The Nature And Role Of The Financial System Finance Essay

Financial system is a mechanism where economic exchange activities can be done. The economic activities can be done through the interaction between financial institutions and the financial market. The purposes of this interaction are to mobilize fund and providing payment facilities for the financing of commercial activities. With the emergence of Islamic finance, the dual financial systems being introduce. In dual financial system the conventional financial systems operating side by side with the Islamic financial systems.

The Islamic Financial system consists of the role of four essential mechanisms: The Islamic banking institutions, Takaful, Islamic Capital Market and Islamic Money market. The structure of this financial system may consist of specialized and non-specialized financial institutions, of organized and unorganized financial markets, of financial instruments and services which facilitate transfer of funds. It also comprises of procedures and practices adopted in the Islamic financial markets. The operation and mechanism of the financial system is scrutinized by Bank Negara Malaysia advisory board and Securities Commission Syariah Advisory Board to ensure compliance of Islamic rules and regulations.

The Islamic financial institutions which are govern and control under Bank Negara Malaysia are the organizations that mobilize the depositors’ savings, and provide financing, acting as creditor or in the form of capital venture or financing in the form of profit and loss sharing (PLS). They also provide various financial services to the community, particularly business organizations. The activities will be dealing in financial assets such as deposits, loans, securities or dealing in real assets such as machinery, equipment, stocks of goods and real estate. The activities of different financial institutions may be either specialized or their function may be overlap. They may be classified base on the basis of their primary activity or the degree of their specialization with relation to savers or borrowers with whom they customarily deal or scope of activity or the type of ownership are some of the criteria which are often used to classify a large number and variety of financial institutions which exist in the economy.

Financial institutions are divided into banking and non-banking institutions. The banking institutions traditionally participate in the economy’s payments mechanism, i.e., they provide transactions services, their deposit liabilities constitute a major part of the national money supply, and they can, as a whole, create deposits or credit, which is money and Banks, subject to legal reserve requirements, can advance credit by creating claims against themselves. Financial institutions are also classified as intermediaries and non-intermediaries. As the term indicates, intermediaries intermediate between savers and investors; they lend money as well as mobilize savings; their liabilities are towards the ultimate savers, while their assets are from the investors or borrowers. Non-intermediary institutions do the loan business but their resources are not directly obtained from the savers. All banking institutions are intermediaries. Many non-banking institutions also act as intermediaries) and when they do so they are known as Non-Banking Financial Intermediaries.

The Evolution of Financial Intermediaries in Malaysia

In this section, our task is to survey the landscape and identify the institutional players. By describing what financial intermediaries look like today, it is also revealing to see how financial intermediaries have evolved over the last century.

Institutional Players

The banking system in Malaysia, which is the major component of the financial sector, consists of Bank Negara Malaysia, commercial banks, Islamic banks, International Islamic banks, Investment bank, other non bank institutions and money brokers. Which are all regulated and supervised by Bank Negara Malaysia.   The other non-bank institutions are supervised by other government agencies. These institutions can be divided into four major groups, consisting of the development finance institutions, the saving institutions, the provident and pension funds, and a group of other financial intermediaries, comprising of building societies, unit trusts and property trusts, leasing companies, factoring companies, credit token companies, venture capital companies, special investment agencies and several financial institutions such as the National Mortgage Corporation (Cagamas) and Credit Guarantee Corporation.

The traditional banking system role has been to make long-term loans and fund them by issuing short-term deposits. [1] But banking systems are prohibited from engaging in securities market activities such as securities underwriting or the sale of trust funds. Therefore, the current design of non-bank financial institution are allowed to deal in the securities market a part of providing services which are similar to the banking system.

