Development finance debates dogmas and new directions (routledge textbooks in development economics)

Development Finance

This book examines the subject of Development Finance, or more specifically
how financial systems can help or hinder the process of human development.
As an expert in this field, Stephen Spratt reviews the components of the
domestic and international financial systems, and considers reform options
objectively against the central goal of human development. The result is a
combination of orthodox and more innovative approaches, which provides
a thorough grounding in development finance theory and practice in the
twenty-first century. Topics covered in the book include:

•
•
•
•

The Millennium Development Goals
Financial crises and international capital flows
Designing and regulating the domestic financial system
Finance and the private sector.

Focusing on the roles of the World Bank and the IMF, and with a host of
case studies and real world examples from Asia, Africa and Latin America as
well as the ‘transition’ economies of Eastern Europe, the author examines
developing countries’ engagement with the international financial system and
its influence on the process of human development, both positive and negative. Spratt argues that the success or failure of financial systems and reforms
can be judged against a simple benchmark: do they positively contribute to
poverty reduction and human development, or not? He goes on to say that
reforms that pass this test are to be welcomed whilst those that do not should
be discarded, regardless of the ideological package in which they are wrapped.

Packed with helpful tables and figures, this book will be essential reading
for students taking courses on: international development; development
finance; development economics; financial theory and practice.
Stephen Spratt is a director of the new economics foundation, a UK-based
think tank. Previously he lectured in development finance at the University of
Reading, has worked in the City of London’s financial markets and at the
Institute of Development Studies at the University of Sussex.


Routledge Advanced Texts in Economics and Finance

Financial Econometrics
Peijie Wang
Macroeconomics for Developing Countries, Second edition
Raghbendra Jha
Advanced Mathematical Economics
Rakesh Vohra
Advanced Econometric Theory
John S. Chipman
Understanding Macroeconomic Theory
John M. Barron, Bradley T. Ewing and Gerald J. Lynch
Regional Economics
Roberta Capello
Mathematical Finance
Core theory, problems and statistical
algorithms
Nikolai Dokuchaev
Applied Health Economics
Andrew M. Jones, Nigel Rice, Teresa Bago d’Uva and Silvia Balia
Information Economics

Urs Birchler and Monika Bütler
Financial Econometrics, Second edition
Peijie Wang
Development Finance
Debates, dogmas and new directions
Stephen Spratt


Development Finance
Debates, dogmas and new directions

Stephen Spratt


First published 2009
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
Simultaneously published in the USA and Canada
by Routledge
270 Madison Ave, New York, NY 10016
Routledge is an imprint of the Taylor & Francis Group, an informa
business

This edition published in the Taylor & Francis e-Library, 2008.
“To purchase your own copy of this or any of Taylor & Francis or Routledge’s
collection of thousands of eBooks please go to www.eBookstore.tandf.co.uk.”

© 2009 Stephen Spratt
All rights reserved. No part of this book may be reprinted or
reproduced or utilized in any form or by any electronic,

mechanical, or other means, now known or hereafter
invented, including photocopying and recording, or in any
information storage or retrieval system, without permission in
writing from the publishers.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging in Publication Data
Spratt, Stephen.
Development finance : debates, dogmas and new directions / Stephen
Spratt.
p. cm.
Includes bibliographical references and index.
1. Finance–Developing countries. 2. Economic development–
Finance. 3. International finance. I. Title.
HG195.S68 2008
332′.042091724–dc22
2008009767

ISBN 0-203-89144-9 Master e-book ISBN

ISBN10: 0–415–42318–X (hbk)
ISBN10: 0–415–42317–1 (pbk)
ISBN10: 0–203–89144–9 (ebk)
ISBN13: 978–0–415–42318–2 (hbk)
ISBN13: 978–0–415–42317–5 (pbk)
ISBN13: 978–0–203–89144–5 (ebk)


Contents

List of figures
List of tables
List of boxes
1 An introduction to the financial system in theory and in
practice

vii
x
xii

1

2 Finance, poverty, development and growth

25

3 Financial repression, liberalisation and growth

56

4 The domestic financial system: an overview

89

5 Reforming the domestic financial system: options and
issues

125

6 The external financial system (I): characteristics and

trends

170

7 The external financial system (II): debt and financial
crises

204

8 The international financial architecture: evolution, key
features and proposed reforms

255

9 Development finance and the private sector: driving the
real economy

297

10 Finance for development: what do we know?

336


vi

Contents

Notes
References

Index

374
385
403


Figures

2.1
3.1
3.2
3.3
3.4
4.1
4.2
4.3
4.4
4.5
4.6
5.1
5.2
5.3
5.4
5.5
5.6
6.1
6.2
6.3
6.4

