Financial System and Institution

Financial Systems and Institutions

Stud Name: Stud ID: 270184LC USN: 07118668223

Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

Introduction:

Financial intermediaries, financial innovation and financial regulatory are all important components in financial markets. Financial intermediaries take charge of transferring information between all the participants including all the news about financial innovation. But all the action are supervised by financial regulatory. This paper discusses these three parts and their roles in financial markets and their influence and their reaction to some financial activities.

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

PART 1.

\"The primary function of the financial system is to facilitate the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment.\" This function, in turn, encompasses a payments system with a medium of exchange; the transfer of resources from savers to investor -users of the resources (and the eventual repayment to the savers); the gathering o f savings for the purposes of pure time transformation (i.e., deferral/smoothing of consumption); and the reduction o f risk through insurance and diversification. The operation of a financial system involves real resource costs, such as labor, materials, and capital employed by financial intermediaries (e.g., banks, insurance companies, etc.) and by financial facilitators (e.g., stock brokers, market makers, financial advisors, etc.). Further, since multiple time periods are an inherent characteristic of finance, there are also uncertainties about future states of the world that generate risks. For risk -adverse individuals, these risks represent costs.

The possibility of new financial products/services/instruments that can better satisfy financial system participants’ demands is always present. Viewed in this context, a financial innovation represents something new that reduces costs, reduces risks, or provides an improved product/service/instrument that better satisfies participants’ demands.

Financial innovations can be grouped as new products (e.g., adjustable rate mortgages; exchange-traded index funds); new services (e.g., on-line securities trading; Internet banking); new \"production\" processes (e.g., electronic record -keeping for securities; credit scoring); or new organizational forms (e.g., a new type of electronic exchange for trading securities; Internet-only banks). Of course, if a new intermediate product or service is created and used by financial services firms, then it may become part of a new financial production process.

There are close analogies with familiar forms of innovation in non-financial contexts. There we see new products (e.g., DVD players; self-stick postage stamps); new

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

services (e.g., Internet based retail shop ping); new production processes (e.g., improved processes for manufacturing computer chips) and new organizational forms (e.g., the \"M-form\" decentralized corporate structure). And innovations in producer goods are often essential for innovations in production processes.

Much of the research attention to innovation focuses on the new idea. But at least as important is the adoption and spread of an innovation -- its diffusion -- across an industry. Indeed, faster diffusion means a higher societal return on the underlying investments in the innovation.

Because of these, decline in activities of financial institutions is must. The simplest explanation is saving enormous labor, money and time, in other words, financial innovation means make more money in the least cost of money and time. Financial innovation makes the financial regulatory unified. Before, we need to set different regulatory rules for different products in different markets. Now, after financial innovation, we only need to set few but unified regulatory rules for different markets in different countries, which is more convenient and efficient for the whole world. Financial innovation can make monetary integration, euro is the best production. Monetary integration can greatly reduce the transfer coat among different banks in different countries. The major impulses to successful innovations over the past twenty years have come; I am saddened to have to say, from regulation and taxes. The list of tax and regulatory induced products would include zero coupon bonds, Eurodollar Eurobonds, various equity-linked structures used to monetize asset holdings without triggering immediate capital gains taxes, and trust preferred structures. If we think of taxes as a major “imperfection” added to the M&M world, then the search to maximize after-tax returns has arguably stimulated much innovation, and changes in tax law in turn stimulate even more innovation. For example, various equity-linked structures used by firms to monetize their holdings of stock permit these firms to delay paying capital gains taxes. These innovations decouple economic ownership or exposure from legal ownership (governance and tax implications.)

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

The first key challenge facing the banks is avoiding risk. Globalization of finance means we need to afford not only the risk from ourselves but also the risk all over the world. To improve liquidity is the best way to avoid risk. As in this financial crisis, high liquidity can ensure the normal business of banks and guarantee the stability. In order to reach this goal, banks need to reduce the loan and increase the reserve. The Fed’s response to 9/11 in U.S. has proved it.

Not only the liquidity risk, bank need to improve the technology system to avoid the banks on Internet bank system which has become the main financial trading platform. The basic underlying \"physical\" technologies of finance are those of telecommunications and data processing, which permit the gathering of information, its transmission, and its analysis. Increasingly, these technologies allow financial market participants to measure and manage their risk exposures more efficiently and effectively. For example, with respect to lending, asymmetric information problems imply that lenders have difficulties determining who is a creditworthy borrower (adverse selection) and also have difficulties monitoring borrowers after a loan has been made (moral hazard). Accordingly, better (more advanced, faster, lower cost) physical technologies have permitted more innovations (e.g., credit and behavioral scoring) that allow lenders better to overcome those asymmetric information problems.