The contribution of each non-bank financial institutions: insurance companies and pension funds; they receive investment funds from their customers, both of these institutions place their money in a variety of money-earning investments. Leasing companies; they purchase equipment/asset and then lease to businesses for a set number of years. Factoring companies; provide specialized forms of credit to businesses by making loans and purchasing accounts receivable at a discount, usually assumes responsibility for collecting the debt, specialize in bill processing and collections and to take advantage of economies of scale. Market makers; as an agent that offer to buy or sell security (trading in securities), [2] storage the securities and insured the securities against loss, provide margin credit, [3] cash management account services. [4] 

Trust funds; pool the funds of many small investors and purchase large quantities of securities, offer a wide variety of funds designed to appeal to most investment strategies, allow the small investors to obtain the benefits of lower transaction costs in purchasing securities and reduce the risk by diversifying the portfolio. The National Mortgage Corporation; is to promote the secondary mortgage market in Malaysia, with the issuance of secondary mortgage securities, Cagamas Berhad performs the function of an intermediary to bring together the primary lenders of housing loans and investors of long-term funds.

Evolution

The evolution of financial intermediation in Malaysia is reflected in Table 1. Table 1 shows the major financial intermediaries by assets and also by percentage share (in parentheses) from 1960 to 2000. To the extent that we can view the pace of financial intermediation as a horse race, there seem to be a clear winners and losers. For example, in terms of relative importance the winners are unit trust, Cagamas Berhad, leasing companies, factoring companies and venture capital companies. Commercial banks and finance companies are losers.

These findings raise some interesting questions. First, what caused the change in the mix of financial intermediaries? In this section, we will examine this evolutionary process via three factors.

Deregulation of Interest Rate

Interest rate deregulation that affects loan pricing takes its earliest form. [5] Canada, in 1960, was the first to deregulate its interest rate. Other countries deregulated in the 1980s or thereafter. [6] This deregulation allows more freedom and activity to the banks and other institutions to issue new depository products as well as diversified short and long term credit instruments. [7] Leightner and Lovell (1998) state that some relaxation to the banks’ portfolio were part of the liberalization that enables bank to diversify investment to private as well as the foreign equity. [8] This made possible with the establishment of the foreign exchange market and the expansion of the underwriting activities of the financial intermediaries. Liberalization in Japan and Germany for instance, brings new paradigm to the roles of the banking institutions. The bank in Germany and Japan is no longer to be a creditor, but can also be the equity holder and in the board of directors and management. Liberalization of the banking industry, for example in Malaysia and some other countries, take banking institution into a new dimension that is the establishment of Islamic banking. [9] The increasing demand on the interest free banking offer by the Islamic financial institutions leads many conventional banks to offer Islamic counter or rather known as dual banking. This development happens to Muslim and non-Muslim countries.

The results show that the individuals prefer to diversify their investment other than deposits. In particular, they invest in securities such as stocks, bonds and unit trusts. Therefore, new investment in unit trust for the small saver altered permanently the financial landscape.

The Institutionalization of Financial Markets

Institutionalization refers to the fact that more and more funds in Malaysia have been flowing indirectly into the financial markets through financial intermediaries, particularly pension funds, trust funds and insurance companies rather than directly from savers. As a result, these “institutional players” have become much more important in the financial markets relative to individual investors.

What caused institutionalization? Quite simply, it was driven by the growth of these financial intermediaries, particularly pension and unit trust. [10] Pension fund growth was encouraged by government policy. Tax laws, for instance, encourage employers to help their employees by substituting pension benefits for wages. This is good for employees because they do not pay taxes on their pension benefits until they are received after retirement.

Unit trusts gained considerably from these changes in pension plan laws. Defined contribution plans were allowed to include unit trust on the menu of assets for which plan members could choose. In addition, the increasing attractiveness of specialized funds such as bond funds and index funds has also fueled unit trust fund growth.