6.5
6.6
6.7
6.8

Regional GDP growth rates, 1960–2006
Real interest rates in Turkey, 1973–1983
Total private capital flows to developing and emerging
economies, 1993–2006
Portfolio flows and bank lending, 1993–2006
GDP growth rates: high, middle and low-income
countries, 1960–2006
Regional privatisations, 1988–2003
Pattern of government expenditure on selected categories,
1990–2002
Central government fiscal balances, 1998–2006
Annual inflation rates, 1998–2006
Annual percentage changes in GDP per capita, 1990–2005
Regional per capita GDP rates, 1990 vs. 2005
Regional tax revenues as percentage of GDP, 1990–1995 vs.
1996–2002
Regional government expenditure as percentage of GDP,
1990–1995 vs. 1996–2002
Developing world inflation vs. growth, 1985–2005
Regional growth rates, 1985–2005
Comparative stringency of banking supervision
Value of securities traded abroad/value trade domestically
Net ODA to developing countries, 1980–2005
Composition of ODA to all developing countries,
1990–2005

Composition of ODA to least developed countries,
1990–2005
Proportion of regional populations living on less than US$1
per day, 1990 vs. 2002 vs. 2004
Sub-Saharan Africa: under-5 mortality rates, 1990–2005
Regional progress on reversing deforestation
Estimated global ODA required to meet MDGs, 2002–2015
Proportion of ‘tied’ ODA, 2006

49
65
70
70
77
100
115
116
117
123
123
138
139
149
150
156
160
171
174
175
179

180
181
181
186


viii
6.9
6.10
6.11
6.12
6.13
6.14
6.15
6.16
6.17
7.1
7.2
7.3
7.4
7.5
7.6
7.7
7.8
7.9
7.10
7.11
7.12
7.13
7.14

7.15
7.16
8.1
8.2
8.3
8.4
9.1
9.2

Figures
Map of main proposals on innovative sources of financing
Net private capital flows to developing countries, 1993–2006
Net private capital flows as percentage of developed
countries’ GDP, 1993–2006
Net private capital flows to developing regions, 1993–2006
Net private flows to Asia (ex China and India) vs. flows to
China and India, 1999–2006
Composition of private capital flows to developing
countries, 1993–2004
Cumulative capital inflows to developing regions,
1993–2004
Regional reserve accumulation, 1999–2006
Proportion of sovereign debt denominated in US dollars,
1980–2005
FDI vs. other capital flows, 1993–2006
Impact of different forms of capital inflow on domestic
investment
FDI’s share of total capital inflows relative to credit rating
Distribution of FDI inflows in sub-Saharan Africa,
1997–2002

Proportion of inward FDI to different sectors, 1990 vs. 2002
The changing composition of capital inflows, 1978–1995
Proportion of foreign debt comprised of short-term loans,
1988–1997
Proportion of international bank loans of less than
one-year maturity, June 1990 to September 2006
Foreign bank ownership in developing regions, 1995–2002
Net international debt issuance by developing countries,
1993–2007
Net equity flows to developing countries, 2000–2006
Selected major financial crises, 1400–2000
Total fiscal costs of banking crises, 1980–2000
External debt to GNI, 1980–2005
Multilateral debt as percentage of total debt, 1980–2005
Selected real agricultural commodity prices,
1970–2005
Hard and soft capital resources of the
multilateral development banks, 1995
Cumulative regional loan approvals to 1995
Absolute poverty, 1981 vs. 1987
IMF resources vs. members’ GDP, 1944–2003
Availability of credit information: high-,
middle- and low-income countries, 2006
Private sector credit (2005) vs. credit bureau
coverage (2006)

188
192
193
193

194
195
195
196
201
205
209
210
213
214
214
215
217
219
221
223
224
228
247
247
252
272
273
282
294
308
313


Figures ix

9.3
9.4
9.5
9.6
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
10.9
10.10
10.11

