Financial Institutions For Capital Market Play A Crucial Role In The Economy.

Description of the Various Types of Financial Markets and their Role

Discuss about the Financial Institutions for Capital Market.

In the words of Clark & Monk (2013), the financial market describes any marketplace, in which the trading of securities like bonds, equities, currencies and derivatives takes place. The different types of financial markets and their associated roles are briefly demonstrated as follows:

As commented by Da Gbadji, Gailly & Schwienbacher (2015), the capital market is the place, in which the institutions and individuals are engaged in trading financial securities. The institutions and firms in both the public and private sectors sell securities in the capital market for generating funds. Hence, the capital market comprises of both primary and secondary markets (Gennaioli, Martin & Rossi, 2014).

The UAE government and corporations need capital to fund operations for involving in long-term investments. In order to raise capital, both the public and private sectors of UAE accumulate funds by selling stocks, securities and bonds in the names of the organisations, which are traded in the capital markets.

As remarked by Hilscher, Landskroner & Raviv (2016), the stock market enables an investor to purchase and sell shares in the public firms. The stock exchange is one of the most significant areas of the market, since it provides companies with an overview of the access to capital. In addition, the investors are provided with an insight of the portion of business ownership and the probability of gains based on the future performance of the firm.

In UAE, the stock market is composed of both primary market and secondary market. In the primary market, the new issues are offered initially with any succeeding trading occurring in the secondary market. The trades are conducted in the central locations of UAE like ADSM and DFM (Al-Tamimi, Miniaoui & Elkelish, 2014).

Ss indicated by Bhagat, Bolton & Lu (2015), over-the-counter market is a decentralised market, in which the physical location is not central and the participants in the market trade with each other via e-mail, telephone and electronic trading systems. In such a market, the dealers play the role of market makers by quoting prices of purchasing and selling any currency or security. Therefore, this market is less transparent compared to exchanges, since it is subject to lesser regulations (Fuller, 2016).

The purchasers of debt instruments are the firm suppliers and the debt instruments have limited lives or dates of maturity. The main advantage associated with the instruments of debt market is the contractual agreement coupled with legal rights to make payments. However, the drawback of this market is that the profit or return is limited or fixed.

Explanation of the Role, Importance and Functioning of Financial Intermediaries

In case of equity market, the owners of an organisation comprise of the common stock purchasers. In addition, the equity instrument, which is common stock, has infinite life or date of maturity. The main advantage of common stock is the higher rate of return, since the same is not limited or fixed However, the equity payments could not be made before the settlement of debts (Huat, 2014).

Figure 1: Types of financial markets in UAE

(Source: Knights & Tinker, 2016)

The financial intermediaries in UAE are engaged in the procedure of indirect finance and it is a better source in contrast to the security market. Along with this, the financial intermediaries are required for managing the cost of transactions and asymmetric information (Lovett & Malloy, 2014). For instance, Abu Dhabi Islamic Bank minimises its transaction costs through the development of expertise and take advantage associated with the scope and economies of scale.

Such low transaction cost would help the intermediary to provide liquidity services to its customers, which make it convenient for the customers in conducting their transactions. Abu Dhabi Islamic Bank (ADIB) gives its depositors checking accounts for easy bill payments (Adib.ae, 2016). Moreover, the depositors are entitled to receive interest on savings and checking accounts and they possess the ability to convert the same into products and services without liquidating and discontinuing investments. The low transaction cost of Abu Dhabi Islamic Bank helps in minimising the investors’ exposure to risk via risk sharing. For instance, the financial intermediaries in UAE develop and sell assets with smaller risk to one party for purchasing assets with higher risk from other party like the banks. This is the method of asset transformation, in which the risky assets are converted into risk-free assets for the investors.

According to the Board of Directors of the central bank of UAE with special reference to “Resolution No. 126.5.95”, it regulates the financial intermediaries in buying and selling of both domestic stocks and bonds. The intermediary needs to be an UAE citizen and the national shareholding need not be less than 60% of the overall paid-up capital for the firms. The amount of capital varies from 1-3 million Dirhams based on the activity scope, which the intermediary aims to conduct.

