This topic may be useful for Students of Finance and Banking
THE IMPORTANCE OF CREDIT
The importance of credit depends on the level of self financing by enterprise in a country: it is less important when self financing is high and more important when self financing is low. On the other hand, credit may play a very important role in financing increase in public investment, and it will also promote economic growth, provided that there is a positive correlation between the use of credit and public sector investment.
Another function the financing of current activity is the basic function of traditional financial intermediaries, particularly the banking system and is common to all countries. This function is related to maintenance of a given level of economic activity and for it to be effective; the financial instruments involved in the debt credit process have to grow more rapidly than the national product. The development of a dynamic banking system capable of guaranteeing a suitable degree of liquidity has over the years been an essential component in financing an expanding economy.
The next function of the financing of consumption is more directly linked to the maintenance or expansion of the level of effective demand, which is of particular significance in at least two situations. The first which is of a continuing nature, involves covering expenditure on customer durables of high unit values, the sale prices of which may not be in line with the average current income of the population. The second occurs when it is wished to raise the level of effective demand, if demand has contracted because of temporary phenomena or is depressed because income has contracted at the higher level of income scale. In this latter case, increasing the size of loans for consumption purpose and their repayment periods may expand the effective market to include the middle income strata, enabling them to increase expenditure by going heavily into debt In the long run, however greater participation by this group cannot be sustained unless their share of total income cannot be modified. This kind of credit instrument has been used by banks and also by agencies outside the banking system to cope with the first situation in developed capitalist countries and both situations in developing countries.
Besides the above, financial intermediation can create credit for purchasing existing real or financial assets for purposes of speculation or accumulation, in which case it does not have a functional relationship with actual production, consumption and investment flows. As the returns on such operations depend to large extent on prevailing institutional conditions, it tends to fluctuate violently and amplifies the normal cycles of capitalist economy. It should be remembered, however, that this kind of financial accumulation gave birth to and promoted the capital markets. Its main purpose was, therefore, not to finance fixed capital formation, although this is not to say, that it has no direct or indirect effects in the rate of real investment. In actual fact, in as such much as financial accumulation yields healthy profits, it stimulates economic activity, boosts demand and strengthens and steps up the expansion of economy. This, in turn may raise real investment to level higher than can be financed out of financial expansion alone. On the other hand, a drop in the rate of accumulation, through a crisis in demand may bring about a more depressed situation in which opportunities for profitable investment may disappear, for a while at least.
Provision of Entrepreneurial Talent
Another Possible function, although it is not inherent in the definition of banking system, is the provision of entrepreneurial talent and guidance for the economy as a whole. That is, instead of restricting themselves to a purely intermediary function, bankers may actively seek out and exploit profitable undertakings in manufacturing, commerce or any other productive activities. The dynamic role of the commercial banks in Germany and developing banking institutions in some countries may serve as a lesson for many other developing countries.
Changes in the Financial World
It May be noted that financial world is constantly changing very fast. There are four particular trends that are making life harder for financial firms and for central banks and financial regulators, who act as guardian of financial system.
First, due to modern communication technology, information is transmitted faster and traders and investors can also respond instantly to news. Second, in many countries there has been a shift from banks and other depository institutions, the traditional focus of financial regulation, to capital markets. Third, the driving line between different types of financial intermediaries and between different markets is becoming blurred. In America, many mutual firms and stock broking firms now offer chequeing accounts. And around the world, different sorts of institutions, such as banks and insurers are forming gigantic financial alliances. Lastly but by no means the least, international liberalization is creating a global capital market. Cross border transactions in bonds and shares, for instance have increased rapidly. In theory, the more internationally integrated financial system become, the easier it will be for funds to flow to the most productive investments, to the benefit both to borrows and savers, and to economies as a whole . Unfortunately, as international capital has become highly mobile, so the risk has risen that departing capital may cause a financial crisis.
It may be noted that financial innovation and globalization are the catalyst behind the evolving financial services industry and the restructuring of financial markets. It respects the systematic process of change in instruments, institutions and operating policies that determine the structure of financial system in a country. Innovations take the form of new securities and financial markets, new products and services, new organizational forms, and new delivery systems. Financial institutions change the characteristics of financial instruments traded by the public and
Create new financial markets, which provide liquidity. Bank managers change the composition of their banks’ balance sheets by altering the mix of products and services offered and by competing in extended geographic markets. Financial institutions from holding companies, acquire subsidiaries, and merge with other entities. Financial institutions form holding companies, acquire subsidiaries, and merge with other entities. Finally institutions may modify the means by which they offer products and services, and merge with other entities. Finally, institutions may modify the means by which they offer products and services. Recent trends incorporate technological advances with the development of cash management accounts, including the use of automatic teller machines, Home banking via the computer and internet, and shared national and international electronic fund transfer system.
