The American Financial System
The American Financial System
The US financial system is one of the most complex financial systems in the world. It consists of different federal, state, and local financial department, private financial institutions, and domestic and foreign corporations and institutions. The system is more market based than bank based, although both components play a significant role in the economy. Many countries have a central bank, which regulates commercial banks and other institutions. For this purpose, the US has the Federal Reserve System. It performs the crucial role of central banks, which includes setting regulations and providing financial services for banks and setting monetary policies. There are four components in the American financial system, and they include financial institutions, financial markets, users, and savers. The American financial system determines the way that money flows from the savers to the users, and this flow can be direct or indirect. A well-functioning financial system eases the access of information, reduces transaction costs and attracts both domestic and foreign investors. Understanding the financial market and financial institutions components of the financial system is crucial because it determines the country’s economic growth.
There are different types of financial securities. They include money market instruments such as treasury bills, commercial paper and bank certificates, bonds and stocks. Investors choose the form of security they want to invest in, based on the rate of interest and the risk associated with the investment. The low risk associated with money market instrument attracts many investors. In addition, the investors also receive an interest for their investment. Governments, corporations, and financial institutions can issue market instruments. Bonds are issued by the treasury, and by state and local governments. They are relatively low risk investments, and they offer interest at the end of a specified period. Investors can choose to purchase and trade in company stocks. This is a high-risk venture, but it attracts many investors because of the high rate of returns. Investors can sell their shares in the company at high prices, once the company stocks start increasing. They can also receive dividends, depending on the performance and profitability of the company. Stocks are highly volatile, and the economic and political environment in a country can cause price fluctuations.
Financial markets are where people trade their financial securities. The markets give people a chance to use their savings to buy investments. Other than securities, investors use financial market to trade in commodities such as gold. Financial markets can be primary or secondary. Anyone selling securities for the first time does so in the primary markets. The investors purchase securities directly from the institutions offering them. Primary markets issue securities in different ways, including initial public offerings, rights issues, and preferential issues. Investors trade their securities in the secondary markets. It is the most common market, and it is commonly referred to as the stock market. It includes the New York Stock Exchange, NASDAQ, the American Stock Exchange, and the foreign and regional stock exchanges. Other markets include bonds markets, money markets, derivatives markets, insurance markets, futures markets, and foreign markets.
The financial markets have made it convenient for buyers and sellers to meet. They enhance trade as they expose the investors to different types of investment. This leads to wider distribution of resources and enhances better resource allocation (Wurgler, 2000). Advancement in technology has led to changes in the financial markets. It has led to the development of electronic communications network, which enables the traders to trade online in a virtual market. Many investors choose to use the services of brokerage firms, which trade on their behalf. Financial markets contribute to economic growth by helping investors make sound investment decisions. Investors buy and sell shares when the prices are right. The market prices help the investors in knowing which investments they should invest in, and which ones they should avoid.
Developed countries are able to maintain high GDP because of investing in their stock markets. They increase investments in their growing industries instead of wasting them on declining industries. America has capitalized on this system. It began as a small country with a small population and a poor economy. Over the years, it has identified which industries are worth investing in, based on the growth of these industries. For instance, it has invested in the development of motor vehicles, agriculture, technology, and even weapons, depending on the performance of these industries at the time. This has enabled it to become the country with the largest economy in the world (Wurgler, 2009).
There are different financial institutions in the country, and they include depository institutions such as commercial banks, saving banks, credit unions, and internet banks, and non-depository institutions that include insurance organizations, brokerage firms, mutual funds, and other finance companies. Commercial banks offer many services. They do not have high deposit interest rates or low loan rates. This dissuades many potential and existing customers to use the services in the banks. Saving and loan institutions attract many people because they offer slightly higher interest rates on deposit and lower interest rates on loans, than commercial banks do.
Credit unions are not for profit institutions. They are a better alternative to commercial bank and savings and loan institutions because of the high deposit interest rate and low loan rate. They have undergone numerous changes over the past years, and these changes have been enhanced by changes in technology. Many financial institutions have introduced electronic banking, which enables users to conduct their transactions online. Financial institutions, banks, and other industry players set the regulations for the financial systems. Financial institutions with high deposit insurance can afford to take more risks (Barth et al, 2004)
Influence of Financial Institutions and Markets on the Economy
The stock market and financial institutions, especially banks influence the country’s economy considerably. The two of them often collide, as they represent different customer interests. Banks represent those who choose to save their money while the stock market represents those who want to invest. If people choose to invest their money, they will have less money to save, and this will affect banking institutions. If people choose to deposit their funds in the banks, then they will not have enough currency to buy any securities or to invest. These conflicting situations have both negative and positive effects on a country’s economy. Other than seeing the banks and markets as different entities, some people have chosen to see them as necessary units that complement each other. Both of them influence economic growth and factors such as inflation, political governance and trade influence how they do this. However, they each determine economic growth in definite ways (Beck & Levine, 2004).
Financial markets and financial institutions have mostly had a positive impact on the country’s economic growth. The two have significantly enhanced efficient resource allocation, ensuring longer lasting economic growth. The improved resource allocation occurs as investors increase and spread their investment in different sectors of the economy (Beck & Levine, 2004). Increase in investment can have a negative impact on the country’s economy. As more people invest, the number of people who save reduces. Increase in savings can lead to increase in investments since people will have more money to use. Banks enhance the financial markets. They provide loans for investors to channel their funds and purchase investments. They take the role of risk managers and financial intermediaries when they issue the credit to interested investors. Investment and merchant banks act as financial intermediaries between the issuers and the purchaser of the securities.
Role of regulations in the finance system
Investors are worried about their assets and investments. The recent financial crisis disadvantaged many people after many investors lost their money. Some banks failed, and they had to be bailed out by the government. Such incidences are not unique to the American economy as they happen in other countries as well. When banks fail, other financial institutions also fail. This affects the consumers negatively as they lose their savings (Barth et al., 2004). The government has found it necessary to protect consumers, and this has compelled it to regulate banks and other financial institutions. There is high competition between banks and this has led them to engage in practices that put those who deposit the money at risk. Such practices include offering many loans and mortgages to customers. When the customers default on the loans, the banks are forced to repossess their securities. This affected many people especially in the financial crisis experienced in 2007/2008.
Many people lost their homes because they had taken mortgages, which they were unable to pay. Non-depository institutions such as insurance organizations, mutual funds, and pension funds are not exempt from the regulations. Some people do not support the idea of regulations claiming that it is a hindrance to development. Regulating financial institutions will increase the hurdles that a person will go through before securing a loan. Many people will avoid taking loans and mortgages because of this. It is paramount and more effective if governments regulate financial institutions. Many institutions oppose this, and they call for self-regulation. This has failed to work in the past, mostly because of lack of enforcement. Regulations will ensure that financial institutions do not deviate from their duties after diversifying their services. If banks engage in more activities such as investment, they will take more risks, which will put the consumers at more risk as consumers do not often have the necessary information to make financial decisions. Failing to monitor the banks will present a situation when the institutions become too large and complex to monitor (Barth et al., 2004)
Markets do not always make the right decision, and this can lead to the misallocation of resources. In an aim to capitalize on the available resources and maximize profitability, they make decisions such as credit expansion, investing all their money on a single asset, company, or sector, which end up hurting the investors. Regulations ensure a reduction of such incidences. Granted, some market securities such as stocks are high-risk investments, and brokerage firms may be compelled to invest in booming industries at the time. When such a venture fails, the investors who had used the particular firm will suffer as some will lose money. The government has established laws that govern market trading, and these laws protect the company and the investors, especially in the primary market. Operations in the secondary markets are different because they involve investors trading with each other. Trading is a matter of risk and intuition, and investors are free to make their choice.
The regulations have affected all sectors of financial institutions and markets. Before trading in derivatives, dealers should have enough derivatives before making transactions. This will force them to make tough decisions such as quitting the business if they do not have enough volume. They will trade the derivatives on exchanges contrary to the previous practice of trading over the counter. This will make it more expensive to trade as firms will have more expenses to incur. The regulations also ban proprietary trading except when it is undertaken by the government. This will affect the firms that deal in proprietary trading. Under the regulations, firms have to increase their capital so that they can deal with any challenges that may occur. This resulted from the government having to bail out many institutions and companies during the previous recession. Capital markets have to increase their capital adequacy. These changes will affect the institutions greatly, and it will cost them a lot of funds in the end in terms of lost revenues and increased operational expenses. Some companies will have to shut down if they cannot conform to the regulations.
The American financial system is more market based than bank based. Financial institutions and markets are indispensable components in the financial system. They seem to play contrasting role, in that while institutions encourage people to save money, markets encourage them to use the money for investment purposes. However, the two complement each other in that greater savings lead to opportunities in investment. Returns from investments lead to investors taking their money to the banks. There is a need to regulate the markets and institutions, to protect consumers from financial crisis. Regulations will be costly to the markets, firms, and institutions affected because it will lead to realized loss of revenue and increased operational costs. Many institutions oppose regulations citing the fact that it hinders development.
Barth, R. J., Caprio, G., & Levine, R. (2004). Bank regulation and supervision: What works best? Journal of Financial Intermediation 13, 205-248
Beck, T., & Levine, Ross. Stock markets, banks, and growth: Panel evidence. Journal of Banking & Finance 28, (3), 423-442
Stiglitz, E. J. (2000). Capital market liberalization, economic growth, and instability. World Development, 28, (6) 1075-1086
Wurgler, Jeffrey. (2000). Financial markets and the allocation of capital. Journal of Financial Economics 58, 187-214.