Christiene P. Schwandner

Financial Sector Defined

The financial sector is the interaction of markets and all therein, within a regulatory framework. This interaction usually entails lending and borrowing both long and short term. This is accomplished through financial intermediaries (banks and other financial institutions) providing a link between households, firms and governments in transferring funds from savers to borrowers, for consumption and investment purposes.

The main functions of the financial sector are :

1.) Mobilisation of savings: Financial intermediaries allow individuals to save money in a secure place, which when accumulated is lent to firms and individuals.- Risk management:  Financial Intermediaries manage risk by lending to a large number of borrowers. They are able to cover risk and absorb the defaults through interest earned on other loans.2.) Expert advice:  Financial Intermediaries are able to acquire information about competing investment opportunities and relay the information to individuals, reducing their information cost. This also aids in ensuring capital are allocated efficiently and to the right projects.3.) Monitoring borrowers: Financial intermediaries monitor the performance of firms, individuals and other borrowers.4.) Facilitating the exchange of goods and services: This is accomplished via the ability of financial intermediaries to reduce information and transaction costs, which spurs an increase in transactions.The informal sector includes economic activity which takes place outside the stipulations of markets. That is, they are not officially regulated.

Central Bank

The Central bank and other financial institutions play important roles in the financial sector.A central bank is a nation’s primary monetary authority. It wears the hats of, regulator (of commercial banks, building societies, merchant banks, financial houses and other financial institutions), lender of last resort (lends money to financial institutions, at higher interest rates), implementer of monetary policies (the management of money supply and interest rates), implementer of fiscal policies(through which it determines appropriate levels of government spending and taxation) and it also is a reserve(it holds a percentage of the total deposits, made to each financial institution).

Financial Institutions

Below is a list of institutions of note and their roles:Commercial Banks: These are institutions whose main objective is to raise funds. They accomplish this by accepting deposits (they usually have a variety of deposit accounts), using these deposits to make consumer, business and mortgage loans and also buy government securities and bonds.Credit Unions: These are non-profit financial institutions which are owned and operated by its members.  They offer services to members of a particular group; employees of the same firm, members of the same union, people who reside in a certain geographic area etc. They obtain funds called shares through deposits and use these deposits to issue loans and in some cases mortgages to members.Insurance Companies: These companies obtain funds from premiums which are paid annually or in instalments and provide protection to clients through life, health and automobile insurance among others.Mutual Funds: These are investment companies which raise money from selling shares to shareholders and invest these funds by buying stocks, bonds and money market instruments.Building Societies: These are institutions which raise funds through deposits and use the funds to issue loans, in most cases mortgages.            Development Banks: These are government owned institutions whose priority is to fund new and upcoming businesses which facilitate growth and development in all areas of the economy. They issue these loans either directly or through Approved Financial Institutions (AFIs). They also offer financial structuring and in the case of the Development Bank of Jamaica, also lead the privatisation of Government of Jamaica assets.    Stock Exchange: This institution provides a medium through which companies who are registered with the stock exchange board, can buy and sells stock and common stock equivalents in other companies.

Role of Financial Sector in the EconomyThe banks’ core business consists in intermediating between those who have financial means at their disposal, and those who are in need of funds.The first category of people lends money to the bank, which in its turn will use it for the funding of the second category.Customers (private persons/households, companies) can give their money to the bank ‘as a deposit’. In this way, they are lending their money to the bank so to speak, and in return, they receive interest. There are several types of deposit, such as call deposits, savings deposits, term deposits and certificates of deposit.Banks will then transform these deposits into credit for the funding of the needs of private persons and households, companies and the public authorities.Anyone who borrows money from a bank, will have to pay interest , because the bank offers a service by putting at his disposal a certain amount of money during a certain period of time.This kind of banking business allows for an optimal use of all funds, since the offer will meet the demand, and so it adds to the efficient organisation of the economy. However, a situation in which there is a perfect match between deposits and credits, is exceptional of course. So, this implies a transformation of deposits before they will become credits.By a change of scale: small deposits will be grouped together for the purpose of offering ‘big’ credit amounts. The funds provided by the thousands of savers in Belgium, taken separately, have no economic usefulness whatsoever. By putting those savings together, the bank will be able to transform them into credits and to provide funds to those who are in need of money.By a transformation over time: short-term deposits are transformed into medium and long-term credit.By a change of currency: in some cases, deposits labelled into a particular currency will be transformed into credits labelled in an other currency.Credit risk: the borrower may go bankrupt and lose his ability to reimburse. In some cases, it will be impossible for the bank to recover the whole of the credit amount.Liquidity risk: depending on the characteristics of their deposits, savers have the possibility to ask for their money at a particular point in time. However, at that moment, the bank must make sure that it will be able to reimburse its creditors.Interest rate risk: a bank has a certain interest rate margin it must try to keep at a positive level. This margin corresponds with the split between the yield generated by the credit interest rates and the cost of deposit interest rates. Anyone who borrows money, may opt for a fixed credit and hence for a fixed reimbursement amount all through the credit term. If the interest rate on deposits goes up however, banks cannot put the cost of this on the borrowers. So, the bank’s interest rate margin may become negative.