Banks and stock markets are a major part of a country's financial system playing an important role in facilitating commerce. In most cases, the two subsectors take the biggest share in terms of the assets as compared to any other sector. Besides their various functions, they facilitate the development and growth of an economy through creation of employment and contributing to the investments (Hoggson, 1996). They facilitate the development of an economy in the following ways.
Capital formation
Banks promote the formation of capital through accepting deposits. Businesses and persons access these deposits inform of loans that they use as additional capital to expand their operations. Through this, they provide financial resources that are necessary for the development of an economy and act as the store of the country's wealth. The deposits earn a percentage of interest rate in proportion of the principal deposited. As a result, depositors increase their capital as they earn the interest. This also applies to the individuals and firms, who take loans from the bank (Mishler & Cole 1995, p35).. The loans disbursed are subject to interest rates and are payable together with the initial principal thus building a bank's capital base (Abeid 2009, p9). In most cases, banks provide short to medium term financing in form of debt.
On the other hand, stock markets accumulate capital for use by companies in form of debt and equity for long-term ventures. In the past one decade, the value of the listed stocks in the stock markets worldwide have tremendously increased from $4.5 trillion to $15.4 trillion, while the market capitalization has increased from by 14%. Trading in the emerging markets has also surged with the total value of shares traded rising from less than 3% in 1995 to 17% in 2005. The upcoming markets have attracted international investors' interests affecting the development of the economy positively. The primary role of stock market in facilitation of economic development is through channeling mainly long-term capital into businesses.
Efficient Capital allocation
Banks offer new investment avenues to investors who are risk averse in line with the profitability/attractiveness of their investments. This means that the most profitable sectors are first given priority. Through offering timely credit, the economy's productive capacity is increased and the available resources are utilized in an effective way. They provide short, medium and long-term loans, which helps entrepreneurs to diversify their investment through adoption of customized production methods (Bożyk 2006, Larry 2000).
The above is similar to stock markets only that in the latter, there are various forms of financing not restricted to debt only. Efficiency is a critical factor considered by large-scale investors when making investment decisions to maximize their return on capital. Due to the concept of maximization, there is large-scale flow of capital towards the companies perceived to offer good returns by managing available resources to realize good profits. Those companies perceived not to be profitable and are ineffective in resource management have to try to be efficient to remain competitive or disappear from the marketplace (Leffler, 2005 Marc, 2003). This behavior of profit maximization by stock market investors is useful in promoting business growth, generating wealth and creation of employment (Peters, 1994). All these factors contribute towards the economic development of the country.
Expansion of trade and industry
Banks promote the expansion of trade and industry at both local and international level. They offer a variety of payment methods including checks, credit cards, and letters of credit that enhances safety in transactions. The use of checks minimizes the risks associated with carrying real cash. Credit cards facilitate effective payments of bills and letters of credit hedges importers and exporters in their transaction on preventing defaulters from either. They offer bank overdrafts as a short-term loan to finance individuals and enterprises in their transactions. This has led to a revolutionized trade and industry both nationally and internationally (Abiad & Oomes, 2008).
Similarly, companies raise additional capital through issuing of securities in stock market for them to be able to finance their ongoing activities and expansions. Company expansions commonly generate additional jobs to help in maintaining the expanded operations. This leads to higher levels of employments generating higher levels of consumer spending.
The multiplier effect
This is also true for banks as it is for stock markets. Individual's rational investment decisions direct money towards the promising businesses to realize greatest economic benefits. For Instance, when an individual buys equity of a particular firm from a stock market, he or she gains partial ownership of the company that is selling the stock. The firm has funds to finance its current projects and future expansions. The firm therefore maintains its employees who in turn spend their money on education, purchasing consumer goods, home mortgages among others (Elton, Gruber &Brown, 2003). This shows how individual contribution towards economic development is achieved through the stock market mechanism. The firm takes the investors' money to finance its operations and on the hand, the investor waits for the return (Fama 1976). Investor uses his or her return for personal development and growth of the country as a whole (Ingham, 2004, Larry, 2000). Banks will also advance credit to the customers who promise the highest return relative to their risk level. Through this efficient allocation, they enhance efficiency of the economy which adds to the multiplier effect.
Development of agriculture
In most developing countries, a significant proportion of the population survives on agriculture. The provision of credit by banks to farmers has led to the development of agriculture as well as small-scale industries related to it. Farmers are able to boost their agricultural productivity after accessing loans from banks to buy farm inputs and other farming equipments necessary for effective farming (Finlay, 2009).
Development of agriculture has not been facilitated largely by the stock exchange as has been by banks (World Bank, 2010). The only direct effect that agriculture has come to benefit from is through infrastructure bonds whose proceeds have been used to develop rural infrastructure to support it. This is because of the long-term nature of agricultural returns and their high level of risk. Banks have stepped in to serve this market due to their adequate knowledge of the local conditions.
Balancing development of different regions
The banks play an important role in balancing development of different regions in the country. They help to transfer surplus capital from stabilized regions to less developed regions within the country. Industrialists and traders from less developed regions are able to get adequate finance to meet their business needs. This enhances effective utilization of their available resources, thus increasing trade, investment and productivity of an economy. The less developed regions are able to grow economically, provide employment and improve its standard of living due to the transfers of funds facilitated by the banks.
