International Monetary and Financial Systems. Week 1

International Monetary and Financial Systems Week 1 What is the Financial System? The financial system is a set of markets and institutions which trade in those markets and the supervisory bodies responsible for their regulation. The end users of the system are people firms and governments whose desire is to lend and borrow. Howells and Bain (2007: 1) What role does the Financial System play? The financial system should facilitate the transfer of funds from those who have excess funds (i.e. ‘surplus units’) to those who need funds (i.e. ‘deficit units’). • Surplus units: individuals/households, companies and governments with surplus funds to save or invest. • Deficit units: individuals/households, companies and governments that need to borrow funds. How can funds be transferred from ‘surplus’ to ‘deficit’ units? The transfer of funds in the financial system can be carried out: • Indirectly through financial institutions such as banks • Directly through financial markets such as capital markets Bank vs Market based Financial Systems Countries differ in the extent to which their financial systems are bank-based or market-based. For e.g., The financial systems of the US and the UK are considered market-based, while those of Germany and Japan are considered bank-based. • A country’s financial structure has implications for firm financing, governance, strategy, and performance. Financial Markets The Money and Capital Markets • Money market: market dealing with short-term* debt securities, such as treasury bills, commercial paper and certificates of deposit. Market where companies and governments can meet their short-term borrowing needs. • Capital market: market dealing with long-term* debt securities and equity securities, such as bonds and shares. Market where companies and governments can meet their long-term borrowing needs * Debt versus equity instruments * Short-term debt instruments are those with maturities of up to 1 year. Long-term debt instruments are those with maturities of more than 1 year. Money Market Instruments • Treasury bills: short-term debt issued weekly by the Debt Management Office on behalf of the UK government. They do not pay interest; they are sold at a discount to their face value. • Commercial paper: short-term debt issued by companies of usually 270 days or less duration; it is sold at a discount to its face value. • Certificates of deposit: short-term or medium-term debt instrument issued by banks and savings institutions. They are issued in return for deposited money. The deposit is for a specified period of time. Unlike other money market instruments, CDs are not sold at a discount, but pay interest on the money deposited. • Interbank loans: they are short-term unsecured loans between banks. The interbank market is the segment of the money market where banks can lend and borrow money from each other. • Repurchase agreements (repos): short-term secured loans between financial institutions: a financial institution sells securities to another and agrees to purchase back those securities at a higher price by a certain date. The securities serve as collateral. Instead of (or in addition to) borrowing from each other in the interbank market, banks can borrow from the central bank through repos. Capital market instrument • Shares or stocks: represent partial ownership in the corporations that issued them. • Bonds: long-term debt securities issued by the Government and corporations to finance their operations. Financial Institutions Deposit Institutions Commercial Banks • The most dominant type of depository institution. • They accept deposits, which become their liabilities. They use these funds to make loans or investments, which become their assets. • Most of them are publicly listed. Savings Institutions such as credit unions and building societies – • Like commercial banks, they also accept deposits and make loans. • A main difference between commercial banks and savings institutions such as credit unions and building societies is that these are mutual organisations owned by, and run in the interest of, their members i.e., their customers. Non-Deposit Institutions • Investment banks: provide (equity/debt) capital raising and (merger and acquisition) advisory services to large companies and governments. They also provide brokerage, trading and asset management services to institutional investors. One of their sources of funds are commissions and fees. • Pension funds: set up by the government or a company to provide pensions for the fund contributors. They raise employer/employee contributions and purchase (long-term) government and corporate securities. • Insurance companies: provide insurance policies that reduce the financial burden associated with death, illness, and damage to property. Charge premiums and invest in financial markets. • Finance companies: obtain funds by issuing securities and make loans to consumers and businesses. • Unit trusts (UK) or mutual funds (US): raise funds from the public and invest them in a variety of financial assets in the money and capital markets. • Investment trusts (UK) or investment companies (US): publicly listed companies that specialise in the buying and selling of financial securities such as equities and bonds. Financial Globalisation: Benefits and Risks Financial globalisation has created new opportunities for companies to raise capital abroad, and for investors to diversify their portfolios internationally. Companies can get access to more capital at a lower cost, while investors can reduce their portfolio risk and increase their returns. At the same time, financial globalisation has increased the frequency and scope of financial crises. International Monetary System The international monetary system is “the framework that facilitates the exchange of goods, services, and capital among countries.” (IMF 2022). Two key dimensions of the system: • Choice of exchange rate regime(s): floating or fixed Reserve Currencies A reserve currency is a currency held by central banks in significant quantities. It is widely used to conduct international trade and financial transactions, eliminating the costs of settling transactions involving different currencies. (Congressional Research Service 2022: 1) As the world’s major economies have moved to floating exchange rate systems, exchange rates have become more volatile and less predictable than they were decades ago under the Bretton Woods System. While the US dollar remains the dominant international (reserve) currency, the monetary system is likely to evolve towards a multi-currency system centered around the US dollar, the Euro and the Renminbi.