Financial system: Difference between revisions

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The '''financial system''' conveys resources from lenders to borrowers,  and transfers  risks from those who wish to avoid them to those who are willing to take them. It is a ''complex interactive system'', events in one component of which can have significant repercussions elsewhere. There are also complex interactions between financial transactions and other forms of economic activity, as consequence of which a malfunction of the financial system can cause a malfunction of the economy, and vice-versa. The system has evolved by adaptation and innovation, and the conduct of its participants has been modified from time to time by regulations designed to preserve its stability. Further modifications are under consideration in light of the [[crash of 2008]].
''(The termninology used in  this article is largely based upon The American Banker Bankers Glossary [http://www.americanbanker.com/glossary.html?alpha=D#content-area]. Terms shown in italics are defined in the glossary on the [[/Related Articles|related articles subpage]])''
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==Overview==
The principal participants in the system are financial intermediaries whose functions are  to transfer resources from those who own them but  do not wish to use them to those who wish to use them but do not own them; and to transfer risk from those who wish to limit their exposure to it to those willing to accept it. It performs those functions by trading in  financial  instruments that represent promises to perform services  in return for payment. The promises that they represent  include promises to make fixed payments (represented by bonds); promises to pay dividends (represented by shares); promises to provide retirement income (represented by pension agreements); promises to bear some of the costs of accidents or financial losses (represented by insurance policies), promises to provide a cash flow, such as mortgage repayments (represented by securitised assets)  - and  promises, such as options, concerning transactions in other promises (represented by "derivatives"). The system includes specialised markets, regulated by custom, rules and legislation, that provide for  trading in financial instruments and in the currencies in which they are denominated; and it is supported by information-providing services from analysts, advisors and rating agencies.
''(for the historical sequence of events in the evolution of the system, see the [[/Timelines|timelines subpage]])''
==Components==
===Instruments===
====Bonds ====
Term "bond" is used in this article to mean an instrument that is issued by a company or by local or central government, that represents a loan that is repayable after an interval of not less than a year. Unlike most other loan instruments, a bond can be bought or sold without reference to its issuer. Bonds issued by the government are termed "Treasury bonds" (or "T-bonds") in the United States and "Gilt-edged securities" (or "gilts") in the United Kingdom.
The simplest form of bond is the "straight" (or "plain vanilla") bond, that  makes a  regular  fixed interest payment and is repaid (or "redeemed") on a predetermined date. The sum of money for which the bond is to be redeemed, is called its "par value", the annual interest rate that is paid is called its "coupon", and its date of repayment is called its "maturity date". A bond's  coupon divided by its market price is called its "current yield" and its ''internal rate of return'' taking account of the eventual repayment is termed its "yield to maturity".
Other forms of bond can be categorised as particular adaptations of those payment conditions. An "irredeemable bond" (or "perpetual bond" or "consol") is not, strictly speaking, a  loan,  but only an undertaking to make stipulated and indefinitely continuing fixed  interest payments. A "zero-coupon bond", on the other hand, pays no interest, is issued at a price that is below its par value, and is held in order to obtain a capital gain. A "callable bond" has a redemption date that is at the discretion of the issuer.  Convertible bonds include an option, under stated conditions, to exchange them for an equivalent amount of the issuer's equity. The interest rate paid on a “tracker bond” is related to the bank or Treasury  bond rate, and the redemption payment of an “index-linked” bond is related to the current level of a consumer price index.
Bonds can also be categorised according to the degree of security provided to their purchasers.
A "covered bond" is a bond that is secured by other assets so that the investor can lay claim to those assets should the issuer of the bond become insolvent. In the United Kingdom the term "debenture" refers to  a company loan secured by a  claim on the company's assets,  but in the  United States the term is applied to unsecured loans (and debentures are sometimes referred to as bonds). In the UK a "fixed-charge debenture" specifies the assets against which it is secured, whereas a "floating-charge debenture" is secured on the issuer's assets as a whole. Repayment of a "guaranteed bond" is guaranteed by a body other than the issuer - such as its parent company or its government. The term "default risk means the risk that the issuer will be unable to repay the loan and the "risk premium" (or "spread")  is the difference between the yield on a bond and the yield on a government bond – except that “sovereign spread” is the difference between the yield on a government bond and the yield on the least risky government bond that is available.  Default risk premia are linked to  risk ratings issued by credit risk agencies  ''(see below)''.  Bonds that are rated below a minimum credit risk level (Baa for Moody’s or BBB for Standard and Poor)  are termed "junk bonds"  (or "high-yielding bonds") and bonds rated above that level are termed "investment-grade bonds".
Finally, bonds can be categorised according to their currency of denomination. The term "eurobond"  (or "global bond") refers to a bond that is traded outside the country in whose currency it is denominated - so called because it is often applied to a bond issued by a non-European company for sale in Europe.
