Role of Banks & Capital Markets in Resource Allocation Essay Example

be utilized for, and ensure growth for the society at large? In providing answers to these questions, Coval and Thakor (2005) divided the economy into three types of agents:

1. the optimistic agents constituting the deficit units
2. the pessimistic agents being the surplus units; and
3. the rational agents where we find the banks and capital markets.

Whereas the optimists have determined the projects they want to execute but do not have sufficient financial resources to expend, they need to approach either the pessimist or the rational agents for additional funding. In the words of Coval and Thakor (ibid), ‘the success probability of projects is correctly estimated by a rational agent, overestimated by an optimist, and underestimated by a pessimist’.In other words, the rational agents standing between the optimists and the pessimists, take on the role of analytical review of investment opportunities requiring funding in order to ensure optimal usage of scarce resources. To give confidence to the pessimists who may be wary of the safety of their hard-earned finance, the rational agents take on the responsibility of screening who among the optimists qualify to be entrusted with the finance supplied by the pessimists.

These responsibilities entail substantial cost outlay which the rational can moderate through economy of scale. Allowing each borrower to search for surplus units ready to part with their finance for a period of time, or the surplus units engaged in searching for credible borrowers will entail duplication of efforts at substantial cost. This will constitute a waste to the economy at large, not withstanding the role of technology in making information readily available. As noted by Coval and Thakor (2005) a financial intermediary arises to

provide screening service so commonly ascribed to it, even though it possesses no special advantage in doing so since advances in technology have led to not only much more public availability of financial information, but also greater availability of tools with which to analyze it. In short information gathering and processing, and post contract monitoring capability are no longer the exclusive domain of intermediaries!Following the search for counterparty is the exercise of background check of information supplied to the surplus unit in order to ensure that the data supplied can be relied upon. The exercise does not end with the surplus unit (the pessimist) searching and verifying the deficit unit (the optimist).

After the supply of funds, there comes the need to engage in continuous monitoring of the activities of borrowers to ensure compliance with contractual arrangement earlier concluded. If it turns out that there has been a breach of trust by the deficit unit, the surplus unit can pursue legal means to enforce compliance.But the rational agents constituting the financial intermediaries can evaluate firms and managers for a large group of investors, and by reducing duplication and free-riding, they improve the ex ante assessment of investment opportunities and the ex post exertion of corporate control once those investment have been funded [Ross Levine, 2000]. In other words, financial intermediaries ‘is an effective solution to adverse selection and moral hazard problems that exit between lenders and borrowers, because banks in particular have developed appropriate expertise to distinguish between good and bad borrowers’. Duisenberg, 2001].All said and done, containing this transaction costs is predicated on the claim that the cost to financial intermediary in undertaking the responsibility

must be lower than it would have been if borrowers and savers were to bear the costs [Cefims notes].

The fact that financial intermediaries instead of declining in importance, continue to occupy and play a pivotal role in advanced economies gives credence to their ability in having superior cost advantage.•Managing Risk The question to ponder is: ’can an individual surplus unit manage the risk of lending to a deficit unit better than a financial intermediary? ’ Here comes the issue of the law of large numbers where a financial intermediary raises funds from large number of disparate savers and makes the fund available to borrowers wanting substantial capital for investment in long-run capital commitment. This process of liquidity transformation is hinged on the fact that not all savers would request to have their money back at the same time, and thus gives room to intermediaries to invest in a varied portfolio of assets. Applying Coval et al (2005) dichotomy of pessimist and optimist earlier mentioned, we discover that the ability of intermediaries to assemble large number of pessimist funds makes it better placed to satisfy the need of any saver that may suddenly be faced with the challenge of ‘consumption shock’. Notwithstanding being able to solve the perennial challenge of savers' consumption shocks, banks are still able to meet the needs of the optimist cravings for investible funds. In effect, they are able to help risk-averse savers manage the uncertainties about the uncertainty associated with taking the risk of investing in the borrowers’ enterprise.

At the same time high-value adding projects are not stifled of necessary funding just because of immature liquidation from individual surplus unit. Banks

alleviate economic shocks on both sides with the diversification of their assets holding, which invariable implies taking on the risk of converting short-term deposits into large long-term loans. In today’s management of the financial system, the associated risks are moderated through the usage of varied derivative instruments such as options, swaps, and futures contracts. Capital market role Similar to the responsibilities assumed by banks, in such advance economies as Britain and the United States capital markets (represented by the stock market) plays a similar resource allocation role through the provision of a viable platform for stimulating the acquisition and dissemination of information on enterprises performances which helps in determining how resources should be apportioned amongst users, that is exerting ex post-corporate control (Ross Levine, ibid).A fully developed capital market engenders resources mobilization through the collection of savings of disparate surplus units and overcoming the transaction costs associated with such exercise.