The Transformation of Traditional Banking

The fact that banks are exposed to the non-performing loans that stood at 9.1% for the periods of 1997 to 1999 and it seems to us that banking is a declining industry. However, first, the so-called decline of commercial banking is limited to a decline in the relative importance of commercial banking. As shown in Table 1, the decline of commercial banks’ assets as a fraction of total intermediated assets from 43.4% in 1980 to 41.3% in 2001. Table 1 also shows that banking industry assets actually increased between 1960 and 2000. In other words, bank assets have actually increased – just not as fast as the assets of other financial intermediaries. Second, many of the new innovative activities in which banks engage are not reflected on bank balance sheets as assets even though they add significantly to bank revenue. [11] These include, for example, trading in interest rate and currency swaps, selling derivative instruments and issuing credit guarantees.

Third, banks have a strong comparative advantage in lending to individuals and small businesses. [12] Finally, banks have joined forces with a number of other types of financial intermediaries. [13] For example, banks have combined with unit trust funds, merchant banks, insurance companies and finance companies. Bank acquisitions of non-bank financial intermediaries are part of broader consolidation of the entire financial services industry.

Diagram 1: Structure of Regulatory Framework

Minister of Land and Co-operative Development

Licensing of :

Brokers & Representatives

Trading Adviser & Representatives

Fund Managers & Representatives

Minister of Finance

Minister of Domestic Trade & Consumer Affairs

Securities Commission Act 1993

Securities Industry Act 1983

Registrar of Companies

Securities Commission

Future Industry Act 1993

Companies Act 1965

Cooperative Act 1993

Kuala Lumpur Stock exchange

(KLSE)

BNM

Islamic Banking Act 1983

Licensing of

Dealers & Representatives

Investment Adviser & Representatives

Fund Managers & Representatives

Securities Clearing Automated Network Sdn Bhd (SCANS)

Malaysian Central Depository Sdn Bhd (MCD)

Kuala Lumpur Commodity Exchange

(KLCE)

Malaysian Futures Clearing Corporation Sdn Bhd (MFCC)

Kuala Lumpur Options & Financial Futures Exchange

(KLOFFE)

Malaysian Monetary Exchange

(MME)

Malaysian Derivative Clearing House Sdn Bhd (MDCH)

Table 1: Malaysia: Assets of the Financial System, 1960-2000

As at end of (RM million)

1960

1970

1980

1990

2000

Banking System

2,356

(66.3)

7,455

(64.1)

54,346

(73.3)

223,500

(69.8)

829,900

(66.8)

Central Bank

1,114

(31.4)

2,422

(20.8)

12,994

(17.5)

37,500

(11.7)

148,900

(12.0)

Commercial Banks

1,232

(34.7)

4,460

(38.4)

32,186

(43.4)

130,600

(40.8)

513,600

(41.3)

Finance Companies

10

(0.3)

531

(4.6)

5,635

(7.6)

39,400

(12.3)

109,400

(8.8)

Merchant Banks

–

–

2,229

(3.0)

11,100

(3.5)

36,900

(3.0)

Discount Houses

–

42

(0.4)

1,292

(1.7)

4,900

(1.5)

21,100

(1.7)

Non-Bank Financial

Intermediries

1,197

(33.7)

4,167

(35.9)

19,807

(26.7)

96,900

(30.2)

413,100

(33.2)

Provident and Pension Funds

733

(20.6)

2,717

(23.4)

11,370

(15.3)

51,800

(16.2)

217,600

(17.5)

Life and General Insurance

Funds

103

(2.9)

439

(3.8)

2,476

(3.3)

10,300

(3.2)

52,200

(4.2)

Development Financial Institutions

113

(1.0)

2,193

(3.0)

6,000

(1.9)

25,100

(2.0)

Savings Institutions

267

(7.5)

645

(5.5)

2,463

(3.3)

10,000

(3.1)

32,300

(2.6)

Other Intermediaries

93

(2.6)

233

(2.0)

1,305

(1.8)

19,800

(6.2)

85,900

(6.9)

Total

3,553

11,622

74,153

320,400

1243,000

Source: Bank Negara Malaysia, Annual Reports (various issues)