====Money market securities====
Money market securities are short term loan instruments issued  by governments banks and businesses.  Those that can be bought and sold during the period between issue and repayment are termed “negotiable”. Those that a marketed on a “yield basis” are repaid  on the due date  by the amount invested,  together with a stipulated interest payment. The category of money market security  that are marketed on a yield basis includes "money market deposits" which are repayable after intervals ranging from one day to one year  and are not negotiable, and “certificates of deposit”  which are receipts from banks for deposits made with them, and are negotiable. Money market  securities that are marketed on a “discount basis”  are sold at a price "below par" (– ie below the amount to be repaid), but without any additional interest payment. That category includes Treasury bills, which are  promises to repay loans to the government – usually after 90 days;  "bills of exchange" (or "trade bills", or "commercial bills") which are similar to Treasury bills  but are issued by companies; and "bankers acceptances" which are negotiable, and "commercial paper" which  consists of  unsecured promissory notes issued by companies.
====Shares====
A share in a corporation is evidence of  a share in the ownership (or "equity") of that corporation, and represents a claim on its  assets and its profits.  The shares in a company are referred to collectively as its "stock" or its "equity". The term "equity" is also used to mean the value of the firm after all its debts and other obligations have been paid.  Except for "non-voting shares" the possession of a share carries the right to vote on matters raised at its general meetings. Holders of "preference shares" are entitled to a specified form of preferential treatment compared with holders of "ordinary shares" - sometimes a guaranteed dividend, sometimes a guaranteed repayment if the company were liquidated. The "par value" of a share sometimes denotes the amount due on liquidation to the holder of a preference share, and  it is unrelated to the share's market value.
====Derivatives====
A  derivative is financial instrument whose  value depends upon the  value of  another  instrument.  The principal categories  of derivative  are "forward contracts", "futures", "''options''", and "swaps". A forward contract is an agreement to buy or sell a specified  quantity of an  asset on a specified  date, at a specified price. An  option  is an  agreement that gives the holder the right, but not the obligation, to buy  ("call option") or sell  ("put option") an  asset, on or before a specified date . A swap is an  agreement to exchange a series of cashflows  from one  asset with a series of cashflows from another asset. Swaps are widely used as credit risk transfers ''(see below)''. Some derivatives are used to create  ''leverage'',  as a means of speculation, or for ''hedging'' against risk.
====Mortgages====
A mortgage is a loan secured on property - usually real estate, although ships and aircraft are commonly mortgaged. A mortgage may be used to help finance the purchase of the property or to obtain money for other purposes.<br> Mortgage interest payments may be fixed or may be varied by the  provider of the loan - usually in response to changes in the general level  of interest rates. The term "adjustable rate mortgage" (ARM) is used in the United States to denote a mortgage for which the interest rate  payable is related to a published index, and a "hybrid mortgage" is one in which the interest rate is fixed for a period, and then varied. "Subprime mortgages" are designed for the use of borrowers with low credit ratings (typically below a FICO rating of 620 in the United States). They are offered at higher interest rates than for other mortgages, but may provide for reduced payments in their early years.<br> If the market value of the property that is mortgaged falls below the amount of the loan, the borrower is said to have "negative equity" in the property and thus to cease  benefiting from the mortgage agreement. <br>Failure to make the agreed payments is termed "default" and usually entitles the provider of the loan to "repossess" the property.<br> A mortgage loan may be financed by its provider by selling claims to its repayments - a procedure known as "securitisation".
====Structured finance====
The term "structured finance" refers to assets created by "securitising"
<ref> Statement on behalf of the American Securitization Forum before the House of Representatives  Subcommittee on Housing and Community Opportunity,  November 5, 2003[http://www.house.gov/financialservices/media/pdf/110503cc.pdf]</ref>  cash flows such as debt repayments by converting them into marketable securities that are structured according to their  maturity and risk rating, and among which priorities concerning payments and liabilities for losses are stipulated in  "waterfall clauses" .  The cash flows  that are securitised  may be income from corporate bonds, in which case  the assets that are created are termed "collateralised debt obligations (CDOs)" or "asset-backed securities (ABSs)", or they may be mortgage repayments, in which case  the assets are termed "collateralised mortgage obligations (CMOs)".  CMOs  are normally segregated into "tranches", each  with its own maturity date and risk rating.
====Credit risk transfer====
A "credit default swap" (CDS), enables a "protection buyer"  to transfer the ''credit risk'' from holding a security to a "protection seller" in return for an annual percentage charge, known as the "CDS spread", that is determined by the credit rating of the protected security. Credit default swaps can be combined to create a "synthetic CDO," in which  credit losses  are allocated to tranches according to stated priority rules. A "total return swap" transfers ''market risk'' as well as credit risk.  Another form of risk transfer is a bank guarantee which is an undertaking to pay compensation if there is a specified form of default by a third party.<ref>[http://www.bis.org/publ/cgfs20.pdf?noframes=1 ''Credit Risk Transfer'', Committee on the Global Financial System, Bank for International Settlements, January 2006]</ref>
===Participants ===
''(for links to, and notes on, selected financial institutions go to [[/Addendum|the addendum subpage]])''
====Categorisation====
Some participants  in the financial system specialise in trading in a single category of  financial instrument while some find it necessary or advantageous to combine different trading or advisory activities; and interaction between different activities can occur even when they are performed by different participants. The attribution in the following paragraphs  of a single activity to each participant is a simplification adopted for the sake of clarity.
There is no functional  difference  between ''investment banks'' and other finance providers: both use short-term borrowing to pay for long-term loans and the use of ''leverage'' by banks is often emulated by other providers of finance. But the deposit facility provided by ''commercial banks'' places them in a different functional category. In some contexts it is obvious that the term "bank" is used to denote a  commercial bank, but it is normally used to denote either type or a combination of both.