Confidence in property rights vs. FDI
R&D expenditure as percentage of GDP, 1998–2000
Proportion of total employment by SMEs in
selected developed economies, 2001
GDP per capita vs. SME manufacturing
labour force share
Regional domestic savings rates, 1989–2005
Sub-Saharan Africa: working-age population
vs. domestic savings rate
Savings rates by income level, 1970–2004
Historical savings rates in US and UK vs.
Malaysia and Korea, 1960–2005
Sources of investment funds for small and large firms
State ownership in the banking sector: global

‘Top 10’
Inflation, credit and growth in Colombia,
1980–2006
Percentage of managers lacking confidence in
courts to uphold property rights
Gross fixed capital formation as a multiple of FDI
Average number of days needed to enforce a
contract, 2006
Regional poverty levels

315
321
322
324
340
342
344
345
346
351
352
360
366
368
372


Tables

2.1

3.1
3.2
4.1
4.2
4.3
4.4
4.5
4.6
4.7
4.8
4.9
4.10
4.11
4.12
5.1
6.1
6.2
7.1
7.2
7.3

Findings of cross-country regressions on impact of
different variables on inequality
Extent of financial repression, 1973
Liberalisation and financial depth: M2/GDP ratios,
1980–1996
‘Bank-based’ and ‘market-based’ financial systems, 2005
Average financial structures of high-income vs.
low-income countries, 2005
Foreign bank ownership in emerging markets before and

after the Asian crisis
Correlations of financial sector development and GDP
per capita
Informal sector as percentage of GNP
Proportion of the population with bank accounts
Regional privatisations as percentage of GDP,
1988–2003
Banks, stock markets and corporate bond markets in
emerging Asia
Sources of government tax revenues as percentage of
GDP, 1990–2002 averages
Government expenditure as percentage of GDP, 1996–2002
Government expenditure as percentage of total
expenditure and GDP, 1990–2002 average
Banking regulation and supervision:
developed vs. developing countries, 2001
Central government fiscal balances
Global progress on the MDGs
Proportion of external debt denominated in dollars
and euros
Changing patterns of regional bank lending, 1996–2002
Cumulative output loss in crisis-afflicted countries
Average low-income sustainability estimates for all
low-income developing countries in 2006

37
61
68
90
91

93
93
95
95
101
107
112
113
114
120
140
179
201
218
234
250


Tables
8.1
8.2
8.3
8.4
9.1
9.2
10.1

Sectoral distribution of cumulative lending, 1995
Average tariffs applied to agriculture and manufactures,
1999–2001

Tariff escalation, 2001–2003
Net transfers on debt owed to multilateral lenders,
1987–1994
Proportion of banking assets owned by state, 2003
FDI stock as a proportion of GDP in five African
countries, 2005
Proportion of banking industry that is foreign-owned

xi
272
276
277
281
319
326
354


Boxes

2.1
2.2
2.3
2.4
2.5
2.6
3.1
3.2
3.3
3.4

4.1
4.2
5.1
5.2
5.3
5.4
6.1
6.2
6.3
6.4
7.1
7.2
7.3
8.1
8.2
8.3
8.4
9.1
9.2
9.3
9.4

Growth and poverty in India
Simon Kuznets
Nicholas Kaldor
Aid, East Asia and the Cold War
Robert Solow
Joseph Schumpeter
Irrational exuberance
Bank privatisations in the transition economies

Capital controls, asset bubbles and crisis in Thailand
Neo-liberal economists and the promotion of capital
account liberalisation
Privatisation and backlash in Latin America
Stock market development in sub-Saharan Africa
Argentina’s Currency Board
Tax reform in Ethiopia
Basel II and developing countries
Pension reform in Chile
The Swedish International Development Authority
Millennium Development Goal (MDG) targets
The distribution of international ODA
US and China’s exchange rate dispute
Export Processing Zones (EPZs)
A chronology of the Asian crisis
Chile’s experience with capital controls in the 1990s
Codes and standards and the Financial Stability Forum
Structural adjustment in Ghana
Estimated regional distribution of welfare benefits from
Doha Round
The Washington Consensus
Trade finance
IAS vs. GAAP
‘Flying geese’ and new trade theory
CSR, SRI and TNCs: compatible acronyms?