On the other hand, banks must provide more products to attract investors. Financial innovation lead finance to a new regime: foreign exchange, futures, forwards, and options. Banks need to seek the new sizes of this contracts and new markets, such as Asian countries. Banks need to expense their services to some new areas.

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

PART 2.

Financial Service Authority

The regulatory agency in UK is the Financial Service Authority (FSA). The Financial Services Authority (\"FSA\") is an independent non-governmental body, quasi-judicial body and a company limited by guarantee that regulates the financial services industry in the United Kingdom. When acting as the competent authority for listing of shares on a stock exchange, it is referred to as the UK Listing Authority (UKLA), and maintains the Official list.The FSA has the legal form of a company limited by guarantee.

The SIB changed its name to the FSA on 28 October 1997 and now exercises statutory powers given to it by the Financial Services and Markets Act 2000, which replaced the earlier legislation and came into force on 1 December 2001. In addition to regulating banks, insurance companies and financial advisers, the FSA has regulated mortgage business from 31 October 2004 and general insurance (excluding travel insurance) intermediaries from 14 January 2005. The main tasks of FSA are as follow:

(1). Maintain the confidence of financial industry. (2). Promoting public understanding of the financial system, understand the different types of investment and the benefits and risks of financial transactions. (3). To ensure that businesses have adequate operating capacity and sound financial structure in order to protect investors. At the same time, educate investors have a correct understanding of investment risk. (4). Supervision to prevent and combat financial crime.

FSA is responsible for the supervision of banking, insurance and investment services, including the securities and futures.

U.S. Securities and Exchange Commission

The mission of the U.S. Securities and Exchange Commission is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. The U.S.

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

Securities and Exchange Commission (commonly known as the SEC) is an independent agency of the United States government which holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation's stock and options exchanges, and other electronic securities markets. The main reason for the creation of the SEC was to regulate the stock market and prevent corporate abuses relating to the offering and sale of securities and corporate reporting. The SEC was given the power to license and regulate stock exchanges. Currently, the SEC is responsible for administering seven major laws that govern the securities industry. They are: the Securities Act of 1933, the Securities Exchange Act of 1934, the Trust Indenture Act of 1939, the Investment Company Act of 1940, the Investment Advisers Act of 1940, the Sarbanes-Oxley Act of 2002 and most recently, the Credit Rating Agency Reform Act of 2006.

The enforcement authority given by Congress allows the SEC to bring civil enforcement actions against individuals or companies found to have committed accounting fraud, provided false information, or engaged in insider trading or other violations of the securities law. The SEC also works with criminal law enforcement agencies to prosecute individuals and companies alike for offenses which include a criminal violation.

To achieve its mandate, the SEC enforces the statutory requirement that public companies submit quarterly and annual reports, as well as other periodic reports. In addition to annual financial reports, company executives must provide a narrative account, called the \"management discussion and analysis\" (MD&A) that outlines the previous year of operations and explains how the company fared in that time period. Management will usually also touch on the upcoming year, outlining future goals and approaches to new projects. In an attempt to level the playing field for all investors, the SEC maintains an online database called EDGAR (the Electronic Data Gathering, Analysis, and Retrieval system) online from which investors can access this and other information filed with the agency.

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

Quarterly and annual reports from public companies are crucial for investors to make sound decisions when investing in the capital markets. Unlike banking, investment in the capital markets is not guaranteed by the federal government. The potential for big gains needs to be weighed against equally likely losses. Mandatory disclosure of financial and other information about the issuer and the security itself gives private individuals as well as large institutions the same basic facts about the public companies they invest in, thereby increasing public scrutiny while reducing insider trading and fraud.