====Financial intermediaries====
=====Banks=====
"''Commercial banks''" accept payments from depositors and lend money to personal and commercial borrowers. In addition to the money they get from depositors, they can get short-term loans from their  ''[[central bank]]'''s "''discount window''", or from the ''money market'' or from other banks via the "interbank market". They make profits by charging higher interest rates to  their borrowers than they pay to their lenders  - a difference that is known as  their "''spread''". 
The banks that lend money to borrowers but do not  accept deposits from the public,  include  "''wholesale banks''" that deal with other banks or financial companies; "''investment banks''",  that raise money for companies  by finding buyers for their equity and  bonds; and "universal banks" that combine all of those activities. Other institutions that lend money to personal or commercial borrowers are referred to collectively as the "shadow banking system".
The practice of retaining only a fraction of the money deposited with it as a "reserve" and lending out the rest is known as "fractional reserve banking".  That practice, together with the  fact that borrowed money can be deposited in commercial banks and repeatedly  used for the provision of further loans,  gives commercial banks an unique role in the expansion and contraction of the supply of credit<ref> As explained on the tutorials subpage[http://en.citizendium.org/wiki/Banking/Tutorials] of the article on banking]</ref>.
=====Other finance providers=====
Loans to consumers are on offer from a number of cooperative (or “mutual”) providers, including savings and loans associations<ref>[http://www.infoplease.com/ce6/bus/A0843804.html ''Savings and Loan Association'', InfoPlease]</ref> ("building societies" in the UK),  credit unions<ref>[http://www.abcul.org/lib/liDownload/956/what%20is%20a%20credit%20union%20Nov%202008.pdf ''What is a Credit Union?'',  Association of British Credit Unions]</ref>, and friendly societies<ref>[http://www.open.ac.uk/socialsciences/friendly-societies-research-group/friendly-societies-for-beginners.php ''What is a Friendly Society?'', Friendly Societies Research Group]</ref>; and from several types of commercial organisation including pawnbrokers <ref>[http://www.thenpa.com/how_pawnbroking_works.asp ''How it Works?'',  The  National Pawnbrokers Association of the United Kingdom]</ref>, and providers of hire purchase<ref>[http://www.moneymadeclear.fsa.gov.uk/products/loans/types/hire_purchase.html "Hire  Purchase",  Financial Services Authority  April 2009]</ref> ("instalment plans" in the United States).
Equity capital is raised by the larger  firms through the services of investment banks, "securities brokers" and "flotation companies" <ref>[http://www.answers.com/topic/security-brokers-dealers-and-flotation-companies ''Securities Brokers, Dealers and Flotation Companies'', Answers.com]</ref>
and, through  other intermediaries, by "initial public offerings" (IPOs)<ref>[http://www.streetauthority.com/terms/i/ipo.asp ''Initial Public Offering'', Street Authority.com, 2009]</ref> of  shares to the public, and it is made available to firms that are too small to qualify for stock exchange listing<ref> See the paragraph on stock exchanges for an explanation of listing </ref> by "venture capital companies" <ref>[http://www.nvca.org/index.php?option=com_content&view=article&id=119&Itemid=147 ''FAQs About Venture Capital'', National Venture Capital Association, 2009]</ref><ref>[http://www.nvca.org/index.php?option=com_content&view=article&id=180:ventureality&catid=41:press-center ''VentuReality" (video), National Venture Capital Association, 2009]</ref> (termed "private equity companies" in the UK). Long-term loan finance is obtained by the issue of corporate bonds, and short-term borrowing by the sale of ''commercial paper'' on the ''money market''. Companies also raise capital by selling the rights to their receipts from invoices and  "accounts receivable" to "factoring companies"<ref>[http://www.businesslink.gov.uk/bdotg/action/layer?topicId=1073924180 ''Debt Factoring and Invoice Discounting'', Business Link]</ref> (or "invoice finance brokers"). They often finance capital equipment purchases by hire purchase, or leasing, and otherwise raise capital by the sale and leaseback of equipment that they own.
====Financial services====
=====Analysts and investment managers=====
The function of transferring resources and risks, attributed above to financial intermediaries, is augmented by the activities of analysts and  financial advisors<ref>[http://www.bls.gov/oco/ocos259.htm#nature ''Financial Analysts and Personal Financial Advisors'', United States Department of Labor, 2008]</ref>, operating within and outwith the financial intermediary organisations.  They collect and analyse financial information and use their findings, either  to inform and advise their clients, or to manage a package of financial assets known as a "fund", or to manage their clients' investment portfolios. Financial advisors  may  be independent of the organisations on whose products they advise, or may be related to them directly or by commission payments <ref>[http://www.moneymadeclear.fsa.gov.uk/products/advice/financial_advice.html#types ''Getting Financial Advice'', Moneymadeclear, Financial Services Authority, 2009]</ref>, and are sometimes provided by companies with information not available to the general public. Among the funds that are so managed are "mutual funds" <ref>[http://www.sec.gov/investor/pubs/inwsmf.htm ''An Introduction to Mutual Funds'', US Securities and Exchange Commission]</ref> (called "unit trusts" in the UK), which are collectively owned by their investors, including "hedge funds"<ref>[http://stats.oecd.org/glossary/detail.asp?ID=1223 ''Hedge Fund'', OECD Glossary of Statistical Terms, 2003]</ref><ref>[http://www.financialpolicy.org/dschedge.htm ''Primer: Hedge Funds'', Derivatives Study Center 2009]</ref>. Company-owned trusts include "unit trusts" (in the USA)<ref>[http://www.investorwords.com/5163/Unit_Trust.html '' Unit Trust'', Investorworld.com]</ref> and "investment trusts"<ref>[http://www.moneymadeclear.fsa.gov.uk/products/investments/types/pooled/investment_trusts.html ''Investment Trusts'', Moneymadeclear, UK Financial Services Authority]</ref>. Investment trusts and unit trusts invest in bonds, shares and money market assets,  are widely marketed, and are  closely controlled by regulatory authorities, hedge funds are offered only to small groups of wealthy investors, adopt unorthodox investment strategies,  often employ very high levels of ''leverage'', and often escape regulation.