30
32
34
43

45
51
57
62
74
81
101
105
131
135
154
164
172
176
183
196
206
225
240
260
267
278
280
300
304
328
333


Boxes xiii

10.1
10.2
10.3

Savings rates, domestic demand and deflation in Japan
The subprime lending crisis
Land tenure and agricultural productivity in Ethiopia

338
347
360



1

An introduction to the financial
system in theory and in practice

Introduction
The aim of this book is to introduce and analyse the issues and debates
surrounding development finance, at both a global and local level. Although
the area is relatively new, at least in the form of a distinct subject in its own
right, the question of the relationship between the financial sector and economic development and growth has a long and occasionally volatile history.
The development of an effective financial system has been seen as an essential prerequisite for growth at some points, and an unproductive parasite on
the real economy at others. The contemporary debate, for the most part,
subscribes to the first of these perspectives, though some still support the
‘parasitic view’. Those reading this book for the first time are also likely to
take a relatively optimistic view of what the financial system can achieve –
there would be little point studying the subject if this were not so. Similarly,

this book takes a broadly optimistic stance on the debate – there would be
little point writing it if this were not the case.
However, it is important to stress at the outset that, as with much in the
fields of economics, finance and development, there is rarely only one answer
to any question. The answers arrived at may owe as much to the ideological
predispositions of their authors as to conclusive empirical evidence. It is
important to bear this in mind as you work through this book, which is
structured so as to equip you with the skills and confidence to critically
analyse the issues for yourself – ultimately, to reach your own conclusions.
Having said that, whilst we do not have all the answers, it is not the case
that we know nothing. Theoretical positions have evolved, changed direction,
gone up blind alleys (and back again) and been informed by real-world
experience for at least a hundred years. It is from this real-world experience
that we have, perhaps, the most to learn: we have seen what has worked and
what has not, though we may not always know exactly why these outcomes
have occurred.
In this first chapter, however, we start with some financial theory and some
basic facts with the aim of establishing a framework for the rest of the book.
Chapter 2 considers the relationship between finance, development, growth


2

An introduction to the financial system

and poverty alleviation. The third chapter reviews both the theory and
practice of the trend towards financial liberalisation that began in the early
1970s, whilst Chapter 4 provides an overview of the key features of the
domestic financial system in developing countries. Chapter 5 examines the
debate around reform of the domestic financial system, focusing on the link

between financial sector development, economic growth and poverty reduction. Chapter 6 then moves to the external financial system and compares
trends and key issues in official development assistance (i.e. aid) and private
sector flows. Chapter 7 considers the incidence and causes of financial crises
and debt crises in developing countries, whilst Chapter 8 assesses reforms to
the global system, under the aegis of the ‘international financial architecture’.
Chapter 9 examines the linkages between the domestic financial sector, private sector development and growth in developing countries. The final chapter pulls these different strands together, and considers the options facing
policy-makers in developing countries, and ends with a discussion of what
countries could do, and what obstacles they may face in proactively developing a financial system that can facilitate high and sustained rates of growth
and, ultimately, the elimination of extreme poverty.
First, however, we must answer some basic questions, before seeing how
others have answered them in the past.
The most fundamental question to answer is simply, what is the financial
system actually for? In principle, the role of the financial system is largely
the same as in Walter Bagehot’s description of the London money
market in 1864: ‘It is an organisation of credit, by which the capital of A,
who does not want it, is transferred to B, who does want it’ (Bagehot,
1978: 422).
Whilst this remains the ostensible purpose of the international financial
system, the reality is now very different. In particular, the scale, complexity
and interrelatedness of financial markets today has created a plethora of
profitable opportunities that are not a ‘means to an end’, but have become
an end in themselves. Total world economic output in 2005 was estimated
at between US$55 trillion and US$60 trillion per year. These are big
numbers, but they are dwarfed by turnover in the global financial markets –
the spot foreign exchange market alone sees more than US$450 trillion
in turnover per year, or almost ten times the real economic output of the
global economy.
Before returning to this issue, however, the next section considers how, in
principle, the financial system performs the functions described by Bagehot
almost 150 years ago.

