Money and Capital Markets Development

¶ … U.S. financial market. To start with, we shall have an understanding of the various concepts for the study. A Financial Market can be defined as the market that is meant for either the raising of finances or money, as it is known, or the investment of assets. (Financial Market) An investment here means the production of capital goods that are not actually meant to be consumed but are meant to be saved up for use at some future date, and an asset refers to anything that is owned by either an individual or by a group of people who possess the asset together. A financial market is therefore the place in which finance is raised or investments of assets are made. Various risks are present in the market, and these are also dealt with in a financial market. A risk in financial terms means that potential harmful effect in the future that may arise due to an action taken at the present time. (Investment) A financial market is generally divided into several types. One of them is the 'Capital Market'. This is the market that is meant for long-term loans and the dealings with equity capitals. When a particular company or even the Government desires some capital for a long-term investment, it can be raised through he Capital Market. (Capital Market)

Some of the sub-sections of the Capital Market are the Stock Market, which deals with the trading of all publicly held stocks and shares and all the various investment opportunities associated with them, like for example, stock options and convertibles, etc. In the days gone by, stock trading was generally done on the floor of the stock market where individual stockbrokers were allowed to shout and scream the rates out loud. Today, most of the trading is done through the Internet via the Computer at the office or at home, and the trading is done in what is now known as the 'cyber market', where trading is done in real time by matching the orders that are being placed by the buyers and the sellers of the stocks and shares. (Stock Market)

Other divisions of the Capital Market are the Bond Market and the Primary Market. The Primary Market is the market that deals with the issue and also the placement of the securities of the financial market. The advantage in the primary market is that there is no need for any form of organized stock exchanges needed, unlike as in the secondary market. An investment banker would be able to contact a whole syndicate of securities dealers on behalf of a company that needs funds for any reason, and these stock dealers would be able to sell the new stock issue. As far as security dealers are concerned, this type of sale of securities is definitely better as far as their business dealings are concerned. This process by which stock issues are sold to prospective investors in the primary market is called 'underwriting' and the securities that are sold are referred to as 'initial public offerings', also known as IPOs. The commission that the dealers would earn is generally built into the price of the security itself, though this is not a well-known fact. (Primary Market)

The Government is generally responsible for overseeing the trading in securities in the organized capital market, while new issues that are being brought out have to have the stamp of approval from financial supervisors, who are responsible in turn for overseeing the financial market and upholding the rules and regulations that the financial market is supposed to follow in its operations. They will be ultimately held responsible for the stability of the entire financial market. (Financial Supervision) In some cases, Banks are also directly or indirectly responsible for overseeing the trading in the financial market, as they are the Institutions that provide banking and other financial services to an individual or a company or to the Government, by virtue of its possession of a banking license that has been provided to them by financial institutions that gives the bank the right to provide such banking services as the acceptance of deposits of money, the granting of loans, and so on. Sometimes it is possible for a bank to operate without a license, and these banks would be called 'non-banks', meaning that they can perform all the tasks that a bank would perform, and without a license. (Bank)

It is therefore evident that an organized and well planned Capital Market would be able to guarantee the fact that the investments that are being made are safe and sound and without risks. However, the presence of the 'Money Market' cannot be ignored, as money market is the term used for the market from which banks borrow or lend finances to each other, and deal with trading in such financial instruments as 'Certificates of Deposit' or the 'Repos and Reverses'. The trading that takes place is generally between the banks located in the most important 'money centers' that include, primarily, New York, London, Chicago, Frankfurt, Singapore, Sydney and Hong Kong among others. (Money Market)

There is, in addition to the Capital Market and the Money Market, the Futures Market, which makes dealings in commodities contracts, also referred to as 'Futures Contracts'. A Future Contract is nothing but a contract that deals with the intricacies of the agreement between two parties to either buy or sell an asset of any nature, at a fixed future date. The price is generally decided in advance, and the buyer and the seller both agree on the fixed price, which is also known as the 'Forward Price' of the future contract, which in turn is also referred to as the 'Forward Contract'. (Forward Contract)

