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FMI Exam Essay Answer
FMI Exam Essay Answer
,
2004) (Levine, 2002) (Levine, 2002) (Levine & Zervous, 1998) (Stiglitz, 1985) (Bailey,
2005) (Bain, 2007)
Q.
Answer:
Developing economies are more related to the countries where the standard of living
are lower than so called developed countries. Industries are also very less in
developing countries compared to developed countries. Other factors like population,
education, technology and infrastructure of the nation also reveals how developed
the nation is and the economy.
Every developing nation is moving towards the growth and expansion so that it meet
its all requirements to become a developed and wealthy nation. Achieving such a
target is not a easy thing. Every economic aspect is related to the industries and the
workforce. A key question in development economics is the relation between a
countrys financial system and its economic development.
Developing countries need to apply certain approach to fulfill the investment needs.
To allocate the capital in a corporate sector various ways of approach can be
identified. Among them market based and institution based are the main approaches
developing countries are using at this context.
Outlining what are the market and the institution based approaches lets first take
some of the examples of both the approaches:
Stock Markets
Bond Markets
Markets which are not solely financial markets but which involve buying and selling
something for use as an asset for example commodity markets
Money Markets
Insurance Companies
Various kinds of regulators central banks, other regulators such as the SEC in the
US and FSA in the UK
The main conclusion that can be drawn from the answer is that the world of financial
institutions and markets is very varied and complex, so that we need to start by
simplifying our analysis down with some basic models and then introduce more and
more of the reality gradually.
There is also a view that various economic developments have led to an increased
importance for finance for example the move towards floating exchange rates after
1971 led to an increase in international capital flows and to the development of new
financial instruments to allow companies to hedge against exchange rate risk. The
problem is that the financial sector now absorbs an awful lot of highly skilled labour
which could be used for other purposes. Some observers like Adair Turner (former
chair of the Financial Services Authority in the UK) have argued that this is
undesirable and that many of the activities of the financial sector have little social
value compared with the cost of the resources (especially human resources) needed
to undertake them. It is hard to find a definite answer to the question about what the
optimal size of the financial sector should be but one key point to note is that over
the years the value of the financial sector to society has increasingly come to be
judged in terms of how well it allows society to manage risk.
A process of how businesses divide their financial resources and other sources of
capital to different processes, people and projects. Overall, it is management's goal
to optimize capital allocation so that it generates as much wealth as possible for its
shareholders.
For example, if a company ends up with a larger than expected windfall at the end of
the year, management needs to decide whether to use the extra funds to buy back
stock, issue a special dividend, purchase new equipment or increase the research
and development budget. In one way or another, each one of these actions will likely
benefit the shareholder, but the difficult part is in determining how much money
should be allocated to each action in order to yield the most benefit.
To finance the expansion of the industries and to facilitate the formation of new
establishment and improving the capital allocation across the industries one should
take a better approach to meet its requirements. Here in this essay we will discuss
about market based and bank based financial systems to approach and its positives
and negative aspects to the nation and the companies.
Financial institutions have a number of purposes. Important ones are the following
To move funds from providers of funds (who have surplus funds available) to users
of funds (who need more funds)
To allocate capital efficiently in line with the preferences of providers and users with
regard to risk and return
To allow providers and users to smooth consumption over time through borrowing
and lending
Financial markets have the same purposes but they also have an extra purpose
which is important
To value assets correctly and spread this information through the financial system
The main stakeholders are households as the chief providers of funds and non-
financial companies and the government as the chief users of funds. In addition,
those who work in financial institutions are potentially important stakeholders and
there is an important question about how returns from such institutions are to be
divided between them and the owners of the institution (shareholders).
Older theories of finance tended to emphasise the choice between using markets or
institutions as the basis for financial transactions in developing economies. More
recently, however, a number of writers have argued that this is a false choice
because financial institutions need markets in order to function effectively and
financial markets also depend upon institutions to work well.
Institutions provide a lot of the liquidity which enables markets to function smoothly
Many of the financial innovations (e.g. derivatives) that have led to new markets
originated in institutions
Developing economies tends to copy what the developed economy has done. one of
the main activities of financial markets and institutions is the buying and selling of
financial assets and we will spend quite a lot of time in this module looking at the
pricing of assets.
Over the last two decades the financial sector has taken on an increasingly large role
in the main industrialised economies. Rise in the importance of finances has been
attributed by some to globalisation (which has reduced the share of manufacturing in
the OECD countries as production has been shifted elsewhere), to technological
change which has lowered the value of manufacturing products and to deregulation
which has encouraged financial activity to spread and has led to financial innovation.
Second, liquid equity markets may facilitate takeovers that while profiting the raiders,
may actually be socially harmful [Shleifer and Summers 1988].
Third, more liquidity may reduce incentives to undertake careful and expensive
corporate governance. By reducing exit costs, stock market liquidity encourages
more diffuse ownership, such that each owner has fewer incentives to oversee
managers actively [Shleifer and Vishny 1986].
Fifth, existing managers often take action poison pills which deter takeovers and
thereby weaken the market as an effective disciplining device. There is some
evidence that, in the United States, the legal system hinders takeovers and grants
considerable power to management. Fifth, although shareholder should be able to
control management through boards of directors, an incestuous relationship may
blossom between boards of directors and management. Members of a board enjoy
their lucrative fees and owe those fees to nomination by management. Thus, boards
are more likely to approve golden parachutes to managers and poison pills that
reduce the attractiveness of takeover. This incestuous link may further reduce the
effectiveness of the market for corporate control [Allen and Gale 1999].