Financial Markets

Financial markets are the centers or an arrangement that provide facilities for buying and selling of financial claims and services the corporations, financial institutions, individuals and governments trade in financial products in these markets either directly or through brokers and dealers on organized exchanges or off-exchanges. The participants on the demand and supply sides of these markets are financial institutions, agents, brokers, dealers, borrowers, lenders, savers, and others who are interlinked by the laws, contracts, covenants and communication networks. Financial markets are sometimes classified as primary (direct) and secondary (indirect) markets. The primary markets deal in the new financial claims or new securities and, therefore, they are also known as new issue markets. On the other hand, secondary markets deal in securities already issued or existing or outstanding. The primary markets mobilize savings and supply fresh or additional capital to business units. Although secondary markets do not contribute directly to the supply of additional capital, they do so indirectly by rendering securities issued on the primary markets liquid. Stock markets have both primary and secondary market segments.

Very often financial markets are classified as money markets and capital markets, although there is no essential difference between the two as both perform the same function of transferring resources to the producers. This conventional distinction is based on the differences in the period of maturity of financial assets issued in these markets. While money markets deal in the short-term claims (with a period of maturity of one year or less), capital markets do so in the long-term (maturity period above one year) claims. Contrary to popular usage, the capital market is not only co-extensive with the stock market; but it is also much wider than the stock market. Similarly, it is not always possible to include a given participant in either of the two (money and capital) markets alone. Commercial banks, for example, belong to both. While treasury bills market, call money market, and commercial bills market are examples of money market, stock market and government bonds market are examples of capital market. Keeping in view different purposes, financial markets have also been classified into the following categories: (a) organized and unorganized, (b) formal and informal, (c) official and parallel, and (d) domestic and foreign. There is no precise connotation with which the words unorganized and informal are used in this context. They are quite often used interchangeably. The financial transactions which take place outside the well-established exchanges or without systematic and orderly structure or arrangements constitute the unorganized markets. They generally refer to the markets in villages or rural areas, but they exist in urban areas also. Interbank money markets and most foreign exchange markets do not have organized exchanges. But they are not unorganized markets in the same way the rural markets are. The informal markets are said to usually involve families and small groups of individuals lending and borrowing from each other. This description cannot be strictly applied to the foreign exchange markets, but they are also mostly informal markets. The nature, meaning, and scope of activities of these types of markets will be discussed later in the book.

As mentioned earlier, financial systems deal in financial services and claims or financial assets or securities or financial instruments. These services and claims are many and varied in character. This is so because of the diversity of motives behind borrowing and lending. The stage of development of the financial system can often be judged from the diversity of financial instruments that exist in the system. It is not possible here to discuss individually the nature of various financial claims that exist in the financial system.

The financial assets represent a claim to the payment of a sum of money sometime in the future (repayment of principal) and/or a periodic (regular or not so regular) payment in the form of interest or dividend. With regard to bank deposit or government bond or industrial debenture, the holder receives both the regular periodic payments and the repayment of the principal at a fixed date. Whereas with regard to ordinary share or perpetual bond, only periodic payments are received (which are regular in the case of perpetual bond but may be irregular in the case of ordinary share). Financial securities are classified as primary (direct) and secondary (indirect) securities. The primary securities are issued by the ultimate investors directly to the ultimate savers as ordinary shares and debentures, while the secondary securities are issued by the financial intermediaries to the ultimate savers as bank deposits, units, insurance policies, and so on. For the purpose of certain types of analysis, it is also useful to talk about ownership securities (viz., shares) and debt securities (viz., debentures, deposits). Financial instruments differ from each other in respect of their investment characteristics which, of course, are interdependent and interrelated. Among the investment characteristics of financial assets or financial products, the following are important: (i)liquidity, (ii) marketability, (iii) reversibility, (iv) transferability, (v) transactions costs, (vi) risk of default or the degree of capital and income uncertainty, and a wide array of other risks, (vii) maturity period, (viii) tax status, (ix) options such as call-back or buy-back option, (x) volatility of prices, and (xi) the rate of return-nominal, effective, and real.