The Derivatives Market that is another sub-sect of the Capital Market deals with a 'derivative' that is, in other words, a contract between two agencies that either deliver or receive the cash flows that are an important part of the 'derivative security contract'. The contract is based on some event that would take place in the future. A derivative can also be explained as a security that defines the value that has been derived from some security or a particular commodity or an event. A derivative market can exist for the purpose of buying and selling stock options, or for the purpose of issuing 'naked warrants' that are actually warrants that have been issued without an accompanying bond, and also for the purpose of 'interest rate swaps' that are exchanges determined by the interest rates of opposite parties, and for the progress of the 'credit default swaps'. (Derivatives Market)

The Insurance Market is also an important component of the Capital Market in general. Insurance is the way in which any risks that are undertaken by a company or an individual are protected in financial terms. This form of protection can extend for life, property, health, and so on and so forth. An insured or the person who wishes to insure will make monthly or annual payment of money called 'premiums' to the insurer, and when there is indeed a loss of any sort, the insured will be able to claim the sum of money that he has paid. A legal contract binds the insurance technicalities so that there may be a way of settling any dispute in an amicable manner. (Insurance) A completely efficient and excellently performing financial market would consist of all the above elements. It is only when all the elements are present that a financial market would function at its optimum best, thereby improving the financial situation of the country to which it belongs.

What are the need and the purpose of the existence of an efficient Financial Market? If it happened that the Financial Market was not efficient, then what would be the result? According to the Chairman of the Federal Reserve Board Alan Greenspan, in a speech made in the year 1999 at a Financial Market conference in the State of Georgia, the question of whether an efficient financial market would be able to mitigate an upcoming financial crisis in one that needs great debate before it can be answered. The first step, he felt, would be to examine the financial market of 1998, when public capital markets in the U.S.A. happened to just seize up completely after the crisis engendered by the Russian default that had taken place in the same year. It was difficult even for investment grade issuers of bonds to conduct their business at this time. The Federal Reserve happened to ease soon after this incident, and the result was that the financial markets could be restored completely in just a few weeks' time. However, this was not the only reason for the restoration; the main reason was that there are in existence quite a few back-up financial institutions, and these institutions were able to fill the gaps that had been left by the fall. Public debt issuance began to fall, and this resulted in the increase of commercial bank lending operations. (The Federal Reserve Board: Remarks by Chairman Alan Greenspan)

Bankers who had avoided risks had the backup of certain lines of credit that had been made in conjunction with the Federal Reserve Bank, and these served as the backstops to the financing business. All this served to reduce the impact on the real economy of the capital market, because business could go on as usual; firms could still sustain production, and consumers and businesses did not lose the confidence in these institutions. The normal occurrence of a vicious cycle in which a major disruption would lead to major losses, and this in turn would lead to a major erosion of the financial sector did not happen at this time, and this was indeed fortunate for the financial sector and for the numerous businesses depending on the efficiency of the financial market. This incident of 1998 revealed an important principle: the numerous alternatives that exist to transform an economy's entire savings into capital investments definitely act as backups should the system fail due to any reason whatsoever. In the United States of America, the back up system was the fact that banking had managed to replace the capital markets of the country. However, it has not always been the case with the U.S.A., as this was a very recent development. (The Federal Reserve Board: Remarks by Chairman Alan Greenspan)

As seen in the remarks given by Mr. Timothy F. Geithner, the President and the CEO of the Federal bank of New York, in the year 2004, the financial system of New York is at present undergoing a transition and a change. It is now that the U.S. financial system has gained considerable strength, and financial institutions are engaged in advanced risk management behavior. However, it was not always like this, and an analysis at this point as to why the strength has increased today as compared to yesterday has to be conducted so that there need not be severe fluctuations in the market in the future. Therefore, the developments that have contributed to the success of the present stability have to be studied. It was over the past twenty years that a wide range of systemic events has in fact been affecting the stability of the U.S. Financial system. Some of the events were related to credit booms and some were related to credit concentrations, and these were the events that led to a large amount of losses to the banking sector. Losses also occurred in commercial real estate, and in the field of agriculture and energy. (Perspectives on the U.S. Financial System)

The results of these 'shocks' were very much evident in the sudden and sharp fall in the interest and exchange rates, as well as in asset prices. Macroeconomic performances were seen to be the cause of such falls, in some cases. Sometimes, the shocks were seen to be happening even during times when there was very strong economic growth, and sometimes when there were some changes in expectations of inflation or of monetary and economic policies, where the shocks would generate changes in the interest rates and also in the shape of the 'yield curve'. After the shock events, there would be a level of change in the financial conditions wherein there would be a fast rate of the growth of credit rates and a rise in asset prices. The positive changes were due to the fact that there was always present a self-reinforcing element within the events taking place, and the initial changes that would take place in both interest and the asset rates would be reinforced by the actions of the participants in the financial market events who would react to the losses in a particular manner.

The event of financial leverage would also be amplified in the face of these events or shocks. Sometimes it would be found that there was a co-relationship between the movement of asset prices and that of the credit losses for borrowers. These events led to a need for changes in the supervision of the financial market, in the practices of the risk management procedures, and in the capability of the Central Bank in containing systemic risks. Even though it is a fact that these recent events have led to the development of a certain degree of immunity to such risks in the future, and also that the overall vulnerability of the entire system to shocks of this kind has been evaluated and contained and therefore the risks have been essentially lowered, it is still true that there can be no single financial institution that can be considered invulnerable to risks and to shocks. It is a definite fact that the financial system of the U.S.A. must prepare for the future with humility and with a great degree of caution. (Perspectives on the U.S. Financial System)

Stresses and shocks must therefore be prepared for in advance so that the financial system finds itself in a good working condition at all times, especially in times of stresses and strains. Is the Financial System of the United States of America's strong and as resilient as it must be, or does the system have to be modified? The truth is that the financial system of the U.S.A. Of today is stronger than that of the previous ten to twenty years. For one, the financial institutions that are present at the very core of the entire system are both well organized as well as profitable. In addition, they are very well capitalized. The sum of the total risk-based capital ratio for the ten of USA's biggest bank holding companies shows a definite increase of 12% over the past two years, from the sum of the same for about ten years before. Almost all the banks in America were declared to be 'well capitalized' in the year 2003, and it was a mere 1% of banks - i. e. less than a hundred of the country that could not meet the regulatory standard. While it is true that in general, risk-based ratios of capital are not indicative of the capital strength of a financial system of a particular country, it still demonstrates the very strong position of the capital of the country. (Perspectives on the U.S. Financial System)

Robust capitalization and strong earnings is a must for any country if there were to be a line of defense against losses; when the capital of a country is strong, then these losses can be countered with ease. If there were indeed loss of any kind, or a negative incident of some sort, then capitalization would help restore the loss of confidence in the customers and the counter parties who would at first attempt to pull out of the institution. Therefore, it is evident that capital is capable of insuring the financial institutions against the system of 'runs', both traditional and on franchise value. The traditional run is one in which the issues at stake are those of short-term funding, and short-term liquidity, whereas for the franchise run the issues that are brought into play are those of the gradual withdrawal of customers from the financial institution on account of the loss of confidence suffered as a result of the losses that the institution has been through.

The customer in fact turns to some other institution to avail of the financial services that he feels that this institution is incapable of handling. Therefore it is evident that when consolidation takes place, the financial institutions attain more diversity as well as an increase in their sizes. The system of 'deregulation' has also helped financial institutions to broaden their scope wherein the scale and the scope and the geographic spread of all operations become better and more optimized. The result of such deregulations is in the emergence of large and diverse financial institutions that have a very high earning capacity. For example, in the year 2003, the total earning for about 18 bank holding companies and about six securities in the U.S.A. had earned more than $1 Billion, while the total earnings for five bank holding companies went up to more than the astonishing figure of $46 Billion, which made up about 40% of the total of the banking industry earnings. These figures show that in the case of any loss, they would be able to provide the various financial institutions with adequate cushioning, so that the fall would not be so painful, and re entry would be easier. In addition to the high figures providing a security blanket, it is the advancement made in risk management that would hold up the financial institutions against losses. With the current training in risk modeling and in data collection that all financial institutions are going through, it becomes easier for these institutions to manage risks. (Perspectives on the U.S. Financial System)