Imp frm here ,,,,,The financial services view notes that markets and banks may
provide complementary services or provide the same financial services. For
instance, stock markets may positively affect economic development even though
not much capital is raised through them. Specifically, stock markets may play a
prominent role in facilitating custom-made risk management services and boosting
liquidity. In addition, stock markets may complement banks. For instance, by spurring
competition for corporate control and by offering alternative means of financing
investment, securities markets may reduce the potentially harmful effects of
excessive bank power. 17 While the theoretical literature is making progress in
modeling the co-evolution of banks and markets [Boyd and Smith 1996; Allen and
Gale 1999], there is already some empirical evidence. For instance, (Levine & Sara,
1998)Levine and Zervos (Levine & Zervous, 1998) (1998) show that greater stock
market liquidity implies faster economic growth no matter what the level of banking
development. Similarly, greater banking development implies faster growth
regardless of the level of stock market liquidity. Moreover, even after controlling for
other country characteristics, such as initial income, schooling, political stability,
monetary, fiscal, trade, and exchange rate policies, the data still indicate that both
banking development and stock market development exert a positive influence on
growth. Using firm-level data, Demirguc-Kunt and Maksimovic (1996) show that
increases in stock market development actually tend to increase the use of bank
finance in developing countries. Thus, these two components of the financial system
may act as complements during the development process. We may not want to view
bank-based and market-based systems as representing a tradeoff. Policymakers
may instead want to focus on providing a legal and regulatory environment that
allows both banks and markets to flourish without tipping the playing field in favor of
either banks or markets.
The bankbased view holds that bank-based systems particularly at early stages of
economic development foster economic growth to a greater degree than market-
based financial system. In contrast, the market-based view emphasizes that markets
provide key financial services that stimulate innovation and long-run growth.
Alternatively, the financial services view stress the role of bank and markets in
research firms, exerting corporate control, creating risk management devices, and
mobilizing societys savings for the most productive endeavors. This view minimizes
the bank-based versus market-based debate and emphasizes the quality of financial
services produced by the entire financial system. Finally, the legal-based view rejects
the analytical validity of the financial structure debate. The legal-based view argues
that the legal system shapes the quality of financial services. Put differently, the
legal-based view stresses that the component of financial development explained by
the legal system critically influences longrun growth. Thus, we should focus on
creating a sound legal environment, rather than on debating the merits of bank-
based or market-based systems. The cross-country data strongly support the
financial services view of financial structure and growth, while also providing
evidence consistent with the legal-based view. The data provide no evidence for the
bank-based or market based view. Distinguishing countries by financial structure
does not help in explaining cross-country differences in long-run economic
performance. Distinguishing countries by their overall level of financial development,
however, does help in explaining cross-country difference in economic growth.
Countries with greater degrees of financial development as measured by
aggregate measures of bank development and market development are strongly
linked with economic growth. Moreover, the component of financial development
explained by the legal rights of outside investors and the efficiency of the legal
system is strongly and positively linked with long-run growth. The legal system
importantly influences financial sector development and this in turn influences long-
run growth. Although the measures of financial structure are not optimal, the results
do provide a clear picture with sensible policy implications. Improving the functioning
of markets and banks is critical for boosting long-run economic growth. Thus, policy
makers should focus on strengthening the legal rights of outside investors and the
overall efficiency of contract enforcement. There is not very strong evidence,
however, for using policy tools to tip the playing field in favor of banks or markets.
Instead, policy makers should resist the desire to construct a particular financial
structure. Rather, policy makers should focus on the fundamentals: property rights
and the enforcement of those rights
Banks perform various roles in the economy. First, they ameliorate the information
problems between investors and borrowers by monitoring the latter and ensuring a
proper use of the depositors funds. Second, they provide intertemporal smoothing of
risk that cannot be diversified at a given point in time as well as insurance to
depositors against unexpected consumption shocks. Because of the maturity
mismatch between their assets and liabilities, however, banks are subject to the
possibility of runs and systemic risk. Third, banks contribute to the growth of the
economy. Fourth, they perform an important role in corporate governance. The
relative importance of the different roles of banks varies substantially across
countries and times but, banks are always critical to the financial system. (Allen &
Carletti, 2008).
Bibliography
Allen, F. & Carletti, E., 2008. The Roles of Banks in Financial Systems:
(Wharton School Working Paper). [Online]
Available at: http://fic.wharton.upenn.edu/fic/papers/08/0819.pdf
[Accessed 01 12 2015].
Beck, T. & Levine, R., 2002. Industry growth and capital allocation: does
having a market- or bank-based system matter?. Journal of Financial
Economics, 64(2), pp. 147-180.
Durnev, A., Li, K., Morck, R. & Yeung, B., 2004. Capital Markets and Capital
Allocation. Implications for Economics of Transition, 12(4), pp. 593-634.
Levine, R. & Zervous, S., 1998. Stock markets, banks, and economic
growth. American Economic Review, Volume 88, pp. 537-538.
Stiglitz, J., 1985. Credit markets and the control of capital. J. Money, Credit
Banking 17, pp. 133-152.