DEFINITION AND SCOPE OF A CAPITAL MARKET (THE ECONOMIC FUNCTIONS OF FINANCIAL INSTITUTIONS)

The previous section gave a brief overview of the major types of financial institu­tions. To understand why financial institutions exist and the economic services that they provide, it is important to understand the different ways in which funds are transferred within an economy between businesses, government, and households (economic entities) that need to borrow funds (borrowers) and those that have sur­plus funds to lend (investors). In a very simple economy without financial institutions, transactions between, different borrowers and lenders are difficult to arrange. Borrowers and savers incur significant search and information costs trying to find each other. Transactions be­tween borrowers and savers may also be limited, because few financial contracts in­volve only two parties. Similarly, risks are great, since individual entities have little or no knowledge of each other and little ability to monitor each other’s actions. Also, the transactions costs may be so high that small entities may be unwilling to supply funds. Investors also have little ability to diversify their risk, due to the high cost of many financial contracts.

Supplier of funds: surplus (savings) units

Lenders: Housesolders, companies, governments, rest of the worlds

Demand of funds: deficit unit

Borrowers: Housesolders, companies, governments, rest of the worlds

Financial Markets

Financial institutions help to reduce transactions, search, monitoring, and infor­mation costs. They provide risk management services and allow investors to diversify their risk and hold portfolios of financial assets by creating ways of indirect financing. Financial institutions also play important roles in an efficient payment system be­tween entities and in managing pure risk (insurance). The upper panel of Figure 1 shows the role of financial institutions as intermedi­aries between borrowers and lenders.

The term primary securities refers to direct financial claims against individuals, governments, and non-financial firms. A simple economy without any financial insti­tutions would accommodate only direct financial claims or financial contracts. In ef­fect, a borrower gives an investor a financial contract or direct financial claim or se­curity that promises a stake in the borrower’s company (i.e., shares of stock) or future payments returning the amount invested plus interest (i.e., a bond, or some other sort of IOU). These are examples of direct or primary securities. As an economy develops, markets emerge for trading direct securities. Some function as auction markets, where trading is carried out in one physical location, as occurs on the New York Stock Exchange; others function as over-the-counter mar­kets, where trading is carried out by distant contacts, perhaps over the phone and computer, as on the National Association of Security Dealers Automated Quotation (NASDAQ) system. Loans made directly with borrowers are another example of a primary or direct security, where a direct contract is made between a borrower and a bank or other individual lender. Table 1.2 provides examples of primary securities in the first column. The financial assets owned by banks, insurance companies, and mu­tual funds, such as loans, bonds, and common stock, are all direct securities, where the lenders give funds to the borrowers, and the lenders receive financial contracts guaranteeing repayment of funds plus interest or shares of ownership in the bor­rower companies.

Investors lend funds in return for a direct or primary security. Secondary securities, in contrast, are financial liabilities of financial institu­tions-that is, claim against financial institutions. In Table 1.2, financial institu­tions’ liabilities-deposits, policyholder reserve obligations, and mutual fund shares-are secondary securities or claims against financial institutions. In effect, fi­nancial institutions created secondary securities that offer advantages over primary securities or direct financial claims.

EXAMPLES OF PRIMARY AND SECONDARY SECURITIES

Primary Securities

Secondary Securities

Commercial loans

Savings deposits

Mortgage loans

Transaction deposits

Consumer loans

Certificates of deposit

Government bonds

Insurance policyholders reserves

Corporate bonds

Mutual fund shares

Corporate common stock

Pension fund reserves

Table 1.2 shows this type of indirect financing.

Unfortunately, like most fields, finance sometimes uses confusing terminology. Readers should carefully avoid confusing the use of the words primary and secondary in this dis­cussion with their use in other contexts. For example, students who have previously stud­ied corporate finance or investments may have encountered the terms primary and sec­ondary markets; primary markets are those for originally issued securities, and secondary markets handle resale of securities. In the context of this chapter, primary and secondary distinguish between issuers of securities and not between changes in securities ownership.