The following are the risks associated with Abu Dhabi Islamic Bank and the ways of measuring the same are briefly summed up as follows:

• Credit risk is the risk, in which the bank borrower would fail to meet the obligations according to the agreed terms. The main reason for such credit risk is the acceptances, loans, trade financing and interbank transactions. In order to measure this risk, Abu Dhabi Islamic Bank use to buy credit default swaps for transferring the risk to another party.
• The interest rate risk is the risk, which leads to potential losses due to the global interest rate fluctuations (Hull, 2012). For measuring the risk, ADIB uses the full valuation approach for revaluing the change in the global scenario associated with interest rate.
• Another risk confronting ADIB is the operational risk, which might lead to losses from the ineffective internal procedures or external events. AIDB uses computerised systems in its branches to avoid human errors. For minimising the programming errors, ADIB recruits expert IT professionals, which has resulted in improved bank functioning and operations.
• Business risk is the risk, in which the organisation would experience lower profit margin in contrast to the anticipated one (Sedunov, 2016). ADIB has concentrated more on retained earnings, which help in coping up with lower profit experience in the subsequent year.

Role and Function of Financial Intermediaries of UAE with Special Reference to Abu Dhabi Islamic Bank:

Risks Associated with Abu Dhabi Islamic Bank and Ways of Measuring Risks

ADIB form a parcel and inter-jointed medium of the Islamic developmental framework. Such intermediation aims to improve the efficiency of the investment process through eradication of the mismatches in the availability of financial resources of the borrowers. The intermediaries of ADIB are liable to identify feasible projects for funding along with monitoring the progress. Along with this, it is the responsibility of the intermediaries to ensure effective accounting and auditing practices (Wang & Hsu, 2013). However, ADIB has restricted the intermediaries in project handling and framing policy decisions.

However, in cases of project failure, the financial intermediaries of ADIB are defaulted and the ripple effect has destabilised the entire system. ADIB is highly efficient in allocating funds based on the project productivity, instead of the creditworthiness of the project holders. Hence, ADIB plays a major role in contributing towards the economic development of UAE by funding in potential capital projects with the help of intermediaries.

References:

Adib.ae. (2016).  Retrieved 23 December 2016, from https://www.adib.ae/en/pages/personal.aspx

Al-Tamimi, H., Miniaoui, H., & Elkelish, W. W. (2014). Financial Risk and Islamic Banks’ Performance in the Gulf Cooperation Council (GCC).

Bhagat, S., Bolton, B., & Lu, J. (2015). Size, leverage, and risk-taking of financial institutions. Journal of Banking & Finance, 59, 520-537.

Clark, G. L., & Monk, A. H. (2013). The scope of financial institutions: in-sourcing, outsourcing and off-shoring. Journal of Economic Geography, 13(2), 279-298.

Da Gbadji, L. A. G., Gailly, B., & Schwienbacher, A. (2015). International analysis of venture capital programs of large corporations and financial institutions. Entrepreneurship Theory and Practice, 39(5), 1213-1245.

Fuller, G. W. (2016). Introduction. In The Great Debt Transformation (pp. 1-24). Palgrave Macmillan US.

Gennaioli, N., Martin, A., & Rossi, S. (2014). Sovereign default, domestic banks, and financial institutions. The Journal of Finance, 69(2), 819-866.

Hilscher, J., Landskroner, Y., & Raviv, A. (2016). Optimal regulation, executive compensation and risk taking by financial institutions. Executive Compensation and Risk Taking by Financial Institutions (March 18, 2016).

Huat, T. C. (2014). Financial institutions and markets. Handbook of Singapore—Malaysian Corporate Finance, 12.

Hull, J. (2012). Risk Management and Financial Institutions,+ Web Site (Vol. 733). John Wiley & Sons.

Knights, D., & Tinker, T. (Eds.). (2016). Financial institutions and social transformations: International studies of a sector. Springer.

Lovett, W., & Malloy, M. (2014). Banking and Financial Institutions Law in a Nutshell, 8th. West Academic.

Sedunov, J. (2016). What is the systemic risk exposure of financial institutions?. Journal of Financial Stability, 24, 71-87.

Wang, T., & Hsu, C. (2013). Board composition and operational risk events of financial institutions. Journal of Banking & Finance, 37(6), 2042-2051.