Now the pricing can also be based after considering the various risks that may be involved. Now financial institutions are given the option of viewing all risks from the point-of-view of the portfolio and not in isolation, and this leads to a better risk management and risk sharing and the spreading of capital. Credit risks are being taken care of too, today. The factors of securitization and of credit derivatives have resulted in the ability to spread credit risks across various different sectors of the financial system, and this in turn has led to risk transfers in the bank, and in the net transfer of risks from a commercial bank to another financial institution. Therefore, credit risks are being diversified, and the transfer of credit risks from one institution to the other would reduce the risk in a significant manner, as well as diversify the risk that has been transferred so that nay risks that may arise out of a business system to a financial system would become less leveraged than those of banks and other security institutions. (Perspectives on the U.S. Financial System)

The advancement in the techniques of risk management has inevitable resulted in the growth and the emergence of derivatives markets and these in turn has resulted in the lowering of the costs of hedging market price sensitive actions. The growth of 'long dated swaps' is one of the results of this type of hedging that companies have been following of late. This is a method in which mortgage securities and loans can be hedged, and the ease with which the company is able to adjust to such hedging shows its adaptability to risk. There have been major improvements in market practice on account of the growth of derivative markets. Now counter-party credit exposures could be easily and with sophistication. The original 'rule of thumb' assessment is now a totally forgotten concept, and this has been replaced by the more sophisticated method of assessing counter party exposures on a portfolio, using different and more practical as well as sophisticated methods in which to assess mark to market exposure, and the future exposure that would arise from any changes that might take place in the rates of the contract and its underlying prices.

These tools make sure that the potential reduction of the future exposure on account of netting agreements and also collateral agreements are appropriately assessed. Dealers and others are also developing the stress testing of exposures in a manner that would greatly increase the assessment levels. Therefore, it is obvious that there have been created methods to assess counter party exposures and for the better management of risks related to these exposures. The use of 'collaterals' has also seen a vast improvement when compared to the past when this was a relatively unused concept. Added to this is the development of new clearing arrangements and these have served to strengthen the crucial payment as well the settlement systems that are the virtual backbone of the financial system of the U.S.A. These changes only demonstrate that great leaps have been taken in the improvement of the financial system of the U.S.A. over the past few decades. (Perspectives on the U.S. Financial System)

However, the financial crash that occurred in the year 2000 in the United States of America seems to be the final culmination of the economic and the social as well as the cultural process that had been going on for the past thirty years. A falling and failing market is actually indicative of a deeper and more sinister process that the entire financial economy of the country is balancing on. It reveals the falling of the entire physical economy of the country, and also of the world. Artificial means such as accounting tricks, heavy and unpayable debts and a mass delusion about the markets by the public have just propped up the market, but how long will this sort of false prop up last? Today, these delusions are breaking apart and people and businesses of today are coming to realize that this is definitely not real. In the year 2002, two years after the dramatic crash of the year 2000, the major stock markets showed the figure of a 50% less from the peak that it had reached in 2000, almost reaching the level that had been reached in the years of 1997 to 1998. (Two Years into the Worst Financial Crash in History)

To quote a simile pertaining to the market figures, the market had reached a peak and had reached the other side of the mountain, from which it was falling, fast, and gathering speed with each moment, not knowing the rate of fall and where it was about to reach, and as long as the Federal Bank maintained that the economy was safe as well as stable, there could be no hope for the prevention of the downward fall. Therefore, economic measures needed to be taken immediately in order to slow down or to stop the fall. One example of the rate at which a fall can occur is the fall in the Dow from a high 381 in the year 1929, to a low 40 in the year 1932, which was actually a fall of 90% in a time period spanning two years. It was not until the year 1933 that the Dow was able to show 100 points, and it could not rise above 300 points until the year 1954. (Two Years into the Worst Financial Crash in History0