Chapter 10: Financial Markets
Chapter One
Introduction
1.1 Background of the Study
Financial institutions, particularly banks, play a pivotal role not only in funding various
economic activities but also in managing a broad spectrum of financial services. For researchers
and analysts focused on financial performance, enhancing this performance is key to advancing
financial operations. The evaluation of financial performance within these institutions is highly
developed, reflecting their integral role in a robust financial system. These institutions facilitate
capital flow and support the money markets within a country.
A bank functions as a financial intermediary by accepting deposits and reallocating these funds
through lending. Banks are essential pillars of the financial system and actively participate in
financial markets. Their primary function is to bridge the gap between capital providers—such as
investors and depositors—and capital seekers, including individuals requiring loans and
businesses aiming for expansion.
However, banks face various risks that can sometimes lead to widespread financial instability.
These risks include liquidity risk, where a surge in withdrawal demands may exceed available
cash reserves; credit risk, which involves the possibility of borrowers defaulting on their loans;
and interest rate risk, where fluctuations in interest rates might cause banks to incur losses if the
cost of deposits surpasses the income from loans.
Historically, banking crises have erupted when these risks materialize on a large scale. Notable
instances include the bank runs during the Great Depression, the U.S. Savings and Loan crisis of
the 1980s and early 1990s, Japan's banking troubles in the 1990s, and the subprime mortgage
crisis in the 2000s. In many cases, governments intervene with rescue packages or direct support
to stabilize the banking sector.
Definition: A financial market is a platform where financial instruments like shares, debentures,
bonds, and government securities are created and traded. It consists of a network of institutions
that facilitate the provision of funds across short, medium, and long-term durations.
Financial markets enable the smooth transfer of capital from investors to entrepreneurial
borrowers by connecting those who have funds to lend with those who need to borrow.
Fund Allocation: Funds can be allocated through two main channels: banks and financial
markets.
Household savers can deposit their extra funds in banks, which then lend these resources
to businesses.
Alternatively, savers may directly invest in financial markets by purchasing shares and
debentures issued by companies. Both banks and financial markets act as competing
financial intermediaries.
Key Functions of Financial Markets:
Mobilizing Savings: They gather savings and direct them toward the most productive
investments, offering investors a variety of options to deploy their surplus funds
effectively.
Price Discovery: The interaction between investors and businesses determines the prices
of financial assets based on supply and demand dynamics.
Providing Liquidity: Financial markets allow assets to be quickly converted into cash by
facilitating easy buying and selling.
Reducing Transaction Costs: By providing a centralized platform, financial markets
minimize the time and expenses involved in trading securities.
Classification of Financial Markets: Financial markets are broadly divided into two categories:
Money Market: Deals with short-term funds.
Capital Market: Handles medium and long-term funds.
Within these, the capital market is further segmented into:
Primary Market: Where new debt and equity securities are issued.
Secondary Market: Where existing debt and equity securities are traded among
investors.
Summary Diagram:
Financial Market ├── Money Market (Short-term funds) └── Capital Market (Medium &
Long-term funds) ├── Primary Market (Debt & Equity issuance) └── Secondary Market
(Debt & Equity trading)