Similarly, federal agencies raise capital to undertake very long-term projects from the stock markets aimed at opening up remote regions. Such ventures may not be attractive to the private sector and thus the government steps in to undertake them. Governments specifically benefits from the issuance of bonds and treasury bills. Bond sold through the market helps the government to borrow funds from the individual and corporate investors. Investors receive regular payments of the interest either semi-annually or annually depending on the coupon rate and payment (Merton, 1992). The government uses the funds generated from the sale of bonds and taxation to finance its long-term projects including roads maintenance, public services, education, and loans for higher education among other expenditure. These are very long term and risky projects that ordinarily carry very low return hence unattractive for private investors (Pilbeam, 2010). The government sweetens the deal by absorbing the risk (Groz, 2009).
Regulating Economic activity
The banks influence the economic activities of a country through the effects interest rates and availability of credit. When banks increase the circulation of the money in to the public through credit creation, citizens buy more and companies are able to produce even more. When a bank offers high interest rates on deposits, people are motivated to invest in a bank since it carries minimal investment risk. This will mop up excess liquidity in an economy. On the other hand, people will borrow more to finance their projects when interest rates are low and thus encouraging investment. The activities of credit creation raise the aggregate demand leading to a more productive economy.
This is similar to stock markets in the sense that the central bank may opt to mop up excess liquidity in the market by launching of bonds, attracting foreign direct investment to buy local securities etc. however, banks play a more critical role in ensuring credit flows to the common man so that aggregate demand is not decimated.
Implementation of monetary policy
Banks facilitate monetary policy implementation. Central banks regulate and control the circulation of money in an economy curb inflation and money laundering. To this end, central banks issue treasury bills and bonds to reduce the money held by the public and taking money back to the treasury. When the government is holding excess money in its treasury, it lowers the interest rates on treasury bills to encourage the public to borrow more. Through this mechanism, central banks are able to control the movement of money within the country. The volume of credit is in control through the active cooperation of the central banks and the banking systems. They help in establishing price stability and promoting economic growth in short periods. As compared to banks, the stock markets are less critical and only reel from the effects of the monetary policy so implemented, more so in developing countries. They only respond to the effects of the monetary policies implemented by central bank through commercial banks.
Export promotion cells
In many countries, banks establish export promotion cells with an aim of increasing exports. They offer information regarding the general economic conditions and trade both locally and internationally to their customers. Through this, they participate positively in contributing towards the economic development process and enlightening its customers on the opportunities presented in the export and import business. Similarly, stock markets facilitate international trade through foreign direct investment where investors pour in capital to the home country. They also provide information on the aspects of home economy to prospective investors prompting them to invest in search of better return.
Economic monetization
Banks have contributed progressively to economic monetization. They have opened branches in backward and rural areas that have facilitated the exchange of good in terms of monetary value rather than on barter trade. They are convert barter economy (non-monetized sector) into a monetized economy and facilitating the use of money that has greatly increased the volume of goods production as well as the efficiency of the market.
Equally, stock markets create extra liquidity in an economy. Liquid stock market creates a less risky and attractive investment as it allows investors to acquire assets and sell them at will to convert them into cash if need be. This is because most of the profitable investments need long-term capital commitment but most investors are unwilling to relinquish control over their savings over a long time. On the same note, firms take advantage of accessing a permanent source of capital raised during equity issues. Liquid markets through the facilitation of profitable and long-term investment improve capital allocation and facilitate long-term economic growth by provision of capital. The market leads to more investments because they make investments more profitable and on the same time less risky meaning investors comes as they leave.
Empirical evidence strongly supports the notion that the greater the market liquidity, the greater its boosts on economic growth. One commonly used measure in determining the liquidity of a market is the total value of traded shares on stock exchange as a portion of GDP. The ratios do not measure directly the costs of acquiring or selling securities at any posted price. There is variation in the equity transaction value as portion on national output average over the long-term. Countries which had liquid market in 1976 tended to grow with a fast pace over the subsequently 18 years than those countries which had illiquid markets. Multiple regression measures show that that liquidity of stock market assists in predicting economic development even after considering a range of non-financial features that control economic development. After control of fiscal policy, inflation, education, political stability, legal system efficiency, policies of exchange rate, and honesty to international trade, liquidity of stock market is still a dependable indicator of determining the future long-term economic development.
Championing Technological advancement and globalization
Commercial banks and stock markets no longer restrict themselves to the local banking and finance. They have greatly shifted towards global trends in finance. This means they are using the latest banking and information technology, understanding global customers, competing in open market using high technological systems and changing domestic banking into investment banking. They are being considered as the central nervous system for attaining an economic development of a country through globalization (Copeland & Weston 1988, p5).
Critique of the role of the two in transitional economies
In transitional economies, stock markets and banks have contributed greatly towards the development of the country's economy. The development of stock market plays a major role in transforming a developing economy to the integrated system of global finance and economics now that capital flows across borders is less burdensome with technology (Valdez, 2006 Boldizzoni, 2008). Stock market having high liquidity states enable companies to acquire the needed capital easily thus facilitating capital allocation, growth and investment (The Business Finance Market, 2008). Take for instance the Nepalese context. As a transitional economy, its government started moderate economic policies since 1980's and their financial system has gone through rapidly structural changes during the last two and half decades. The country's stock market has mobilized the domestic saving and allocation of the funds efficiently (Sophastienphong & Kulathunga, 2010).
The Nepalese financial system is mainly bank-dominated and its stock and capital markets are not fully developed. The banking institutions appear to take the major share of the financial intermediaries. Even though the Nepalese stock market is relatively small, thinly traded and illiquid, its implication towards the economy is highly experienced. The stock market has offered opportunities to Nepalese investors to venture into the equity that generates good returns in a way that banks have not (Sophastienphong & Kulathunga, 2010). Information is readily available to these investors to make informed decisions on how they can maximize their wealth. Through this, the market provides a channel towards achieving financial independence of the people in this developing economy.
In the stock market, there is movement of fund from those with surplus fund and directed towards those with shortage of funds (Mishkin, 1998). As a result, the party that is borrowing the funds for business expansions is able to utilize the available resources it posses in the most effective way and thus generating significant revenues (Hassan & Hunter, 2004). As seen in the Nepalese stock market, firms have raised additional capital in issuing of equities to facilitate their expansions. This has resulted in creation of jobs, as the firms need human resources to cater for added activities reducing the employment rate of the country (Davidson, 2002). Consumer consumption has risen because people are having disposable income to buy essential goods and services they require. The impact is that there is improved economic stability and development of the transitional economies.
Stock markets in the transitional economies have enabled governments to supplement its revenues from corporate taxes by issuing of bonds to the public. The government of Nepal has greatly benefited from this in it quest to achieve its economic goals. The country's infrastructure has been improved, provision of education, and improved living standards through provision of essential social amenities like water and electricity among others through capital raised through its stock market. The stock market is particularly important because it reallocates capital to different economic sectors providing a way for a continued economy restructuring needed to support a transitional economy. Banks in Nepal have played a facilitative role in the issuance process. Most of them buy the government securities in their own capacity just as individuals and corporate investors do (Sophastienphong & Kulathunga, 2010).
Banks contributed greatly towards the development of transitional economies and realization of the country's full financial potential. In most developing economies, banks consists of about 40% of the collectively resources of financial segment. They act as the immediate link between the government and the public in the transmission of the economic policies especially monetary policies. An example is when there is the scarcity of credit, expensive from the banks, there is spending reduction in the economy, and the employment rate tends to increase. There are also profound economic implications due to the fluctuation of the availability and the cost associated with the bank credits. If interest rate rises, the cost of acquiring credit also rises meaning the rate of inflation is high(Sullivan & Sheffrin, 2003). In such cases, firms run to the stock markets to access long-term capital(Sophastienphong & Kulathunga, 2010).
In Trinidad and Tobago, banks form one of the most essential financial intermediaries towards the development of the country's economy. The banks solve the asymmetric risk problem encountered by most of the groups in the country in accessing credit for their developmental needs. Borrowers and depositors are different people with different levels of risk preference. The banks solve the information asymmetry problem by offering loan contracts. Businesses, consumers and government apply for the bank loans in various forms to meet their developmental objectives (Townsend 2006, Townsend 2009).
Trinidad and Tobago has Banks that boast a modern and refined financial structure (World bank, 2010). They come in terms of various institutional mixes with available ranges of financial instruments. They are fundamental institutions in the financial system of the whole country as compared to credit unions, developments banks, stock exchange, and mutual funds among others. Banks in this country are the largest providers of loaned funds and mobilize the savings that enhance future economic independence of its citizens. In terms of the total assets, they account for over 50% in the whole financing system far more than the half of domestic economy financial saving(World bank, 2010).
This shows their critical role of driving the country towards achieving its economic development goals. They perform financial intermediation whereby they source deposits or funds from the public and then lend them to other individuals or institution for productive financial activities and for financial consumptions. Through this, they help in determining the efficiency degree of the functions of the entire developing economy. Banks have specialized in assessing the potential borrowers and thus reducing the cost of acquiring credits. They also process information regarding the potential projects and firms assisting to overcome the duplication and overriding of information problems(World bank, 2010). However, in countries such as Kenya, banks have been criticized for charging high interest rates as to choke economic development as compared to the stock market (World bank, 2010).
As banks and capital markets ease the information friction between borrowers and savers, capital accumulation and saving increases in an economy(Teall, 1999). They also foster efficient resource allocation and innovation through identification of most worthy firms and projects to invest. As they pool together saving, they reduce the liquidity risk by investing in long-term and short-term securities transforming savings maturity and facilitating the long-term commitment of resources towards investment projects. Banks allow the sharing and pooling of risk by reducing transaction costs of individual investors. They provide channels for risk diversification resulting in shifts towards higher return projects. This indicates the important roles the banks and stock markets are playing in helping transitional economies to achieve its economic developments (Sophastienphong & Kulathunga, 2010).
