The Role of Financial Institutions and Markets

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The Role of Financial Institutions
in Financial Markets and Financial Crises

1.

The Financial Market and The Recent Financial Crisis
1

2.

Financial Institutions
3

2.1
Types of Financial Institutions
3

2.2
The Role of Financial Institutions in the Financial Markets
4

2.3
The Role of Financial Institutions in the Financial Crisis
6

3.

Conclusion
7

1. Financial Market and Financial Crisis
Technology, globalization, competition, and deregulation all have contributed to the revolution of worldwide financial markets and the creation of an efficient, internationally linked market. However, these developments have created potential problems (Brigham 1995: 111). As the worldwide financial crisis, which started in the early summer of 2007 in America and spread globally, still shapes the headlines of newspapers and the political agenda of developed countries. These recent economic developments drew back societies’ attention to the importance of the world economy and financial markets. A financial market is considered as “a market in which financial assets [..] can be purchased or sold” (Madura 2012: 3). Here, any kind of marketplace, where buyers and sellers participate in the trade of financial assets such as equities, bonds, currencies and derivatives, is meant. Mostly financial markets have transparent pricing, basic regulations on trading, costs and fees, and market forces that determine prices of securities that are traded. There are three relevant classifications of financial markets in the context of the financial crisis: money versus capital markets, primary versus secondary markets, and organized versus over-the counter markets (Madura 2012). The money versus capital market distinguishes in various points: The money market is only short- term oriented, a maturity of less than one year, and the trading objects are referred to as money market securities, which are debt securities. These have a “high degree of liquidity” and therefore offer a low return; however, they are less risky (Madura 2012: 5). In contrast, capital markets promote the sale of long-term securities, called capital market securities, which are most often bonds, mortgages and stocks. These are often bought with the intention of financing the purchase of capital assets such as buildings, equipment, or machinery. Capital market is composed of primary markets and secondary markets: In the primary market only the trade of newly issues securities occurs, whereas in the secondary market previously issued - so existing - securities are traded (Madura 2012). The organized versus over-the counter markets differentiate in the location factor. Whereas the organized markets represent true visible marketplaces, where member meet to trade and securities are listed like the New York Stock Exchange, the over-the-counter markets are a wired network of dealer, which do not need a central and physical location to trade, because it is a direct trade between the two participants (Madura 2012). Telecommunication and Internet allowed businesses to trade all over the world in every financial market. However, this global interconnection of financial markets also has its side effects as the fall of the Lehmann Brothers and following economic developments have shown.

In 2008 and 2009 there has been a worldwide crisis in the international financial markets, which has lead to an extreme high number of credit defaults and amortizations on speculative assets of banks and financial institutions. The financial crisis has been triggered by the lending practice, the insufficient collateralisation of mortgages and securitization of credits in the real estate market in the United States of America. The speculation on rising real estate prices bursted and risky bonds lost their value dramatically. The financial crisis developed to a liquidity crisis, because the credit lending of banks, which are equipped with...
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