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Management of Financial Institutions - BNK604

BNK604 - Management of Financial Institutions - Lecture No 1

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Financial Environment & Role of Financial Institutions

The economic transformation under way in the former centrally planned economies (FCPEs) was motivated in part by the recognition that central planning has failed to allocate financial and real resources efficiently. This paper addresses the question of what kind of financial system should replace central planning in allocating capital and maintaining effective corporate governance during the transformation period. Financial sector reform has, at times, been portrayed as a question of adopting either a bank-based or a (securities) market-based model. In the bank-based model, commercial banks, often licensed as universal banks, take the lead in financing enterprise restructuring and investment. Proponents of the market-based model argue that the structural problems in the banking sector cannot be overcome easily; so firms will have to look to equity and bond markets for sources of new capital. Equity and bond markets in the FCPEs are not sufficiently well developed to support significant issues of new securities or to provide a mechanism for corporate control. They lack adequate liquidity, regulatory oversight, information disclosure, and clearing and payment systems. The important role of banks in maintaining the payment system and in providing credit to market participants to support trading and settlement means that until banks are restructured and recapitalized, securities market development will be constrained.

Investment funds emerging from mass privatization schemes may create concentrations of equity ownership that would allow them to play an important role in corporate control and perhaps, too, in finding sources of investment capital. They are a relatively recent innovation, however, and it remains to be seen how active they will be in financing and managing privatized enterprises.

The authorities should first establish a healthy banking sector, because it is the banks that are the most promising source of working capital and corporate control. This does not mean that securities market development should be ignored, only that it should not be a priority use of scarce government resources at the present time.

Many observers recommend that banks be given the power to act as universal banks, combining lending with securities market operations and equity investment. The potential problems associated with such a model in the FCPEs during the transformation period outweigh any potential benefits. It is recommended, therefore, that commercial banking and investment banking activities be separated, at least until banks have demonstrated competence in their commercial lending operations.

Long Run Performance of Financial Institutions for Economic Growth

The recent economic difficulties in Southeast Asian economies are often linked to the financial sector in these countries. The business and popular press around the world are replete with stories connecting the economic crisis with difficulties in the financial sectors in these economies. The connection between the troubled banking sector and the economic slowdown is especially stressed. Asian economies that have been less impacted by the economic crisis, for example Taiwan, are often characterized as having more stable financial institutions then their neighbors. Yet this is not the first time “financial difficulties” have been linked with poor macroeconomic performance. Many today believe the Great Depression of the 1930s was made much more sever by problems in the banking sector specifically and financial markets inefficiencies in general. More recently the dramatic economic slowdown in the 1980s in the state of Texas in the United States are often linked to the banking and savings and loan crisis that gripped the state at the same time. This raises the question, what is the link between financial institutions and the macroeconomic performance of an economy? Economists hold dramatically different views regarding this question. From a much earlier time, Bagehot (1873), and Schumpeter (1911) argued that an efficient financial system greatly helped a nation’s economy to grow. As Ross Levine has pointed out it was Schumpeter’s contention that well-functioning banks spurred technological innovation by offering funding to entrepreneurs that have the best chances of successfully implementing innovative products and production processes.

More recent economists have more skeptical about the role of the financial sector in economic growth. Joan Robinson (1952) asserted that economic growth creates (emphasis added) demand for financial instruments and that where enterprise leads finance follows. Robert Lucas (1988) has also dismissed the finance-economic growth relationship stating that economists “badly over-stress” the role financial factors play in economic growth. However in recent years thanks to the work of Ross Levine (1997, 1998), Robert King (King and Levine 1993a, 1993b, 1993c) and others (Pagano 1993), economists are again reexamining the role financial markets play in economic growth. On the theoretical side complex models have been developed to illustrate the many channels through which the development of financial markets affect and are affected by economic growth. These>channels include the facilitation of trading hedging, diversifying, and pooling of risk;the efficient allocation of resources; the monitoring of managers and exerting corporate control; the mobilization of savings; and the facilitation of the exchange of goods and services. On the empirical side a growing body of studies at the firm-level, industry-level, countrylevel and cross-country comparisons have demonstrated the strong link between the financial sector and economic growth. King and Levine’s (1993a, 1993b, and 1993c) research has shown that level of financial depth (defined as the ratio of liquid assets to GDP) does in fact help to predict economic growth. Other work by Levine (1997, 1998) has shown that financial intermediary development does positively influence economic growth, these results are shown to be robust, that is the relationships still hold when other factors that are know to influence economic growth are held constant. In many ways the current research has opened as many new questions as it has attempted to answer. On the theoretical side, questions still exist on how and why do financial markets and institutions evolve? Why are financial markets at different levels of development in different markets?

This research has also raised a number of very interesting public policy questions. Such as: under what legal environment do financial institutions development more rapidly? Financial regulation -- how are countries’ financial systems regulated and supervised, how can these be quantified, and to what extent do the differences matter. What is role of regulation in encouraging financial market development? What impacts both positive and negative will the recent bailout of financial institutions and financial markets have on the long run development of financial markets?

I would like to turn our attention to one of these issues that I find most intriguing: why do financial markets develop at different rates in different economies? That is, why do financial institutions tend to cluster in high-income areas or economies and low-income areas seem to suffer from a lack of financial institutions? A related question is; do financial markets drive economic growth or does economic growth drive the creation of financial market and institutions?


In economics a financial market is a mechanism that allows people to easily buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient market hypothesis. Financial markets have evolved significantly over several hundred years and are undergoing constant innovation to improve liquidity. Both general markets, where many commodities are traded and specialized markets (where only one commodity is traded) exist. Markets work by placing many interested sellers in one "place", thus making them easier to find for prospective buyers. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy in contrast either to a command economy or to a non-market economy that is based, such as a gift economy.


In Finance, Financial markets facilitate:


  • The raising of capital (in the capital markets);
  • The transfer of risk (in the derivatives markets); and
  • International trade (in the currency markets)


They are used to match those who want capital to those who have it.Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends.