Understanding the financial system

Understanding the Financial System

Sam Choon Yin

July 2004


1. Introduction

A country’s economic development depends on many factors, one of which is the quality of its financial system. The financial system connects the borrowers and lenders in the country, the former being those individuals who are in need of funds or capital while the latter comprise individuals who have excess funds. They trade in financial instruments like shares and bonds in the financial markets. In some cases, the financial institutions provide the middlemen role in connecting the borrowers and lenders.

Having a well develop financial system is undoubtedly essential to promote smooth transfer of capital from one party to another. But it is important to define exactly what it means by a well develop financial system. Is it one which allows free flow of capital from one country to another? Is it one which must be heavily regulated by the government, to see that the financial crisis does not occur? If this so, what are the specific areas which the government should lay its hands on? The Asian crisis which hit the region in mid 1997 reminded us that answering these questions is not easy but a very essential one.

I do not pretend to be able to provide correct answers to the above questions. Instead, my purpose of writing this essay is to provide an understanding of the financial system. Even doing so is not an easy task because the financial system comprises many big issues. I should therefore lay down before hand the topics which I will be examining in this essay. In Section 2, I will briefly highlight the reasons for studying the financial system. This will lead me to exposit the Asian crisis in Section 3 and the essentiality of liberalizing the financial sector in Section 4.


2. Why study the financial system?

Many books have been written about the financial system. We have books on the financial institutions, the financial markets, monetary policies, money, business finance, corporate finance, international financial management and derivatives (to name a few), all of which are related to the financial system. These are specific topics meant to provide the individuals specific knowledge about the financial system. With the outbreak of the Asian crisis, books and articles on corporate governance and financial crisis are also growing in number.

Some of these topics are micro in the sense they deal with a specific function in a typical organization, namely the finance function. The finance managers are responsible in seeing that the firms they are affiliated to are able to acquire the necessary funds and use the funds in the most efficient and effective manner. A typical firm could acquire funds through the issuance of equities (for public listed companies), or they could borrow directly - and thus incur debt - from the public or financial institutions say by issuing bonds. Determining the optimal equity-debt ratio is one of the main challenges facing the finance managers.

It is also important that the finance managers are able to provide good advice in terms of how the funds acquired are to be used. In this respect, it is useful for them to work closely with other departments to arrive at the most optimal decisions. For example, it is useful for the finance and operations managers to determine the optimal stock positions that the firm should hold. While the finance may be reluctant to hold much inventories because doing so essential dries up the cash position, the operations side may want to hold more inventories to guard against uncertainties in demand, supply and lead-time. Books on business finance, corporate finance or financial management provide useful knowledge to see how these issues can be dealt with.

At the macro level, the financial system could decide how well the country’s resources are allocated. In Economics, the Pareto efficient is reached when it is no longer possible to allocate the resources such that one is better off without making another worse off. In this respect, the ability to transfer resources from lower return businesses to higher return activities promotes the attainment of Pareto efficient. For example, through the financial system, the lenders would offer rates higher than what they might earn if they ‘deposit’ the funds elsewhere. Of course, the borrowers must also ensure that the funds used could earn returns exceeding the cost of capital. A good financial system essentially broadens the access of funds. Today, funds could be transferred from within the country and across borders relatively easy.

A good financial system could also raise the country’s national income. The reason being that those needing funds could attain the necessary funds because of their ability to generate higher returns, albeit forecasted, while those who have excess funds are willing to lend them. Households may decide not to delay their consumption any further and thus go ahead with the purchase of consumer goods. Investors too may be able to obtain the necessary funds to make purchases for investment goods to further support their production. Increments in consumption and investment will accordingly raise the country’s national output or gross domestic product by a multiplier effect.

However, some have cautioned the use of GDP as a useful measure of standards of living. The measure for example focuses exclusively on the production of goods and services with no attention paid to the issue of income distribution. While the ‘pie’ may have enlarged, the standards of living of the general population could not be said to have improved if the rich are the ones acquiring the excesses. Also, increments in the GDP may be attributed to an increase in government expenditures on defence related goods. Should we be pleased with the recorded higher GDP in this respect? Not likely if people are fearful about upcoming war that the country may be participating. Moreover, social indicators like the life expectancy, infant mortality rates and literacy rates should be taken into consideration in measuring the standards of living.

The other problem relates to the outbreak of financial crisis which some observers believed could have been attributed to the rapid liberalization of the financial sector. The next section discusses this point with reference to the Asian financial and economic crises which hit the region in mid 1997.


3. Asian crisis

Prior to the Asian crisis, liberalization of the financial sector was strongly promoted to bring about the above-mentioned ‘positive’ macro effects. But overzealous banking provided numerous funds to the borrowers which were mainly channelled to the property sector and security market. Funds were readily available domestically and from abroad. The lenders from abroad were willing to lend in view of their interests to diversify the risks. Investors from the US for example might have found investing in the emerging markets in Asia to be worthwhile because of the not-so-strong correlation between the returns in the US and those from Asia. The foreign investors therefore were willing to invest at offer funds to the Asian markets at relatively low rates. These funds are attractive to the Asian borrowers, like the financial institutions, to acquire.