=====Credit rating agencies=====
Credit ratings reflect their authors' estimates of borrowers' ability to repay what they have borrowed and if accepted, relieve their creditors of the problem of judging the risk of default. Some  agencies provide such ratings for individuals,  others for the issuers of  debt instruments and their derivatives<ref>[http://www.iosco.org/library/pubdocs/pdf/IOSCOPD153.pdf. ''Report on the Activities of Credit Rating Agencies'', The Technical Committee of the International Organisation of Securities Commissions, September 2003]</ref>. For bonds, the highest ratings are assigned to issuers who are expected never to default - such as the United States Treasury - and prospective buyers of other issuers' bonds respond to the assignment of a lower rating by demanding a higher yield than that obtainable on Treasury bonds in order to compensate for the greater risk of default. The yield to be expected of a structured finance instrument such as a "collateralised mortgage obligation"  ''(see above)'' depends entirely upon the credit rating of its tranche. Following the [[crash of 2008]] the methods used by the major credit rating agencies are under review <ref>For a critique of their methods see the tutorials subpage[http://en.citizendium.org/wiki/Crash_of_2008/Tutorials] of the article on [[crash of 2008]]</ref>.
===Markets===
====Stock exchanges====
Trading in the different categories of instrument takes place in different types of [[market]]. "Primary markets" for pensions and insurance policies take the form of one-to-one "over-the-counter" (OTC) transactions with their  suppliers, and there is seldom  any further trading because those instruments are considered to be "non-negotiable". The primary markets in stocks and shares and bonds usually start with an "initial public offering" (IPO) in which the issuers  deal directly with professional traders, and through them with the public. Subsequent trading in those instruments can take place, either as over-the-counter deals between dealers and individual customers, or in "auction markets" in which numbers of  holders trade with each other, or in "dealers markets" in which numbers of  holders trade with dealers. The traditional way of making deals on an exchange is by "open outcry" in which sellers/buyers shout an offer and buyers/sellers shout an acceptance. Few financial exchanges now use that method and those that do<ref>[http://www.nyse.com/pdfs/Next_Generation_Model.pdf ''Next Generation Model'', New York Stock Exchange, 2009]</ref><ref>[http://www.newsday.com/business/chi-070318burns-story,0,2836457.story?page=1 Greg Burns ''Open-outcry system going by the boards at Chicago exchanges'', Newsday.com June2 2009]</ref> plan to change to an electronic trading system such as London's "Stock Exchange Electronic Transfer System" (SETS)<ref>[http://www.londonstockexchange.com/en-gb/products/membershiptrading/tradingservices/sets.htm ''SETS'', London Stock Exchange, 2009]</ref>, (augmented by clearing and settlement systems that provide the buyer with his stock and the seller with his payment). A company's shares may be traded on a stock exchange only if it is granted a "listing", the granting of which is typically  subject to rules <ref>[https://hughjamesonline.secureclient.co.uk/hughjames/?event=base:article&node=A76058BD76744 ''Listing on the Stock Exchange'', Hugh James online]</ref><ref>[http://www.fsa.gov.uk/pubs/occpapers/op28.pdf Susanne Leitterstorf, Petronilla Nicoletti and Christian Winkler''The UK Listing Rules and Firm Valuation'', Financial Services Authority, April 2008]</ref> concerning the meeting of a minimum capital value requirement, and concerning the qualifications and conduct of its directors. Most stock exchanges also provide for trading in other financial instruments including structured products<ref>[http://www.nyse.com/pdfs/ts_beyond_equities.pdf ''NYSE "Beyond Equities"]</ref>, and some provide a second-level market for the shares of smaller firms (such as London's "Alternative Investment Market<ref>[http://www.londonstockexchange.com/en-gb/products/companyservices/ourmarkets/aim_new/AIM "London Stock Exchange AIM"]</ref>).
====The foreign exchange market====
National currencies are traded against each other in countries all over the world and the  transactions are facilitated by multiple clearance systems<ref>[http://www.streetdirectory.com/travel_guide/185617/foreign_exchange/payment_and_settlement_systems_in_the_forex_market.html Donald Saunders: ''Payment and Settlement Systems in the Forex Market'', Streetdirectory.com, 2009]</ref>.
