The primary functions of a financial system
The primary function of a financial system is resource allocation. To accomplish these tasks, financial system performs six basic functions:
1. Clear and settle payments ( a payment system) to facilate trade and commerce. They provide the primary means of payment like chequing accounts, debit cards.
2. Aggregate 9pool) and disaggregate wealth and flows of funds so that both large scale and small scale projects can be financed. They gather deposits and other sources of funds, such as savings accounts, CDs, and federal funds etc.
3. Transfer economic resources over time, space and industries. They make loans to individuals, business and governments in various locations for different maturities.
4. Accumulate process and disseminate information for decision making purposes. They provide various record keeping services involving the processing, storing and disseminating the financial information.
5. Provide ways for managing uncertainty and controlling risk. They reduce the uncertainty associated with default, liquidity and interest rate risk, and they sell risk management service.
6. Provide ways for dealing with incentive and asymmetric information that arise in financial contracting. They monitor borrower’s credit worthiness, signals changes in the credit quality, and provide guarantees such as a banker acceptance.
Judging the Efficiency of a Financial System
We may assess the efficiency of a financial system by using three concepts: allocative efficiency, price efficiency and cost efficiency. [sinkley, 2002]
Allocate Efficiency refers to moving scarce funds to investment projects with the highest returns. Financial markets unimpeded by artificial constraints provide the best method for achieving allocate efficiency. At the micro-economic level, allocate efficiency means that businesses accept all projects that exceed their cost of capital and that households focus on portfolios that offer the highest return for a given level of risk or minimum risk for a given level of return.
Informational or price efficiency refers to how quickly and accurately security prices reflect existing and new information. In an efficient market, characterized by7 large number of buyers and sellers and free flow of information, security prices reflect all existing information and when new information becomes available, it is quickly and accurately embodied in share prices.