PRIMARY AND SECONDARY MARKET

In a market economy the existence of financial markets can greatly ease the process of exchanging loanable funds for financial claims. A firm that wants to borrow money can go to the market in the knowledge that those with funds to lend will be there. The process is made easier still if specialist traders are known to be actively participating in the markets, buying and selling financial claims on their own account, thereby smoothing over days on which trading is thin or when there is an excess of potential borrowers or lenders. Further economies are achieved if agents or brokers can be employed to enter the market representing the customer to buy and sell securities. The existence of the market serves borrowers and lenders alike by reducing the search costs which each has to incur to get in touch with the other, and also maintains confidence in market prices. Markets do not always have a physical location. A market for loanable funds might consist of nothing more than a list of known dealers who can be contacted by letter or telephone. The International Stock Exchange is the centre of the securities market. It has both a physical trading site which is used for a very small number of securities, and a highly developed system of trading which takes place in a number of locations via computer linkages. The discount market is another traditional financial market, but one which operates without a physical site at all.

This market operates by representatives of the discount houses maintaining close daily contact with the leading banks, either by telephone or personal visits, to determine where trading opportunities are. Two types of financial markets exist for real and financial assets, and it is important to distinguish between them. A primary market for financial assets deals in new issues of all types of loanable funds. Transactions in primary markets result either in the creation or in the extinction of financial claims. The creation of a new loan causes the transfer of cash from a lender to a borrower in exchange for a financial claim on the latter. The claim is extinguished when the cash, usually interest and principal, has been repaid to the lender. A secondary market is a market in old issues. Transactions in secondary markets do not create or extinguish financial claims. Cash does not pass between borrowers and lenders, but existing issues simply change hands. The borrower remains unaffected by the transaction while the lender transfers the right of repayment to another. The main economic function of the secondary markets is to support the operations of the associated primary markets for new issues by providing liquidity to lenders. In the absence of a developed secondary market an individual saver might be very unwilling to lend out money for long periods of time, except at rates of high interest too high to be attractive to borrowers. If the chances of making a sale when necessary are unacceptably low, no lender would commit funds. Therefore an active secondary market is essential for an active primary one. However, there is no guarantee that the lender will receive back in sale proceeds the full amount at the time they are sold, since markets fluctuate all the time, and prices are not constant.

Secondary markets also contribute to the efficiency of the primary market by providing pricing information. In the share market, for example, the current prices of traded securities significantly reduce the problem of setting a price on new issues with similar risk profiles, and information from the secondary market will also influence the attitude of potential participants in primary markets. Figure 3.2 illustrates the connections between primary and secondary markets. Not all primary markets have secondary markets associated with them and some securities are issued for which there are no secondary markets, that is, the securities are not negotiable. Conversely, for every secondary market there must exist, or have existed, an associated primary market. The distinction between primary and secondary markets is not unique to financial markets. The same is true in the markets for physical goods. There is both a market for new and for used cars. In the primary car market, newly manufactured cars are sold, and in the secondary market, often in a different location and involving another group of participants, used cars are bought and sold. On the other hand, a haircut is an example of a good, or in this case a service, bought in a primary market, but for which a secondary market does not exist. It is possible for a physical good to be sold or a financial security to be issued in a primary market which subsequently ceases to function, leaving the secondary market only. Examples are to be found in the markets for farm land and the paintings of old masters. The creation of new farm land is limited to countries still exploiting formerly unused land, whereas in the UK, there has been a substantial and continuing loss of farm land to other uses. In the case of the paintings of continued to be actively traded. The mismatch in activity levels of the primary and secondary markets for securities is not usually quite so marked, but it is considerable. Another example is that of ECU denominated bonds where the market effectively disappeared during 1992/3 and then recovered. Trading in new issues of ordinary shares, for example, is variable in frequency and may be subject to distortionary pricing. But trading in existing corporate issues is very active, although the monetary value of money transactions is not always very great.