The activities of the traders in the different countries interact so strongly that the system behaves as though all trading were done in one centrally-administered exchange.
The system is referred to as the foreign exchange (or "Forex") market  although there is no central market to coordinate its transactions. The ''central banks'' of countries with "fixed exchange rates" buy and sell their countries' currencies in order to keep its exchange rate with the dollar (or other reference currency)  within an intended range. Otherwise, most trading is done by banks, on there own account or on behalf of private-sector clients. Other central banks do not normally intervene in the forex market (although they sometimes act to ''sterilise'' the domestic effects of foreign exchange movements).
Exchange rate movements influence other international financial transactions and - because of the interactive character of the global financial system - they influence, and are influenced by, financial activities within trading countries.
===Regulators===
Governments have sought to regulate the conduct of participants in their financial systems in view  of the influence of that conduct upon other sectors. The main purpose of financial regulation has typically been to preserve the financial system from the danger of ''systemic failure'', and it has sometimes been used to further its efficient operation, for example by requiring open access to financial information, but an important secondary purpose has been to protect investors against fraud and the misuse of inside information.
Regulation has usually developed piecemeal in  response to a sequence of problems - starting with the banks, and getting applied elsewhere as the need seemed to arise. In the United States, for example, federal governments have, over time,  appointed six regulatory bodies, together covering all of the participants in its financial system except the non-bank lenders, the hedge funds and the traders in OTC derivatives. <ref>[http://assets.opencrs.com/rpts/R40249_20090224.pdf Mark Jickling and Edward Murphy: ''Who Regulates Whom?'', Congressional Research Service, February 2009]</ref>, and, until 2000, Britain's financial industry was regulated by nine different bodies. In the 1990s, however, unified systems of financial regulation were adopted by Norway, Denmark and Sweden<ref>[http://www.imf.org/external/pubs/ft/fandd/1999/12/taylor.htm Michael Taylor and Alex Fleming: "Integrated Financial Supervision: Lessons of Scandinavian Experience", ''Finance and Development'', IMF December 1999]</ref>, followed in 2000 after intensive all-party investigation<ref>[http://www.publications.parliament.uk/pa/jt199899/jtselect/jtfinser/328/32803.htm ''Joint Committee on Financial Services and Markets, First Report, House of Commons, 29 April 1999]</ref>, by Britain<ref>[http://www.parliament.uk/commons/lib/research/rp99/rp99-068.pdf ''Financial Services and Markets Bill'', Research Paper 99/68, House of Commons 24 June 1999]</ref>, and  subsequently by Australia (except for separate prudential supervision of the banks)<ref>''The Integration of Financial Regulatory Authorities – the Australian Experience'',
Paper presented to a conference sponsored by the Securities and Exchange Commission of Brazil, 4-5 September 2006 [http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/integration-financial-regulatory-authorities.pdf/$file/integration-financial-regulatory-authorities.pdf Jeremy Cooper]</ref>, and in March 2009 the US Treasury announced plans to create "a single independent regulator with responsibility over systemically important firms and critical payment and settlement systems"
<ref>[http://www.financialstability.gov/latest/tg72.html ''Treasury Outlines Framework For Regulatory Reform'', US Treasury, March 26, 2009]</ref>.
The [[crash of 2008]] has led to generally agreement that current regulatory systems are inadequate for the purposes that they are intended to serve.
''(the rôles of the financial regulators are examined further in paragraph 5 of the article on [[financial economics]])''
===The central banks===
A  central bank normally  implements  its  country’s monetary policy<ref>the control of the money supply is explained in paragraph 3.2 of the article on [[banking]] and the use of interest rate policy for the control of inflation is explained on the Bank of England's website [http://www.bankofengland.co.uk/monetarypolicy/how.htm]</ref>,  manages its gold and foreign currency reserves,  acts  as the government’s banker  and as  ''lender of last-resort'' to its country’s banks. In some countries the central bank also regulates the banking system and in countries with fixed-rate currencies, it manages the exchange rate by operating in the foreign exchange market. Within that general framework, national practices differ. In the United States, the Federal Reserve Board regulates only the member banks of the [[Federal Reserve System]], and in  the United Kingdom, and neither the [[Bank of England]] nor the [[European Central Bank]] have any regulatory responsibilities.
==Global finance==
===Exchange rates===
The [[gold standard]] was a commitment  to fix the price of  a national currency  in terms of a specified amount of gold.  It was adopted  de facto  by England in 1717,  by the United States in 1834  and by other major  countries in the 1870s.  It broke down during World War I and was  reinstated from 1925 to 1931 as the Gold Exchange Standard.  That version broke down in 1931, and between 1946 and 1971 most countries operated  the [[Bretton Woods system]] under which their exchange rates were fixed in terms of the United States dollar, which was  convertible to gold.  Convertability  of the dollar  was abandoned  in 1971 and most countries then adopted a “floating exchange rate” system under which exchange rates were determined by transactions in the foreign exchange market  (but  some currencies continued to be linked to the dollar).