1.1 How do financial systems do this, in theory?
Bagehot described how the nineteenth-century London money market channelled surplus financial resources to capital-scarce borrowers looking to
invest. The first function of the financial system is therefore:


An introduction to the financial system

3

(a) To mobilise savings and allocate credit – banks, as well as other financial
institutions, act as intermediaries between savers and borrowers/investors.
Thus households with surplus resources place these resources with
banks, which in turn sift through potential borrowers and allocate credit
to its most productive use. Similarly, asset management companies and
‘contractual savings’ institutions1 also mobilise savings and allocate these
funds as investments, usually in public capital markets.
As well as channelling resources indirectly from the capital-rich to the
capital-poor through third-party financial intermediaries, the financial system
also enables the process to occur directly:
(b) It enables individuals to directly provide surplus resources through the
capital markets – individuals and institutions with surplus capital to
invest can directly participate in the capital markets of the financial
system through providing debt financing to companies by purchasing
corporate bonds, or by providing equity finance to companies through
the purchase of shares.
In addition to these key functions, the financial sector also organises and
implements various aspects of the ‘plumbing’ of the national economic system. Perhaps the most important of these is:
(c) The provision of clearing and settlement services – if the national economic system is seen in terms of an engine, then clearing and settlement
systems can be viewed as the fuel that enables the machine to function.

Specifically, businesses and individuals are able to settle financial balances, whether they be cheques or credit and debit cards for smaller
balances usually associated with individuals or small businesses or large
value payments between financial institutions, which are generally settled
centrally within the national central bank.
As well as providing these vital functions for the private sector, the financial
system is both overseen and used by national governments in a variety of
ways.
(d) Governments regulate the activities of the financial system – the
government has an indispensable role in terms of setting and enforcing
the regulation of financial institutions, whether directly or through
specialist agencies set up by government to undertake this role. The
international system, in contrast, does not have one regulator, but relies
on coordinating the activities of national regulators.
(e) Governments also borrow from the financial system – the government
issues sovereign bonds, which are purchased by the financial system


4

An introduction to the financial system

(both nationally and internationally), thereby providing the funds needed
to finance government expenditure (i.e. to finance fiscal deficits).
(f) Governments may also take a more direct role in the financial system –
both historically and today, many governments have sought to intervene
directly in the functioning of domestic financial systems. Examples
of such activities include directing the allocation of credit through
development banks and/or directly owning or controlling a section of the
commercial banking sector.
Ultimately, therefore, the ostensible purpose of the financial system remains

as described by Bagehot above, and the system performs these functions
within a regulatory framework implemented and enforced by national governments. However, it is important to reiterate that, at least in principle, the
system does not simply allocate surplus capital to any borrower, but to the
most productive possible use. In theory, this efficient allocation therefore
maximises the productive use of capital.
Later we will consider the theoretical principles and assumptions
behind this perspective in some detail. Before this, however, the next section
highlights the key features of the financial system’s infrastructure,
before discussing the most important financial institutions that operate
within this framework.

1.2 What are the key features of the financial system?
1.2.1 Capital markets
(a) Bond markets (or ‘fixed income’ markets) enable corporations and governments to borrow directly from investors in the capital markets
through the issuance of bonds. Bonds are issued in the ‘primary market’,
and then traded in the ‘secondary market’. The resultant debt provides
investors that purchase the bonds with a regular stream of income payments through ‘coupons’ (i.e. interest payments) for the life of the debt,
as well as the payment of the debt’s ‘principal’ upon maturity. The
magnitude of the coupon is set at the time of issuance, hence the term
‘fixed-interest’. In the secondary markets, a fall in the price of the bond
therefore results in an increase in the rate of interest, or ‘yield’ paid, as
the fixed coupon payment becomes a larger percentage of the price of the
bond. The reverse is obviously true of a rise in the price of a bond. In
terms of the pricing of risk, therefore, falling demand for a bond – perhaps due to market perceptions of deteriorating credit quality of the
issuer – leads to falling prices and higher interest rates. The higher interest rate therefore reflects the perceived increase in the risk attached to the
bond. Bonds may have any maturity, and in general terms the shorter
the maturity the lower the rate of interest. Other factors that influence
the level of interest attached to a bond are (a) the creditworthiness of the

