The relationship between institutions and markets

the relationship between institutions and markets

includes financial markets and institutions, tax and regulatory policies, and the .. ated directly between two parties, are differentiated from public markets, members of a self-regulatory body known as the National Association of Securities. Study on the Relationships between Institutions, Governance and Leadership markets and plans to socioeconomics and powers of association, Economy and. the broad national level, as well as key institutions within particular markets and To understand the complex relationships between institutions, markets and.

Integrating existing EU financial markets The European Unionwith its single banking market and single currency, the Euro, has created Europe-wide financial markets and institutions. These markets use the Euro to facilitate saving, investment, borrowing, and lending. Euro-denominated stock, bond, and derivative markets serve all of the EU countries that use the Euro—replacing smaller, less-liquid, offerings and products that previously were available mostly on a country-by-country basis.

In addition, the Euro likely increases the attractiveness of Euro-based financial markets and instruments to the rest of the world. Within the EU, the Euro eliminates the cross-border exchange rate risks that are part of transactions between countries with different currencies. What happens without well-developed financial markets? In many developing nations, limited financial markets, instruments, and financial institutions, as well as poorly defined legal systems, may make it more costly to raise capital and may lower the return on savings or investments.

the relationship between institutions and markets

Limited information or lack of financial transparency mean that information is not as readily available to market participants and risks may be higher than in economies with more fully-developed financial systems.

In addition, it is more difficult to hold a diversified portfolio in small markets with only a limited selection of financial assets or savings and investment products. In such thin financial markets with little trading activity and few alternatives, it may be more difficult and costly to find the right product, maturity, or risk profile to satisfy the needs of borrowers and lenders.

More evidence that financial development matters For further research on the topic, you may wish to review a study of financial structure and macroeconomic performance by Lopez and Spiegel, economists at the Federal Reserve Bank of San Francisco.

the relationship between institutions and markets

With respect to the long-run relationship between financial systems and the economy, they reached the following conclusion: We examine the relationship between indicators of financial development and economic performance for a cross-country panel over long and short periods.

Third, for much the same reasons and contrary to conventional wisdom, the roles of financial markets and financial institutions have become more complementary. At first sight this may appear counterintuitive. After all, the conventional classification of financial systems distinguishes between those where intermediation takes place mostly on the balance sheet of institutions and those where financing through capital market transactions is more pervasive.

Please explain how financial markets may affect economic performance.

Institution-based systems put more emphasis on the ability of intermediaries to extract and utilise information about borrowers by leveraging close and long-term relationships. Clearly, there are large benefits for economies that combine effectively both intermediation channels. The ability to switch smoothly between balance sheet financing and market-based financing contributes to the robustness of a financial system and improves its ability to deal with strain.

Think, for instance, of the resilience exhibited by the US financial system in the early s as one of the two channels of finance - commercial banks - experienced difficulties. At the same time, the greater complementarity between these two forms of intermediation should not be overlooked. On the one hand, institutions rely more and more on markets for their funding, for their investments and, crucially, for the management of risks.

Continued market liquidity is essential in this context. On the other hand, markets rely more and more on institutions for their liquidity, drawing on market-making services and backstop credit lines. Globally, the ongoing consolidation in the financial sector has created a smaller number of very large financial firms that are engaged in both types of intermediation. But financial conglomerates that combine commercial and investment banking operations, insurance and brokering services raise potential concentration risks for the financial system, despite apparent diversification of intermediation channels.

In these large, internationally active financial institutions, a common capital base underpins on-balance sheet intermediation, capital market services and market-making functions. By the same token, losses in one activity can put pressure on the entire firm, affecting its activities in other areas. Fourth, arguably the interaction between the determination of value and the drivers of risk has become tighter, or at least more clearly visible.

This is not simply because market participants, in determining valuations, have become more operationally aware of the importance of risk assessments and the willingness to take on risk. Think, for instance, of the growing use of risk-adjusted returns as a basis for evaluating performance and allocating capital.

This is the component that reflects the impact of the collective actions of market participants on the ultimate drivers of risk themselves, such as asset prices and system-wide leverage. While this endogenous component of risk has always existed, it has arguably become more visible as a result of several factors.

One is the relaxation of aggregate financing constraints associated with financial liberalisation. Another is the much larger role played by markets, with prices telescoping the impact of the changing collective assessments and attitudes towards risk. A third is the increasing common component of asset prices that results from the greater interconnectedness of the financial system, as exemplified by the closer co-movement of returns across different asset classes, especially in times of stress.

This endogeneity is natural - it is part of the physiology of the financial system. At times, though, it may have undesirable side effects and result in financial distress. For example, lending booms can boost economic activity and asset prices to unsustainable levels, sowing the seeds of subsequent instability. Likewise, if a large number of financial market participants assume that markets will remain liquid even under collective selling pressure, they could be induced to overextend their position-taking, thus generating the very pressures that would cause markets to become illiquid.

From this perspective, financial distress reflects the unwinding of financial imbalances that have gradually built up over time. This type of behaviour can be collectively dysfunctional. And it is especially hard to address because it can be fully consistent with individually rational behaviour.

Markets and institutions: Managing the evolving financial risk

Concerns with underperformance in the short term may numb the contrarian instincts of investors and push them to seek safety in numbers. Likewise, the impact of the rational retrenchment of individual investors and market-makers in reaction to spikes in market volatility or losses can trigger a self-propelling spiral of selling, market price declines and evaporating liquidity. Tighter financing constraints at those times can exacerbate distress further.