===International capital flows===
As a matter of logical necessity, for every borrower there must be a lender and the total amount borrowed must be the same as the total amount lent - or in other words, the total amount of debt must be the same as the total amount of savings. In accountancy terms that means that the sum of the balances of payments of all the world's countries must be zero. If savers and borrowers were spread randomly around the world, that would also be true of each country viewed individually. As a matter of observation, that is not true and there have, from time to time, been  very large national  balance of payments surpluses and deficits (termed "imbalances"). And, as a matter of logical necessity, those surpluses and deficits  must be due to national differences in their inhabitants' propensities to save. Such differences may be attributable to differences in prosperity, to social norms, or to different government interest rate, exchange rate, monetary or fiscal policies<ref>Those policies are discussed in the article on [[international economics]]</ref>.
The international capital flows that create those imbalances are mainly  made up of foreign ''direct investment'', private ''portfolio'' investment, and credit transfers by the banking and ''shadow banking'' systems, and there are some "official flows" involving national governments and ''sovereign wealth funds''.
===International institutions===
The Bank for International Settlements (BIS) was established in 1930 to deal with the reparation payments imposed on [[Germany]] by the [[Treaty of Versailles]]. Nowadays it serves as the central banks’ bank and provides a forum to promote discussion and policy analysis among central bank governors and senior executives. It has five standing committees: the Basel Committee on Banking Supervision, the Committee on the Global Financial System, the Committee on Payment and Settlement Systems, the Markets Committee and the Irving Fisher Committee on Central Bank Statistics.
Although not binding upon its members, the  Basel Accords of 1988 and 2004, (known as Basel I and Basel II) are the standards for banking supervision that have been adopted by central banks in developed countries worldwide.
The [[International Monetary Fund]] (IMF)<ref> [http://www.imf.org/external/about.htm International Monetary Fund website]</ref> was set up by the ''Bretton Woods'' Conference in 1944, mainly to provide loans to member governments in support of policies to deal with [[balance of payments]] problems. In recent years it has also  devoted its resources to the strengthening of the international financial system and relieving  financial crises. It also  advises member governments about their economic problems and, when necessary, it grants loans to help resolve them.
The World Bank<ref>[http://web.worldbank.org/WBSITE/EXTERNAL/EXTABOUTUS/0,,pagePK:50004410~piPK:36602~theSitePK:29708,00.html World Bank website]</ref> was also set up by  the Bretton Woods Conference. Its purpose is to reduce global poverty and improve living standards by providing low-interest loans, interest-free credit and grants to developing countries.  It includes the International Bank for Reconstruction and Development, which provides loans to middle-income countries; the International Development Association, which gives interest-free loans to the poorest countries; the  International Finance Corporation, which finances private-sector projects; the Multilateral  Investment Guarantee Agency, which guarantees foreign investors against non-commercial risks; and the International Center for the Settlement of Investment Disputes, which seeks to settle disputes between foreign investors and host countries.
The International Organization of Securities Commissions <ref>[http://www.iosco.org/about/index.cfm?section=history The IOSCO website]</ref> (IOSCO) is an international organisation representing national regulators of  securities markets, that has agreed a set of principles concerning the regulation of securities markets, made a number of further recommendations  and is represented on most of the other international organisations that are concerned with the maintenance of financial stability.
The Financial Stability Forum<ref>[http://www.fsforum.org/about/who_we_are.html The Financial Stability Forum website]</ref>  is made up of  senior representatives of central banks and finance ministries  and international financial institutions including the International Monetary Fund , the World Bank and  the Bank for International Settlements. It was set up  1999  to promote international financial stability, improve the functioning of financial markets and reduce the tendency for financial shocks to propagate from country to country. At working level it includes the Working Group on Market and Institutional Resilience whose task is to  identify  institutional vulnerabilities  and recommend action  to tackle them.  It is serviced by a small secretariat housed at the Bank for International Settlements
==Trends and  innovations==
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From the early years of modern commercial history, the banks have been the core element of the financial system, and their relationship with their national governments has had a significant influence on its development. In the nineteenth and early twentieth centuries, it was essentially an arms-length relationship, despite frequent bank failures and several financial panics, culminating  in  the [[crash of 2009]] and the [[Great Depression]]; but the price that the United States banking system then paid  for  its rescue from threatened extinction was a regime of tight regulation that was emulated by other industrialised countries. The regulations  that were then imposed required  banks to limit the extent to which their loans exceeded the funds provided by their shareholders  by the imposition of minimum "''reserve ratios''"  and  placed various other restrictions upon their activities<ref>[http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/weill/demise.html ''The Long Demise of the Glass-Steagall Act'', PBS, 8 May 2003]</ref>.
In the 1980s, however, it was widely considered that those regulations  were imposing  excessive economic penalties, and there was a general move toward "deregulation" <ref>[http://www.reagan.utexas.edu/archives/speeches/1982/101582b.htm Ronald Reagan ''Remarks on Signing the Garn-St Germain Depository Institutions Act of 1982'', October 15, 1982]</ref>
<ref>[http://www.bis.org/publ/econ43.pdf?noframes=1 Claudio Borio and Renato Filosa: ''The Changing Borders of Banking'', BIS Economic Paper No 43, Bank for International Settlements December 1994]</ref>. Restrictions upon the range of financial activities open to banks and providers of housing finance were dropped, and reserve requirements were relaxed or removed.