The SEC makes reports available to the public via the EDGAR system. SEC also offers publications on investment-related topics for public education. The same online system also takes tips and complaints from investors to help the SEC track down violators of the securities laws. Chinese CBRC

The China Banking Regulatory Commission (CBRC) is an agency of China authorized by the State Council to regulate the Chinese banking sector. The main functions of the CBRC:

(1).Formulate supervisory rules and regulations governing the banking institutions; Authorize the establishment, changes, termination and business scope of the banking institutions. (2).Conduct on-site examination and off-site surveillance of the banking institutions, and take enforcement actions against rule-breaking behaviors. (3).Conduct fit-and-proper tests on the senior managerial personnel of the banking institutions. (4).Compile and publish statistics and reports of the overall banking industry in accordance with relevant regulations. (5).Provide proposals on the resolution of problem deposit-taking institutions in consultation with relevant regulatory authorities. (6).Responsible for the administration of the supervisory boards of the major State-owned banking institutions; and Other functions delegated by the State Council.

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

Maintenance of liquidity.

When bank customers attempt, en masse, to convert their deposits into cash at a large number of banks more or less simultaneously, economists call it a banking crisis. During the national banking period, the most severe banking crises occurred roughly every 10 years. Once a banking crisis got going, several things typically happened. First, bank reserves were depleted rapidly. Banks refused to make payments in cash, partially or completely. Firms had difficulty making their payrolls, and long-distance trade was interrupted. Interest rates went through the roof, and currency premia were charged. So it is quite important for the financial intermediaries to maintain the liquidity.

The link between liquidity and economic performance arises because many high return investment projects require long-term commitments of capital, but risk adverse lenders (savers) are generally unwilling to delegate control over their savings to borrowers (investors) for long periods. Financial systems mobilise savings by agglomerating and pooling funds from disparate sources and creating small denomination instruments. These instruments provide opportunities for individuals to hold diversified portfolios. Without pooling individuals and households would have to buy and sell entire firms.

Diamond and Dybvig (1983) show how financial intermediaries can enhance risk sharing, which can be a precondition of liquidity, and can thus improve welfare. In their model, without an intermediary (such as a bank), all investors are locked into illiquid long-term investments that yield high payoffs only to those who consume at the end of the investment. Those who must consume early receive low payoffs because early consumption requires premature liquidation of long-term investments. When agents need to consume at different (random) times, an intermediary can improve risk sharing – by promising investors a higher payoff for early consumption and a lower payoff for late consumption relative to the non-intermediated case.

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

Financial markets can also transform illiquid assets (long-term capital investments in illiquid production processes) into liquid liabilities (financial instrument). With liquid financial markets savers/lenders can hold assets like equity or bonds, which can be quickly and easily converted into purchasing power, if they need to access their savings.

For lenders, the services performed by financial markets and intermediaries are substitutable around the desired risk, return and liquidity provided by particular investments. Financial intermediaries and markets make longer-term investments more attractive and facilitate investment in higher return, longer gestation investment and technologies. They provide different forms of finance to borrowers. Financial markets provide arms length debt or equity finance (to those firms able to access markets), often at a lower cost than finance from financial intermediaries.

Risk sharing

The second main service financial intermediaries and markets provide is the transformation of the risk characteristics of assets. Financial systems perform this function in at least two ways. First, they can enhance risk diversification and second, they resolve an information asymmetry problem that may otherwise prevent the exchange of goods and services, in this case the provision of capital. Financial systems facilitate risk-sharing by reducing information and transactions costs. If there are costs associated with the channeling of funds between borrowers and lenders, financial systems can reduce the costs of holding a diversified portfolio of assets. Intermediaries perform this role by taking advantage of economies of scale, markets do so by facilitating the broad offer and trade of assets comprising investors’ portfolios.

Financial systems can reduce information and transaction costs that arise from an information asymmetry between borrowers and lenders. In credit markets an information asymmetry arises because borrowers generally know more about their

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

investment projects than lenders. A borrower may have an entrepreneurial “gut feeling” that can not be communicated to lenders, or more simply, may have information about a looming financial risk to their firm that they may not wish to share with past or potential lenders. The problem with imperfect information is that information is a “public good”. If costly privately-produced information can subsequently be used at less cost by other agents, there will be inadequate motivation to invest in the publicly optimal quantity of information. Financial markets create their own incentives to acquire and process information for listed firms. The larger and more liquid financial markets become the more incentive market participants have to collect information about these firms. Financial intermediaries and financial markets resolve ex post information asymmetries and the resulting moral hazard problem by improving the ability of investors to directly evaluate the returns to projects by monitoring, by increasing the ability of investors to influence management decisions and by facilitating the takeover of poorly managed firms. When these issues are not well managed, investors will not be willing to delegate control of their savings to borrowers.

