Financial Markets, Intermediaries, Liberalization, and Crisis
Key Financial Markets
Three primary financial markets exist:
- Bank Lending: An obvious source of money is the bank. In the international market, money is typically lent at a floating rate, which changes periodically according to market rates.
- Bonds: Often, a borrower issues a receipt for borrowed money, which is a promise to repay. Key information includes the amount owed, the repayment date, and the interest rate. The term “bond” usually implies a fixed interest rate. Bonds are generally considered medium and long-term instruments.
- Equity (Shares): If new shares are offered in exchange for cash, existing shareholders must typically be approached first.
Market Distinctions
A crucial difference exists between primary and secondary markets:
- Primary markets are where financial assets are initially issued.
- Secondary markets are where previously issued financial assets are traded and exchanged.
Markets can also be categorized by term:
- The money market involves the trading of short-term debt.
- The capital market encompasses trading in both stocks (equity) and bonds (medium to long-term debt).
Financial Intermediaries
Banks
Banks play a central role:
- Commercial Banks: Involved in retail banking (serving individuals and small businesses) and wholesale banking (serving larger corporations), contributing to money creation.
- Investment Banks: Assist entities in raising capital. There are three main options: bank lending, bond issuance, or equity issuance.
- Central Banks: Their activities primarily include setting and implementing monetary policy.
According to their legal status, banks can also be divided into standard banks and savings banks.
Non-Bank Financial Intermediaries
Other important intermediaries include:
- Pension Funds and Insurance Companies: A pension fund, for example, takes the savings of young workers. Since they don’t need to repay this money for a long time, they are significant long-term investors.
- Investment Funds and Asset Management Companies: These entities pool funds from various investors to invest in a diversified portfolio of assets.
Functions and Evolution of the Financial System
Core Functions
- Credit to the State: Financial markets provide essential financing to governments.
- Credit to Households: Access to credit is crucial for households, especially as workers’ real wages have faced pressure over recent decades, potentially losing purchasing power in an increasingly unequal society.
Financial System Liberalization
Post-WWII Context
After the Great Depression, the major advanced economies operated within the Bretton Woods system (established 1944), which aimed to end protectionism and stabilize currencies. In the US, the McFadden Act restricted banks from expanding across state borders.
Seeds of Change
London emerged as a major international financial center, partly independent of US regulations. It developed the Eurodollar market (US dollars held in banks outside the US) and the Eurobond market. These *offshore centres* and tax havens grew, operating largely outside the control of any single national government and attracting foreign banks to establish branches in London. This period is sometimes referred to as the foundation of ‘the second British empire’ in finance, challenging US dominance.
Theoretical Shifts and Policy Changes
Changes in economic theory influenced policy. Keynesian theory, advocating government intervention (like increased spending during unemployment) to stabilize the economy, influenced post-war policy. However, later shifts emphasized that monetary policy works through credit markets and the banking system.
Financial market liberalization accelerated significantly after 1971, driven by three common factors:
- Restrictions on the total amount of lending in the economy were largely removed.
- Financial institutions were granted more freedom, with banks increasingly allowed to combine retail, corporate, and investment banking activities.
- There was an increasing reliance on adjusting short-term interest rates as the primary, and sometimes only, necessary policy tool.
Regulatory Attempts
The new environment required new rules, leading to regulations like the 1988 Basel I accord. However, Basel I’s capital requirements are often seen as having failed because they regulated specific *banks*, not the overall *banking system* or activities. Banks found ways to move assets off their balance sheets while still retaining the underlying economic risk.
The 2008 Financial Crisis and Aftermath
Causes Linked to Liberalization
Financial liberalization is widely considered a major contributing factor to the global financial crisis of 2008. A key element was the rise of shadow banking – financial activities conducted by non-bank institutions outside traditional regulation. Repos (repurchase agreements), a form of short-term borrowing using securities as collateral, became central to shadow banking and the most widely used method for obtaining short-term liquidity. The crisis involved a tide of withdrawals, soaring interest rates, and failing financial institutions, including those in the shadow banking sector.
Rescue and Restructuring Efforts
The crisis prompted significant global responses:
- One major consequence was the decision to elevate the G20 (Group of Twenty major economies) to become the central informal meeting for global economic decision-making.
- The G20 established the global Financial Stability Board (FSB) to coordinate international financial regulation and supervision.
- Various national rescue packages and regulatory reforms were implemented.
Reflecting on the crisis, some analysts, like McMillan, have even questioned the necessity of traditional banks in the future financial landscape.