An introduction to the financial system

5

issuer (be it corporate or sovereign), and (b) specific features that may be
attached to the bond to alter its nature (more will be said of these features below, but a bond without such additions is known as ‘vanilla’)
(b) Equity markets enable investors to obtain a percentage of the ownership
of the company in question. There are two forms of equity market:
(1) ‘public equity markets’ (share markets/stock exchanges) are where
companies ‘list’ their shares for trading purposes, with the total value of
the company’s outstanding shares termed ‘market capitalisation’. Investors that purchase a company’s shares are entitled to a share of the
company’s profits in proportion to their stake in the form of ‘dividends’,
which are usually paid annually. Although in many markets – particularly developed ones – anyone can invest in public equity markets, in
practice major institutional investors play a dominant role. In the UK,
for example, just 14% of the total market capitalisation of the London
Stock Exchange is held by private individuals (i.e. ‘retail investors’), with
the remainder being held by financial institutions (i.e. ‘institutional investors’). (2) The second form of equity market is ‘private equity’, where
shares are not listed on a public market, but are sold directly to investors.
In terms of pricing, the value of both bonds and equities can be described as
the present value of future revenues derived from the financial instrument.
For bonds: ‘The value of a bond is the present value of the promised cash
flows on the bond, discounted at an interest rate that reflects the default risk
in these cash flows’ (Damodaran, 2002: 887). For equities, value can be
determined either ‘intrinsically’ or ‘extrinsically’. Intrinsic valuation refers to
the fundamental value of the equities, which is usually determined in a similar way to that described for bonds above: future (net) revenues of the company in question are discounted back to arrive at a ‘net present value’ (NPV)
today, which is then simply divided by the number of shares issues to produce
the ‘fair value’ of each share today. There are a variety of models that have
been designed to perform this function, but the most commonly used are
some variant on the standard discounted cash flow (DCF) model.
A key distinction between bond and equity markets relates to the nature of

risk. In bond markets, it is the issuer who carries the primary risk, since
payments must be met regardless of the financial circumstances of the company. In equity markets, however, the risk is primarily held by the investor,
since dividend payments will be linked to the financial performance of the
company so that in a bad year no payment will be made. Put another way, if a
company raises finance in the bond market debt accrues, but if it raises
finance in the equity markets it does not.
1.2.2 Other financial markets
(a) Money markets provide a market for short-term debt securities, such as
bankers’ acceptances, commercial paper and government bills with short


6

An introduction to the financial system

maturities. Money market securities are generally used to provide liquidity to companies and banks – including overnight loans to meet their
reserve requirements as usually determined by the central bank. As such,
they are associated with low rates of interest, which reflect the very
short maturities involved, and the low credit risk (zero in the face of
government) of the participants in the market.
(b) Derivatives markets provide instruments for the handling of financial
risks, where participants in the derivatives markets purchase instruments
that enable themselves to ‘hedge’ themselves against future movements in
asset prices. A derivative is therefore a financial contract whose value is
derived from a financial instrument such as a stock or bond, an asset
(such as a commodity), a currency or a market index (such as the FTSE
100, for example). Derivatives may be traded on market exchanges, such
as the Mercantile Exchange in Chicago (CME), the Chicago Board of
Trade (CBOT) or the London International Financial Futures and
Options Exchange (LIFFE). Derivatives may also be bought or sold

privately on an ‘over-the-counter’ (OTC) basis between major financial
institutions. By 2004, average daily turnover in the global derivatives
market was estimated at $2.4 trillion, with the largest form of contract
relating to interest rates, followed by foreign exchange (FX), equities and
commodity-related contracts.
(c) FX markets trade currencies internationally. By 2004, global FX markets
saw average daily turnover of US$1.8 trillion, which is broadly equivalent to the annual GDP of the United Kingdom. Historically, the
FX market has been rather an ad hoc affair, with no central market.
However, since 2002 an increasing proportion of global FX trades have
been transacted and settled through the Continuous-Linked-Settlement
(CLS) Bank, which by 2006 processed more than half of all global FX
trades. CLS Bank was established to reduce settlement risk in international FX transactions, which is particularly problematic given that
such trades often involve more than one time-zone. That is, as both sides
of an FX trade have to be settled for the transaction to be complete, it is
possible for an institution in one time-zone to settle its side of the trade,
only for its counterparty in another time-zone subsequently to default
on its side of the trade. Settlement risk of this kind in FX markets is
often described as Herstatt Risk after a German bank in the early
1970s.2
From a national/international perspective, capital and money markets are
almost entirely national, whereas derivatives and FX markets are more international in nature. In terms of participants, ‘retail’ investors (i.e. the general
investing public, as opposed to financial institutions) may provide financing
directly to borrowers through any of these markets (though in practice they
tend to focus on equity markets). Alternatively, however, they may provide
funds indirectly through financial institutions, which may operate on a