These mechanisms were quite prominent, for instance, in the market turbulence following the Russian default and the LTCM crisis of Implications for market participants The structural changes I have just discussed have had a profound impact on the way market participants measure and manage financial risk.

Education | Please explain how financial markets may affect economic performance.

Risk management has now become a core activity for financial firms, with much more resources devoted to it at all levels of an enterprise. More specifically, its transformation has largely mirrored that of the broader environment.

Let me briefly review three changes and highlight areas where further work is desirable. First, companies have increasingly focused on the management of risk on a firm-wide basis.

The general principle is that similar risks should be measured and managed in a similar way across the firm, irrespective of their location. In the process, the financial industry is reconciling differences in methods and frameworks reflecting historical and institutional factors.

After all, the value-at-risk measures that are common in banking and the stochastic asset-liability techniques that are common in insurance are, conceptually, the same sort of tool; they differ primarily with respect to the instruments that are included in the analysis and the horizon used for assessing risk.

As a recent Joint Forum report has concluded, this natural and welcome trend is unmistakable, although it still has a long way to go.

the relationship between institutions and markets

Second, firms have adopted a more holistic approach to risk management, taking into account the interactions between different types of risk. The long-term ideal would be a fully integrated treatment of risk, based on a common metric. Here again, the trend is unmistakable but the challenge is truly daunting. Current measurement technology is just not sufficiently advanced. In line with trends in the development of markets, the process has advanced furthest in the integration of market risk and credit risk; it is at best incipient for other categories of risk, not least for liquidity risk.

Arguably, stress testing is the only concrete tool available that allows firms to analyse the joint impact of the broader set of risks in a meaningful way. This practice should be encouraged and developed further. This raises questions with regard to both risk measurement and risk management.

As regards measurement, stress tests can of course help here too: I would argue, nevertheless, that firms should devote more resources to two additional tasks. One is developing techniques that uncover vulnerabilities which emerge from the endogeneity of risk. Of course here I am referring to the signs of overextension that can herald subsequent distress. One may wonder whether similar indicators might also be possible for signs of pending market distress, as occurred during autumn Perhaps such indicators could be based on measures of excessive compression of spreads and some indirect measures of market leverage.

Many commonly used measures of risk, such as those derived from equity prices and credit spreads, are likely to be contaminated by time-varying risk appetite. This introduces an extraneous element that can lull participants into a false sense of security, because it is precisely high risk appetite that can sow the seeds of subsequent problems.

As regards risk management, the challenge is even more daunting. Addressing it clashes with the incentive structures that are at the root of the problem. Admittedly, even here some progress seems to have been made. For instance, a recent survey conducted by the BIS-based Committee on the Global Financial System CGFS suggests that, since the events of autumnsome key market participants have become less inclined to respond automatically to risk limit violations because they now have a better awareness and understanding of the strategic interdependencies among players, and the impacts on market prices.

This is an area that, by its very nature, falls naturally within the remit of prudential authorities, whose task is precisely that of internalising such externalities. Implications for prudential authorities and standard setters To a considerable extent, the implications of the changing nature of financial risk for prudential authorities mirror those for the private sector. In the limited time that remains, let me briefly highlight four points: First, the wide-ranging convergence process in the financial industry naturally calls for greater consistency in the supervisory treatment of financial risk across sectors, be they geographical jurisdictions or functional segments of the industry.

Greater consistency of prudential rules enhances the efficiency of the financial system by removing any distortions embedded in the policy framework, notably by promoting a level playing field and reducing the scope for regulatory arbitrage. As you are well aware, substantial progress has been made here. Across geographical jurisdictions, progress is most advanced in banking, less so in insurance.

Across functional lines, it has clearly proceeded much further within national jurisdictions, not least helped by the increasingly common practice of consolidating financial sector supervision into a single agency.

At the same time, some steps have also been taken internationally. Witness the work of the Joint Forum, which brings together representatives of the international regulatory authorities in banking, securities and insurance.

Increasingly, the benefits to prudential authorities from developing a common view are becoming evident. Second, improving the safeguards against instability for a financial system that is larger and more interconnected, and where the endogenous component of risk is more prominent, naturally calls for a strengthening of the macroprudential orientation of prudential frameworks.

After all, it is now well accepted that a system-wide perspective and a focus on the endogenous component of risk are precisely the distinguishing features of such an approach. It involves the same shift in focus that a stock analyst is required to make in order to become a portfolio manager. In evaluating financial system vulnerabilities, a macroprudential approach would focus on the commonality in the risk exposures of the different segments of the financial system.

the relationship between institutions and markets

In calibrating policy instruments, it would stress the need to establish cushions as financial imbalances build up, in order to give more scope to run them down as the imbalances unwind. This would act as a kind of self-equilibrating mechanism. The logic is analogous to that of calling for fiscal consolidation in good times to allow an effective countercyclical fiscal policy in bad times.

Relationship between bond prices and interest rates - Finance & Capital Markets - Khan Academy

By now, the importance of the macroprudential perspective as a complement to the more traditional microprudential focus is widely recognised. As a result, steps have been taken to put it into practice. For instance, as regards the task of identifying vulnerabilities, macroprudential analysis is now routinely carried out in various forums, including the IMF and the World Bank, the Financial Stability Forum, and the CGFS; and, of course, in many national jurisdictions.

As regards the calibration of policy instruments, too, there are signs of a keener awareness. In banking, for instance, one such illustration is the various adjustments that were made to Basel II, at least partly with a view to addressing concerns about procyclicality.

And banking supervisors here in Spain have gone one step further, by adopting statistical provisioning in loan accounting. This provides a long-term anchor to loan provisioning that is independent of the state of the business cycle.