Generally, there was the perception that the Asian borrowers would be able to make use of the funds properly and repay the loans. It was also perceived that the government would be accountable to their domestic funds. The lenders were confident that they would be able to recover the loans, as the government would bail out any failed corporations.

The government therefore is thought to be at fault, first, for failing to detect the problem of over borrowing at an early stage and resolve it. Second, the government might have given the impression to the lenders that the private corporations would be bailed out should they fail to repay their debts. The perceived guarantee essentially reduced financial cost and made economic agents in private corporations more willing to take unhedged risks. 

When the bubbles burst in the property and stock markets, many financial institutions found themselves holding large non-performing loans. The firms were not able to repay their loans thus jeopardizing the financial institutions from not being able to recover the funds lent out. Other financial institutions which have lent to other financial institutions were also worried. As such, the institutions ‘panic’. There were rapid withdrawals of funds both by domestic residents and foreigners. The herd instinct soon prevailed with the countries’ economic fundamentals appeared to be of secondary importance. The supply of domestic money increased. To maintain the ‘fixed’ exchange rate applied then, the governments in the crisis-hit countries must buy over the domestic currencies with the foreign reserves. While most of them were enjoying balance of payment surpluses (despite facing current account deficits, the inflow of capital and thus surpluses enjoyed in the capital accounts were sufficient to outweigh the current account deficits), there was a limit as to how much foreign reserve they could afford to supply in absorbing the local currencies. When it was not feasible to do so any longer, the government, started off with Thailand, floated its currency, leading to a rapid devaluation of the Thai baht. Other currencies like Korean won, Malaysian ringgit and Indonesian rupiah soon followed.


4. Should the financial sector be liberalized?

According to Raghuram Rajan and Luigi Zingales (2003), opening up the financial sector is inevitable because of technology advancement. Competition from outside could potentially break down any attempts to block the flows of capital from one place to another. In their book, Rajan and Zingales (2003) discussed how some states in the US have disallowed out-of-state banks from opening branches so that existing in-state banks could remain profitable despite being less efficient. But this soon changed when technology improved. Advancement of technology allowed banks to borrow and lend at a distance. Local governments could not limit this competition because they had no jurisdiction over it.

Developing a good financial system allows broader access to funds around the world. The resulted competition boosts financial and economic growth as enjoyed in small countries like Hong Kong, Luxembourg and Switzerland. In Malaysia for example, liberalization of the financial sector was deemed necessary in conjunction with the government’s intention to let the private sector in driving the country’s economy but this comes with a price. As Mahani Zainal Abidin noted, ‘the decision to liberalise the economy and to make the private sector the engine of growth had made the economy more flexible and competitive, and these features together had attracted foreign investment and expanded our export markets….the economic structure was so closely integrated with the world economy that Malaysia was vulnerable to external vagaries, including sharp changes in market confidence, and these later proven to partially cause the (Asian) crisis’ (Mahani, 2003, p. 326).

Having a good financial system is undoubtedly essential although care must be taken to see that the process is not undertaken too hastily. Chen (2000) provides a good discussion on these issues. He mentioned the essentiality for countries to sequence the financial liberalization process like the approach popularised by McKinnon (1991) and warned the importance of reforming the institutions. In the former for example, distinguishing between portfolio investment and foreign investment may be useful (with some controls applied to limit free flows of short term capitals at least in the short term). The latter could include reforming the accounting and legal systems, strengthening the managers’ skills, improving the dissemination of accurate and timely information and raising the standards of corporate governance. While these are applicable to all countries, one should not be overly concerned in applying the same standards in all countries. Every country has its unique system and informal institutions (including beliefs, culture and values). What a country needs therefore, are effective and efficient public officers to initiate the reforms and see that they are carried out thoroughly and effectively. The quality of governance thus matters.



Chen, Edward, 2000, The Asian Financial Crisis of 1997-98: A Case of Market Failure, Government Failure or International Failure? In Brigitte Granville (editor) Essays on the World Economy and its Financial System, Royal Institute of International Affairs, Great Britain.

Mahani, Zainal Abidin, 2003, Economic Governance in Malaysia and its Links with the Asian Crisis, in Yasutami Shimomura (editor) The Role of Governance in Asia, Institute of Southeast Asian Studies, Japan Institute of International Affairs and Asean Foundation, Singapore.

McKinnon, Ronald, 1991, The Order of Economic Liberalization: Financial Control in the Transition to a Market Economy, The John Hopkins University Press, Baltimore, MD.

Rajan, Raghuram and Luigi Zingales, 2003, Saving Capitalism from the Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity, Crown Business, New York.