Some controversy surrounds the economic function of the secondary markets. The fact that there is active trading in these markets, sometimes in circumstances where the associated primary market appears to have disappeared, often leads financial commentators and others to conclude that the activities of these secondary markets are bringing about a misallocation of resources. But consider the choices open to savers who wish to invest. They can invest in the markets, either directly or through an intermediary. The saver has the choice of either lending directly to a deficit unit via the primary markets or of purchasing an existing security in the secondary markets. If an existing security is purchased, the previous holder of that security will receive cash which can be used either to spend on consumption goods and services or reinvested in the financial markets. Only if the money is spent on imported goods, or in the acquisition of foreign assets are the proceeds lost to the economy. Finally it is desirable that markets should operate in such a way that savings are directed to the most productive firms, or be allocatively efficient. This is attractive to individual lenders, as it leads to maximum return and minimum risk, the optimal trade-off facing the investor. If managers in financial institutions consis­tently place lenders’ funds with borrowers yielding low returns or high default records, investors will either take their funds elsewhere, increase the interest compensation they require, or impose severe restrictions on the kinds of business in which they will invest.

Allocative efficiency may also be desirable from a social point of view and savings should flow to the most productive firms to benefit the economy as a whole. The problem gets more complicated when viewed from this angle because the definition of productivity from a social perspective may be different from that taken by lenders. Lenders may not care whether the firms to whom they lend are monopolists, pollute the atmosphere or engage in illegal activities, but other groups in society might. Clearly, it is possible for there to be conflict between the objectives of the individual decision-makers and the wishes of society. This problem can even exist within a single group of investors. Pension funds, for example, invest money in order to provide pensions for their members but may find that some of their members demand that the funds are not invested overseas or in a competing firm in the same sector. Whilst these decisions may. if sufficiently widespread, affect the relative issue costs, it is not clear that the result should be interpreted as being allocatively inefficient. This idea that investors should have a strong view about the uses to which their funds are put is becoming increasingly important and is taken seriously by fund managers, and many financial institutions use ethical or environmental factors in their marketing. In a monetary economy, the distinction between saving and investment is a real one. Savings can always be held in the form of cash and near-cash assets, such as precious metals. To lend is to forgo liquidity. In order to stimulate long-term lending it is necessary to provide the means by which lenders can restore liquidity without calling in their loans. This is the function of the secondary markets.

DESIRABLE CHARACTERISTICS OF MARKETS

Whenever funds change hands as a result of voluntary exchanges, financial markets can be said to exist, but some markets function better than others. It is helpful to have criteria which can be used to evaluate the effectiveness of these markets. To begin with primary markets, the most pressing need of users is that they should be able to do business with each other at low cost. If transactions costs, such as brokerage fees, are a significant proportion of the funds borrowed then the effective rate of interest paid on loans will be very high, reducing the demand for loanable funds. So one test of the economic value of a primary market is the average proportion of the borrowed funds consumed in transaction costs. It is also beneficial to be confident about the existence of a healthy secondary market, and be sure that securities are truly negotiable. The main value here is in minimising the interest compensation sought by lenders. It follows that a primary market should operate in such a way that it minimises disruptions to the secondary markets. Suppose each new issue of loans caused dramatic falls in the prices of old issues, perhaps because each new issue more than marginally increased the total stock of a particular type of security. The effect of new issues might then be decrease the price and undermine the value, and hence the liquidity, of old issues, in turn negatively affecting the primary market. Therefore, it is desirable that transactions in the secondary market should be much greater in value and volume than those in the primary one. There are limits to the extent to which it is possible for markets to bring about the optimal allocation of funds. Mistakes occur because decisions are made with imperfect information, but the costs of gaining more information are greater than the benefits. The additional information may be known to transactors in the secondary market, and if so, the condition and prospects of borrowers will be monitored there. To now consider secondary markets, it is important to remember that the purpose of a secondary market is to enable holders of securities to convert them into cash without undue loss. Therefore one desirable characteristic of this market is for it to be an active one.