After the 1980s there was a dramatic surge in financial activity and a transformation of its character. The volume of financial assets grew from just over over 100 per cent of global GDP in 1980 to over 300 per cent in 2005, the total value of financial derivaties in use grew from 2½ per cent of global GDP in 1996 to over 8½ per cent in 2006, and by 2006 the volume foreign exchange trading wa s over 12 times its 1986 level
<ref> Rob Hamilton, Nigel Jenkinson and Adrian Penalver: "Innovation and Integration in Financial Markets and the Implications for Financial Stability", in ''The Structure and Resilience of the Financial System'', eds Christopher Kent and Jeremy Lawson, Reserve Bank of Australia,pp. 226-250, November 2007[http://www.rba.gov.au/PublicationsAndResearch/Conferences/2007/Hamilton_Jenkinson%20_Penalver.pdf]</ref>. Among innovations introduced during that period were the adoption of the strategy known as "originate and distribute", under which  securitised bonds, many of them mortgage-based, were sold  to pension funds, insurance companies and banks <ref>[http://www.imf.org/external/pubs/ft/wp/2007/wp07195.pdf  Ashok Vir Bhatia: ''New Landscape, New Challenges: Structural Change and Regulation in the U.S. Financial Sector'', Working Paper No WP/07/195, International Monetary Fund, August 2007]</ref> a  change in the funding of bank lending, away from deposits towards short-term ''interbank'' and ''money market'' borrowing, and large  increases of ''leverage'' <ref>[http://www.bankofengland.co.uk/publications/fsr/2008/fsrfull0810.pdf ''Financial Stability Report'', Chart 1.9, Page 9, Bank of England, October 28 2008]</ref>, . There was also a massive expansion of the unregulated ''hedge funds'' – to the point at which they are estimated to have accounted for 40 to 50 per cent of stock exchange  activity by 2005
<ref>[http://www.bankofengland.co.uk/publications/fsr/2007/fsrfull0704.pdf ''Financial Stability Report'', p36, Bank of England April 2007]</ref> - many of which dealt in high-risk, high-return investments, and some of which depended upon borrowed money amounting to over twenty times their capital. The period from 1986 to 2006 was also characterised by a  substantial upward trend in household debt<ref>[http://www.oecd.org/dataoecd/40/31/39698857.pdf  Nathalie Girouard, Mike Kennedy and Christophe André: ''Has the Rise in Debt made Households More Vulnerable?'', Economics Department Working Paper 535, OECD December 2006]</ref>, particularly in the United Kingdom and the United States.
In parallel with the expansion in financial activity  was a series of new developments in the previously neglected discipline of [[financial economics]], that were then applied  to  the  quantitative analysis of investment decisions. The theoretical basis for most of those developments was the treatment of investment risks as the consequence of random fluctuations conforming to mathematically defined "probability distributions" that could be quantified by statistical analysis of available historical records. Their application involved the formulation and application of highly sophisticated computer models operated by experts that came to be known as "quants". Those developments tended to relieve investment managers of the reponsibility for judging the risks involved in their companies' investment decisions.
The increase in domestic financial activity was accompanied by a massive growth in the volume of international transactions, with the development of large payments imbalances and correspondingly large international capital flows. For most of the 20th century capital flowed mainly from the developed economies to the emerging economies, notably  bank lending to Latin American countries in the 1970s and direct and portfolio investment in Asian countries in the 1990s <ref>[http://www.un.org/esa/desa/papers/2005/wp10_2005.pdf Graciela L. Kaminsky: ''International Capital Flows,Financial Stability and Growth'']</ref>. During the first 7 years of the 21st century, however, the balance of capital flows was from the emerging economies to the developed economies and there was a corresponding  development of  balance of payments surpluses and deficits. China's current account balance, for example, grew from $9 bn in 1995-6 to $970 billion in 2000-07, and annual capiital outflows from Asian emerging economies increased from $51 bn in 1990-97 to $502 bn in 2007 <ref>[http://www.bis.org/publ/bppdf/bispap44.pdf ''Financial Globalisation and Emerging Market Capital Flows'', BIS Papers No 44,  Bamk for International Settlements December 2008]</ref>. The counterparts of the payments imbalances were differences in national savings rates, which in 2006 ranged from 14 percent of GDP for the United States
to 60% for China <ref>[http://www.imf.org/external/pubs/ft/weo/2007/01/pdf/text.pdf. ''World Economic Outlook'', International Monetary Fund, April 2007]</ref>
''(for the sequence of major developments, and links to more information on those developments, see the [[/Timelines|timelines subpage]])''
==Performance==
===Benefits===
Economic theory suggests that benefits should accrue from a well-functioning financial system. The theorems of [[welfare economics]] establish that a system governed by  ''perfect competition'' is ''Pareto-efficient'', meaning that no better system is possible,  and the ''efficient market hypothesis'' suggests that stock markets meet its information requirements.  Empirical support for that hypothesis was provided by  studies undertaken and  summarised by  the economist Eugene Fama<ref>[http://www.e-m-h.org/Fama70.pdf Eugene Fama: "Efficient Capital Markets: A Review of Theory and Empirical Work", ''Journal of Finance'' Vol 25 No 2]</ref> <ref>[http://www.financeprofessor.com/summaries/fama91efficientcapitalmarketsii.htm Eugene Fama:  "Efficient Capital Markets II", ''Journal of Finance'', December 1991]</ref> and others. Fama concluded that there is no important evidence to suggest that prices do not adjust to publicly available information, and only limited evidence of privileged access to information about prices.
