Financial Systems: Arms Length and Relationship Based

By | September 5, 2014

In this era of globalization, there has been dilution of the world boundaries, economic relationships between the countries have grown stronger and many multilateral and plurilateral economic systems such as the European Union, ASEAN or BRICS have been set up. However, the financial system of these countries has run on different platforms and principles and their lines of differences have so far been difficult to bridge. Of these financial systems, Arm’s length Financial Systems and the Relationship Based Financial Systems are two important categories.

financial systems

According to Investopedia, an Arm’s Length Financial System is the one in which the parties have no relationship or contact with each other apart from the transactions involved. The arm’s length Financial System’s principles are adopted by most of the Anglo American firms including those of America, Canada, United Kingdom and Australia. The arm’s length system promotes principles such as transparency and accountability in carrying out transactions. The relations developed by firms are only short term in nature.

In arm’s length financial systems, the firms share all their annual and quarterly details with all the stakeholders. Profits and sales are important parameters and are the sole pillars on which a firm’s relationship and contracts with other firms are based. The soft information, which doesn’t have concrete proofs and could be inaccurate, is very difficult to be transmitted to the market in an arm’s length system. That is why investors and banks tend to pull out their money during economic turmoil.

However, in case of Relationship Based Financial Systems, carried out in most of continental European (France & Germany) and Japanese economies, there are stronger, closer relations and relationship based interactions between the firms and the investors who are typically banks and insurance companies. They thrive on long term relationships with one another. Just for instance, the investors develop long term relations with the firms and adhere to the company even in the times of financial distress if they foresee an economic turnaround. They intend to settle for lower returns for the period of recession rather than ending their relation with the firm.

Both these financial systems are fundamentally different from each other and the subsequent face off between the two, have led to a lot of financial crisis in this globalized world. The East Asian crisis was well the most conspicuous consequence of the clash of these two financial systems.


Excerpts taken from Fault Lines: How hidden fractures still threaten world economy: Dr Raghuram Rajan


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