An introduction to the financial system

7

national or international basis depending on the scope and scale of their
activities:
1.2.3 Commercial financial institutions
(a) Commercial banks take deposits from the public and lend money on a
short- to medium-term commercial basis to individual and corporate
borrowers. The difference between the interest rate paid to savers and
that charged to borrowers is called the ‘spread’. Crucially, commercial
banks transform short-term liabilities (i.e. current account deposits that
can be withdrawn on demand) into long-term assets (i.e. loans of longer
maturity).
(b) Investment banks/merchant banks undertake a broader range of financial
services, which are generally related to the business and financial institutions sectors. These forms of banks assist businesses in finding and structuring various forms of finance, including the issuance of corporate
bonds and the ‘underwriting’ these issues (i.e. they agree to purchase
any unsold bonds). Investment banks also arrange mergers and acquisitions (M&A) and may invest their own capital by taking equity positions
(public or private) in selected businesses.
(c) Universal banks perform all the functions of commercial banks, combined with the services offered by investment banks.
(d) Mortgage banks/building societies specialise in providing finance for
the purchase of property, both residential and commercial. (Although
these distinctions between types of banks remain, the last two decades
have seen considerable erosion of the ‘functional boundaries’ between
the different types of bank and non-bank financial institutions.)
(e) ‘Contractual savings’ institutions such as pension funds and insurance
companies pool and invest the savings of their members to generate
sufficient funds to meet their liabilities (i.e. pension liabilities and paying
insurance claims). The investment and asset management activities
involved in this function may be performed ‘in-house’ or may be outsourced to a third-party asset management company.
(f) Asset management companies provide ‘portfolio management’ services
for retail and institutional investors (including pension funds) by accessing the public (and private) financial markets described above.
(g) Venture capitalists/private equity companies provide seed (or growth)

capital for new (or expanding) businesses.
(h) Finance companies have less clearly defined activities than banks, and are
frequently established to circumvent restrictive regulation. They are generally regulated far less stringently than commercial banks in particular,
as they do not take deposits from the general public.


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1.2.4 Quasi-commercial financial institutions
(a) State development banks are directly owned by governments (either
wholly or partially) and are used to direct credit to those sectors of the
economy identified by government as priorities. The finance may be on
either concessional or commercial terms.
(b) Mutual /cooperative banks are collectively owned by their members and
operate on a basis that is not strictly commercial but is designed to
maximise the benefits to these members. They are therefore often able
to pay higher rates of interest to savers and charge borrowers lower rates
of interest than purely commercial banks.
(c) Post office savings banks provide basic financial services, often to those
on low incomes.
(d) Credit unions/friendly societies are also owned by their members, where
savings are pooled and credit granted to members on low incomes.
(e) Microfinance institutions may be organised as a bank, cooperative, credit
union etc. Aims vary, but providing the poor with access to financial
services is a core feature.
1.2.5 Governmental financial institutions
Central banks have a monopoly of ‘fiat money’ issuance (i.e. paper money,
which is not backed by gold, for example). Central banks also:

•
•

Provide liquidity on a day-to-day basis, which is often used to control the
money supply.
Act as the lender-of-last resort (LOLR) to the domestic banking system,
thereby providing sufficient confidence to prevent bank runs. A bank
run occurs where depositors simultaneously attempt to withdraw their
deposits, perhaps because of fears over the solvency of the bank. As
described above, however, banks transform these ‘demand deposits’ into
longer-term loans (i.e. they borrow short-term and lend long-term).
Furthermore, banks also multiply these deposits – so that a £10 deposit
can form the basis of £100 worth of loans, for example – on the
assumption that only a certain proportion of depositors (10% in this
example) will seek to withdraw their funds at the same time. A bank run
where many (or all) depositors seek to do so, however, can lead to the
insolvency and closure of a bank, as the bank is unable to meet its
depositors’ requests simultaneously. By standing ready to provide liquidity to banks to enable them to meet their obligations (i.e. the LOLR
function) the central bank is able to ‘short-circuit’ bank runs, many of
which are generated and amplified by the knowledge that not all depositors will be able to access their money. If it is known that the central bank
stands behind the commercial banks in this respect, depositors have no
incentive to rush to withdraw their money before other depositors are
able to do so.


