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What Is the Importance of Capital Markets?

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  • Written By: K. Kinsella
  • Edited By: Shereen Skola
  • Last Modified Date: 14 July 2014
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The capital markets provide a venue for entities and individuals to seek financing from lenders and investors. During periods of recession, the importance of capital markets becomes more apparent because banks and finance firms usually curtail lending and this means that those seeking finance become even more reliant on these markets. Capital markets come in many varieties including stock exchanges and other similar types of venues where brokers attempt to match up investors with those who are in need of finance.

In many nations, government entities fund public schools, healthcare programs, national defense and a variety of other operations and projects. Governments pay for these programs and services with tax revenues and rather than drastically raising taxes to cover the upfront cost of such projects, governments normally borrow money from the capital markets and then repay those debts with tax revenues that are raised over the course of many years. This means that tax levels remain relatively low, but government programs retain funding. The importance of capital markets becomes obvious when a government's credit rating drops and investors refuse to buy government bonds. In the absence of funds from the markets, governments have to raise taxes and this can severely impact the economy of a nation or region.

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Traditionally, entrepreneurs either had to obtain loans from banks or use their own money to cover their costs when starting new business ventures. People with poor credit and those who lacked cash assets were therefore unable to start their own companies due to a lack of funds. Therefore, the importance of capital markets is readily apparent to business owners who are able to fund company expansions with money raised through the sale of company stocks and bonds. Investors, benefit from the capital markets because the yields on bonds and growth opportunities on stock investments are much greater than with traditional bank products such as certificates of deposit although this upside comes with a high level of principal risk.

The housing market is a key component of the overall economy and in many nations homeowners typically had to rely on bank loans to finance the purchase of new homes. As with entrepreneurs, prospective homeowners with poor credit or modest assets were often unable to qualify for mortgages which meant that wealthy individuals could more easily buy property than low-income families. In modern times, many investment companies buy loans from banks and lenders and convert those loans into mortgage-backed-securities that are sold to investors on the capital markets. The importance of capital markets to the housing industry is most obvious when banks tighten underwriting standards during periods of recession. When this occurs, prospective homebuyers can obtain loans from investment firms that securitize mortgages; these firms enable the housing market to remain active.

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