Important Role of Financial System in the Economy

The financial sector provides six major functions that are important both at the firm level and at the level of the economy as a whole.

1. Providing payment services. It is inconvenient, inefficient, and risky to carry around enough cash to pay for purchased goods and services. Financial institutions provide an efficient alternative. The most obvious examples are personal and commercial checking and check-clearing and credit and debit card services; each are growing in importance, in the modern sectors at least, of even low-income countries.

2. Matching savers and investors. Although many people save, such as for retirement, and many have investment projects, such as building a factory or expanding the inventory carried by a family micro enterprise, it would be only by the wildest of coincidences that each investor saved exactly as much as needed to finance a given project. Therefore, it is important that savers and investors somehow meet and agree on terms for loans or other forms of finance. This can occur without financial institutions; even in highly developed markets, many new entrepreneurs obtain a significant fraction of their initial funds from family and friends. However, the presence of banks, and later venture capitalists or stock markets, can greatly facilitate matching in an efficient manner. Small savers simply deposit their savings and let the bank decide where to invest them.

3. Generating and distributing information. One does not always think of it this way, but from a society wide viewpoint, one of the most important functions of the financial system is to generate and distribute information. Stock and bond prices in the daily newspapers of developing countries (and increasingly on the Internet as well) are a familiar example; these prices represent the average judgment of thousands, if not millions, of investors, based on the information they have available about these and all other investments. Banks also collect information about the firms that borrow from them; the resulting information is one of the most important components of the “capital” of a bank, although it is often unrecognized as such. In these regards, it has been said that financial markets represent the “brain” of the economic system.

4. Allocating credit efficiently. Channeling investment funds to uses yielding the highest rate of return allows increases in specialization and the division of labor, which have been recognized since the time of Adam Smith as a key to the wealth of nations.

5. Pricing, pooling, and trading risks. Insurance markets provide protection against risk, but so does the diversification possible in stock markets or in banks’ loan syndications.

6. Increasing asset liquidity. Some investments are very long-lived; in some cases – a hydroelectric plant, for example – such investments may last a century or more. Sooner or later, investors in such plants are likely to want to sell them. In some cases, it can be quite difficult to find a buyer at the time one wishes to sell – at retirement, for instance. Financial development increases liquidity by making it easier to sell, for example, on the stock market or to a syndicate of banks or insurance companies.

Both technological and financial innovations have driven modern economic growth. Both were necessary conditions for the Industrial Revolution as steam and water power required large investments facilitated by innovations in banking, finance, and insurance. Both are necessary for developing countries as they continue their struggle for economic development. But the effective functioning of the financial system requires, in turn, the precondition of macroeconomic stability.