An introduction to the financial system

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As well as these features of all central banks they may:

•
•
•

•

•

Own or oversee national payment and settlement systems (see
above).
Provide prudential regulation/supervision of the banking (and
broader financial) sector.
Provide (or require banks to provide) deposit insurance, which, as
the name suggests, insures depositors’ money held in banks. The
purpose of deposit insurance is broadly similar to that of the LOLR
function described above: by guaranteeing individuals’ money held
in banks, deposit insurance schemes may prevent the onset of bank
runs. In the USA, for example, deposit insurance schemes are operated by the Federal Deposit Insurance Corporation (FDIC), which
was established in the wake of the Wall Street Crash of 1929 when
large numbers of American banks were forced to close as a result of
panic-fuelled bank runs.
Determine and/or execute monetary policy. The past decade has seen
increasing moves towards independence of central banks with regard
to executing monetary policy. In the UK, for example, the Bank of
England was given responsibility for setting UK interest rates in 1997
by the incoming Labour government. The Bank works within a
framework established by the UK Treasury, with the remit of hitting
an ‘inflation target’ of 2.5%, and alters interest rates to achieve this

end. The European Central Bank (ECB) is charged with keeping
inflation at or near 2%, though, unlike the UK, the ECB’s target is
not symmetrical.3 The US Federal Reserve has similar independence,
though it does not aim for an explicit inflation target and also takes
economic growth considerations into account.
Determine and/or execute exchange rate policy. Since the 1970s,
many countries – particularly developed countries – have avoided
targeting specific exchange rates, preferring a free-floating currency,4
with the onus of macroeconomic management placed on monetary
policy as described above. However, many other countries – particularly developing countries – maintain a fixed or managed exchange
rate, which the central bank often has the role of managing.

1.3 How do financial markets differ from other markets?
In some ways, the financial markets are similar to any other market for goods
or services. However, in certain key respects, they are fundamentally different.
The key areas of distinction in this respect relate to time and the management
of risk:
1

Fundamentally, financial markets differ from other markets in that
they generally involve delivery in the future as opposed to the present.


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An introduction to the financial system

Consider the difference between buying a car today with your own
money in cash and borrowing the money to buy the care on hire purchase
over a period of some years. The key difference is that the future is
inherently uncertain, which carries risks. The interest rate paid on the
borrowed money is a reflection of this risk. This is the ‘time value of
money’, which is the term used to describe the fact that a rational individual will value £100 today more than £100 in six months’ time.
Financial markets also allow transfers across time – individuals can
choose to defer part of their consumption until the future (through saving), while businesses and governments without sufficient funds can
invest today (through borrowing), in the hope of generating more income
in the future. Consumption and investment can both therefore be
‘smoothed’ through time through the use of the financial markets.
Financial markets also transfer and manage risk by channelling funds
from risk-averse savers to risk-taking investors. Depositors receive a rate
of interest from the bank, whilst the interest rate charged to risk-taking
investors who borrow is a reflection of the following risks:

•
•
•
•

credit risk – the danger of default (applicable to individuals, companies and some governments);
market risk – the risk of loss caused by sudden changes in asset
prices;
liquidity risk – the risk of being unable to sell financial assets quickly
without loss;
systemic risk – the risk of contagion from another bank or commercial institution.

All financial institutions are subject to some or all of these risks to differing
extents, depending on the nature of their activities. Indeed, many financial

institutions, particularly banks, largely emerged, historically, to mitigate these
risks.
For example, banks are able to reduce credit risk through gathering information on borrowers ex ante, and monitoring them ex post. In the absence of
the banking sector acting as an intermediary, individuals would have to perform this function themselves if they wished to lend their surplus resources.
Furthermore, if they did do this, they would face severe liquidity risk in the
event that they wished to withdraw their funds. Banks enable individuals to
obtain the benefits of such investment (i.e. a rate of interest), while retaining
the option of withdrawing their funds at any time (i.e. liquidity risk is dramatically reduced). Banks are also able to greatly reduce market risk through
holding a widely diversified portfolio of investments across a range of different markets, both geographically and sectorally.
Thus far, we have examined the key features of the financial system, and
the most important markets and institutions that comprise it. We have also
considered the various functions that, at least in theory, the financial system