With that substantial availability of liquidity, the market makes long-term investment attractive because they allow savers to sell equities quickly if they need to access their savings at any time to satisfy unexpected consumption shock. Enforcement of discipline in the usage of societal scarce resource by the deficit units is achieved through varied regulatory frameworks such as accounting standards for reporting and disclosure requirements, security and exchange commission requirements prior to listing on the exchange; and many other rules governing market activities, all helping to give comfort to the surplus unit making their funds available for use by the deficit unit. Recent Financial CrisisThe intermediary-based mechanism constitutes the channeling of funds from the surplus units to the deficit units through the banks, mutual funds, and pension

funds; while on the other hand, that is the market-based mechanism, the deficit units raise funds through the stock market and the bond market. Economists have never agreed on which mechanism is best suited for economic growth. But the main issue is that either mechanism provides the financial service necessary to ensure the mobilization of financial resources from savers to borrowers who need the funding for investment purposes.

Added to the debate is the issue of having the right legal environment in determining the provision of growth-promoting financial services. Notwithstanding the sub-prime debacle of 2007 which I will partly ascribe to the brake down of discipline in the enforcement of laid down norms protecting against adverse selection and moral hazard, and the weak dollar which helped in pushing oil prices up and created inflation spiral (which cannot be said emanated from improper resource allocation mechanism), banks intermediation role will continue to be the bedrock for economic growth. So also is the financial services provided by the capital markets. Crises in the global credit market can be regarded as part of normal cyclical phenomenon of economic performance of any country. Japan where the bank-based financial system is pronounced went through a banking crisis in the 70s and 80s, recovered and still remained a highly developed economy.

Germany too, a bank-based financial system has had her own bout of crisis without watering down the role of banks in performing that essential role of providing the mechanism for resource apportionment to high yielding entrepreneurial activities. The United State also suffered a stock market crisis in the 1970s. Would a multitude of individual surplus units achieve a superior resource allocation mechanism

better than the intermediation mechanism provided by banks? The fact that banks can aggregate the individual resource of disparate savers and make large loans lends credence to their position as better placed to perform that essential role in any society.Allen and Gale (2001) noted that the distinction between bank-based and market based system is less clear-cut since both constitute the financial system operating in most developed economies. For instance, not all enterprises qualify to raise funds in the capital market, yet by the standard of what economic activity they intend to pursue, they ought not to be denied the opportunity of raising the additional capital to augment their own internally generated funds.

Banks stand ready to provide many customers with funds even in adverse circumstances, e. g. when the liquidity of financial markets dries up’ (Duisenberg, ibid). ’ One recognizes the fact that recent credit crisis could precipitate bank runs which could lead to instability in the financial system because of funds withdrawal by all depositors, including those that would ordinarily prefer their monies to remain in the bank vaults since they do not have an immediate need for them. But there are institutional remedies available to counter or moderate the impact of bank runs. If that were not available, the 2007 credit crisis would have amounted to the total collapse of the western economies as they are known today! Furthermore, in responding to the issue of whether banks has superior economic advantage on cost in information assemblage and processing over individuals because of the role of information technology in modern societies, one need to look at what subsist in developing economies vis-a-vis more-developed countries.

The analysis

should also encompass comparison of the level of sophistication of the banking and capital markets institutions. It has been indentified that the percentage of banks contribution to GDP is much higher in more-advanced economies, and their performance continues to thrive in spite of information-processing and monitoring facilities driven by technological advancement. And apart from lack of information on how and where to raise funds, a significant impediment to reviving emerging market economies is insufficient bank lending (Coval and Thakor, ibid). Therefore in agreeing with the strengthening of the role of banks in the advanced financial system, notwithstanding the crisis, one needs to look at the disadvantaged position of the economic performance of third world countries where such institution have not made an appreciable impact because of the rudimentary stage of their sophistication, less availability of required technology for overcoming information asymmetries!I agree with John Dungan, the US Comptroller of Currency, that what is required to stem the credit crisis is that banks need to strengthen their underwriting standards so that they move back towards the fundamental principle of maintaining a reasonable expectation that loans will be repaid, even if the loans are to be sold to third parties – and that goes for mortgages loans, leveraged loans, or any other syndicated credit.

The thrust of this position is that banks avoided or dodged intense scrutiny of the regulatory requirement through the usage of special purpose entities for securitization. They use special purpose entities are dummy securitization trusts set up to allow banks to take assets off their balance sheet and thus avoid falling foul of loan to asset ratio rule. Tougher accounting standards on securitization disclosures

and tougher laws will help check speculation and abusive lending practice.