Economics of scale

A key objective for financial regulation and supervision is to increase the effective functioning of the financial system in order to enhance the ability to absorb shocks and maintain financial stability. As financial regulatory can control the financial intermediaries by one rules, they can control the economic well. We can think this in the goods market, the cost of produce 100 and 100000 radios is almost the same because of the same equipment and labor. The same in the financial, the more financial intermediaries take part in the process, the more return in the whole economic with low cost.

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

PART 3.

Strong expense management

Expense management is a mark for bank to show their management in business. Interest, salary and benefits, premises and fixed assets, other non-interest expense and taxation are all main expense in banks. How to management its own expense will tell investor how well they can allocate the investor’s money. The efficient bank is the get the greatest profit with the least cost, which shows that the bank services the investors well.

Clients relationship

Banks should establish, maintain, and enhance ongoing long-term multi-service partnership relationships with corporate clients. Private banking service is popular in modern society. Investors have the option right to choose their preferring bank, how to attract potential investors and maintain their existing investors are vital for banks. Not only banks should have good product, but they should keep their close relationship to their customer. Banks should always have more scientific and rational system of customer relationship management database. Technological systems and growth

Financial systems may affect technological innovation. By allowing diversification, financial systems allow savers to obtain their desired level of exposure to high risk/reward firms, potentially increasing the level of finance directed at such activities. Financial intermediaries are well suited to provide external finance to new firms that require staged finance because they can credibly commit to additional funding based on key benchmarks. Specialised intermediaries can improve the willingness of savers to provide finance to firms with innovative or novel business plans through monitoring and oversight activities. Financial markets are effective at financing industries where relatively little information or few data are available or where a diversity of opinion is persistent. This is because markets allow investors with similar views to form coalitions to finance a particular investment project. New investment

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

financed by financial intermediaries or markets is a channel for the diffusion of new technologies and productivity gains.

So technology improvement is quite important for banks. Talents

Talents are must anywhere, especially professional experts. Banks are always lack of expertise staff that can give investors more useful advice and gain more excellent results.

Capital allocation

Banks affect capital accumulation in three ways. First, financial systems lower the cost of channeling funds between borrowers and lenders, by reducing information and transaction costs. A decline in the cost of accessing finance frees up resources for other uses, including consumption, investment and capital accumulation.

Second, they can alter individuals’ and households’ saving decisions by making longer-term investments more attractive. If financial intermediaries and markets are unable to convince savers of the soundness of the investment projects that they are planning on funding, savers may choose to consume rather than save or place their savings in other less productive forms.

Third, bank affects capital accumulation by reallocating funds to their most productive uses, which raises the rate of return to saving. However, the effects of a change in the rate of return on saving are ambiguous. This is because higher rates of return increase the cost of consumption today or the cost of not saving, leading to more saving. But an increase in the rate of return to saving also means that individuals/households don’t need to save as much to achieve desired future levels of income. Empirically, the elasticity of saving with respect to rates of return is found to be small, suggesting that both effects are of approximately equal importance.

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

Input accumulation, or capital more broadly defined, can lead to a permanent increase in the long-run rate of economic growth if it has spill-over effects to other factors of production and/or productivity.

Viewed from another point, capital allocation can improvement the liquidity and the ability to afford risk. Managing global risk

Globalization has been a fashion word for the world, of course, risk is not an exception. With the rapid speed of financial innovation, the risk has change from domestic to global. How the managing global risk is a vital problem for the bank to afford crisis. In this financial crisis, many banks have been down. Establish strong system to afford risk is the way to live longer.

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

Conclusion:

In summary, financial intermediaries and financial markets can in many cases act as substitute sources of financial services. Lenders/savers in particular have a choice between the risk, return and liquidity offered by both segments of the financial system. Each segment is able to offer a different range of investments and offers services to firms that are not complete substitutes. Broadly speaking, financial markets provide lower cost arms length debt or equity finance to a smaller group of firms able to obtain such finance, while financial intermediaries offer finance with a higher cost reflecting the expense of uncovering information and ongoing monitoring. Financial intermediaries and markets may also provide complementary financial services to many firms. Financial innovation provides more invest forms to investors. There are also many influence caused by it. Financial regulatory enhance their responsibility and obligation to ensure the normal running of financial market and the right of investors. As the main form of financial intermediaries, banks should concentrate on managing key areas of operations and resources in order to guarantee investors’ profit.

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

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Financial Systems and Institutions Stud Name: Liang CHEN Stud ID: 270184LC USN: 07118668223

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