We also notice that foreign markets and institutions are becoming increasingly international in scope. U.S. corporations, for example, can borrow from domestic or foreign institutions. They can issue securities denominated in us dollars or foreign currencies of countries in which they do business. Foreign companies have the same alternatives. Investors increasingly view securities issued in different countries as substitutes. Large firms thus participate in both domestic and foreign markets such that interest rates on domestic instruments closely track foreign interest rates. This globalization is the gradual evolution of markets and institutions such that geographic boundaries do not restrict financial transactions.
Innovations have many causes. Firms may need to stop the loss of deposits, enter new geographic or product markets, and deliver services with cheaper and better technology, increase their capital base, alter their tax position, reduce their risk profile, or cut operating costs. In virtually every case, the intent is to improve their competitive position. The external environment, evidenced by volatile economic conditions, new regulations, and technological developments, creates the opportunity for innovation.
Financial Development and Real Development:
Several empirical studies have confirmed that there is a strong link between financial development and economic growth. Countries with well-developed banking system and capital markets tend to enjoy faster growth than those without. A study by rose Levine and Sara Zervos examined forty seven countries from 1976 to 1993. They found that stock market liquidity (the value of shares traded relative to stock market capitalization) and the size of the banking sector (measured by the lending to the private sector as a percentage of GDP) are good predictors of future rate of growth, even after controlling for other factors, such as initial level of income, education and political stability.
In rich economies, the assets of financial intermediaries and the size of stock and bond markets all tend to be bigger in relation to GDP than in poor ones. In emerging economies, banking system is quick to develop, but capital markets take longer, because capital market need a financial infrastructure that provides, among other things, adequate accounting standards, a legal system that provides , among other things, adequate accounting standards, a legal system that enforces contracts and protects property rights, and bankruptcy provisions.
However, the relationship between the real and financial components of the development process is to a large extent, influenced by large number of factors. They include factors affecting financial growth whose relationship with economic development is very difficult to pinpoint, For example, the degree of centralization of economy, international relations, methods of financing public debt and existence of acute or chronic inflation. Another set of factors which affect the structure and modus operandi of the economy and financial system include the subsistence nature of economy, the degree of sectoral and spatial diversification, Pattern and level of urban consumption compared with average disposable income, and prevailing habits and forms of savings by economics agents. Although, the fundamental dynamics of development lie outside the banking system, the way the system is structured can either significantly hasten or retard development.
It must be remembered that the method of operation of financial institutions and the way in which agents and functions are specialized depend to a large extent on the characteristic of each country, especially its policy guide lines, relation between the public and private sector as regards financial matters and the level of openness of self financing of the dominant enterprises.
Financial Repression and Financial Liberalization:
The formal banking and financial sector is repressed primarily by interest rate ceilings that are particularly binding when inflation is high; or artificially low (sometimes even negative).Real returns discourage the holdings of bank deposits, holding down intermediation through the banks and savings in total. On the other hand, artificially low loan rates create an excess demand for loanable funds that may be rationed through favoritism to licensed imports, large scale exporters, protected manufactures and government agencies. Un favored enterprises are excluded from the long term finance of the formal banks and left to borrow at much higher rates from the informal financial sector of local money lenders, landlords, pawnbrokers etc. McKinnon makes this point clear by citing a truly alarming difference between official and unofficial lending rates in Ethiopa 6 to 9 percent versus 100 to 200 percent respectively. This is true for many other developing countries of Asia, Africa and Latin America. Extending the usury ceiling to the formal sector by the government does not remedy the problem, but worsens it by making credit still less available.
The remedy lies in eliminating financial repression so that bank intermediated funding becomes available to entrepreneur throughout the economy. With free entry into banking, the money lenders can transform their own operations in to formal of quasi formal banks.
In fact monetary and financial regulatory policies that stifle domestic intermediation, creating “financial Repression” are primarily responsible for poorly functioning domestic monetary system and capital markets, and thus for poor growth. Interest rate ceilings on deposits and loans, combined with inflationary rates of monetary expansion, are the most important policies creating financial repression.
In developing countries, there is considerable debate about the desirability of moving away from controlled economic order and toward a more liberal one. Financial Market liberalization refers to decontrol of interest rates, the removal of exchange controls, the exchange rate float, the abolition ratio requirements etc.
According to shaw Financial liberalization (reforms) brings the following benefits to an economy.
a. It tends to raise the rations of private domestic savings to income.
b. It permits the financial process of mobilizing and allocation of savings..
c. It opens the way to superior allocations of savings by widening and diversifying the financial markets where investment opportunities compete for the savings flow. Financial liberalization and financial deepening contribute to the stability and growth of output and employment.
Once an economy is sufficiently liberalized, the above benefits may be ensured, whereas in a financially repressed economy, prices are distorted due to interventionist policy of the government. It is argued that piecemeal reforms may not achieve the objectives for which reform measures are adopted. Where financial reforms have been successful, it involved complete or near complete removal of controls in favor of market generated solutions.