Joseph Schumpeter had  argued in 1911 that the services provided by financial intermediaries - mobilizing savings, evaluating projects, managing risk, monitoring managers, and facilitating transactions -  stimulate technological innovation  and economic development <ref> Joseph Schumpeter: ''The Theory of Economic Development'', Harvard University Press, 1911</ref>,  World Bank economists, Robert King and Ross Levine provided empirical support for that proposition in 1993
<ref>[http://www-wds.worldbank.org/external/default/WDSContentServer/IW3P/IB/1993/02/01/000009265_3961004042036/Rendered/PDF/multi_page.pdf Robert King and Ross Levine: ''Finance and Growth: Schumpeter Might Be Right'', WPS 1083, Country Economics Department, The World Bank, February 1993]</ref>, and it has become the consensus view among economists. (However, a critical survey of the empirical evidence has  noted that the proposition  was not universally accepted and that, although the evidence wass generally supportive of the proposition, the connection between finance and growth is not fully understood <ref>[http://www.econ.umn.edu/~guvenen/paper5.pdf Paul Wachtel: ''How Much Do We Really Know about Growth and Finance?'', Paper  presented at a Federal Reserve Bank of Atlanta conference on finance and growth, November 15,2002]</ref>.)
===Systemic instability===
The theory underlying those conclusions embodies the assumption that the people concerned always behave rationally, and it is thus regarded - like most economic theory - as providing  a working approximation rather than a universal truth. Similarly the empirical evidence reveals what usually happens, not what always happens. Thus an occasional departure from their findings (resulting, for example, from ''panic'' or ''herding'')  is to be expected. Such  departures are usually transitory and of little importancet, but in a ''tightly-coupled'' interactive system, such as the current financial system, they can  be crucial. The tightly-coupled characteristic of such a system means that the failure of one component can trigger the failure of  a component  that has ''feedback'' links with the originator. If the feedback is positive, the effect can be  explosive,  and if there are other such links it can lead to the destruction of segments of the system, or even of the system as a whole. The complexity of the  system implies its ability to develop a mix of positive and negative feedback links - and possibly to experience long periods of stability, interspersed with systemic failures. It also implies the impossiblity of identifying the crucial triggers, or of predicting their timing.
Complexity is increased by the fact that financial system is not closed: that it has active two-way linkages with the economic system and with the political system, both nationally and internationally. Among the interactions that link the financial system to the economic system are the fact that a reduction in the availability of credit  can affect economic activity by reducing consumers' purchasing power, and the fact that a reduction of in economic activity can reduce the financial system's ability to supply credit - facts that together constitute destabilising positive feedback. An interaction that links the financial system with the political system is the tendency of democratic governments to defend the interests of those who elect them, by intervening  in their financial systems, either to restrict the conduct of its participants or to rescue them from threatened insolvency. vernment Restrictions  tend to increase  domestic stability at the expense of efficiency, and  rescues tend to reduce stability by enabling banks to "appropriate their gains and socialise their losses"  thus reducing their motive to avoid risks.
===Costs===
In any assessment of the net benefits from the current financial system, account has to be taken of the fact that the cost of a systemic crisis is apt to be devastating: even before the [[crash of 2008]] they were often more than 10 per cent of GDP, and sometimes much more.  The global costs of the early stages of the 2008  crash were estimated by IMF economists  as over $500 billion
<ref>[http://www.imf.org/external/pubs/ft/wp/2008/wp08224.pdf Luc Laeven and Fabian Valencia: ''Systemic Banking Crises: A New Database'', Working Paper No WP/08/224, International Monetary Fund, November 2008]</ref>, and its ultimate cost promises to amount to tens of $trillion. A balanced assessment is hampered by the fact that the a collapse on the scale of the 2008 crisis is unprecedented (with the possible exception of the [[crash of 1929]]) and the fact that their expected incidence in any single  country is otherwise low  (the IMF economists have identified only 42 systemic crises in 37 countries during the period from 1970 to 2007}.
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==Reform==
==Reform==


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<ref>[http://www.financialstability.gov/docs/regs/FinalReport_web.pdf ''Financial Regulatory Reform: A New Foundation'', US Department of the Treasury, June 2009]</ref>
<ref>[http://www.financialstability.gov/docs/regs/FinalReport_web.pdf ''Financial Regulatory Reform: A New Foundation'', US Department of the Treasury, June 2009]</ref>
==Prospects==
==References==
<references/>

Revision as of 07:54, 19 June 2009

Reform

(links to proposals for regulatory reform that are noe under consideration ars available on the addendum subpage)


[1]


[1]

[2]

[3]

  1. ↑ Barry Eichengreen and Harold James: Monetary and Financial Reform in Two Eras of Globalization, (Revised version of a paper prepared for the NBER Conference on the History of Globalization, Santa Barbara, May 2001
  2. ↑ New Foundation, New Stability, Statement by President Obama, The White House, 17th June 2009
  3. ↑ Financial Regulatory Reform: A New Foundation, US Department of the Treasury, June 2009
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