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The financial sector provides six major functions that are important at the firm level and at the level of the economy as a whole.
1. Providing payment services. Carrying enough cash with you to pay for purchased goods and services is inconvenient, inefficient and risky. Financial institutions provide an efficient alternative. The most obvious examples are personal and business checking and check-clearing and credit and debit card services; The importance of each is growing even in low-income countries, at least in modern regions.
2. Matching of 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 wildly coincidental that each The investor saved only as much as was needed. To finance a given project. Therefore, it is important that the saver and the investor somehow meet and agree on the terms for the loan or other form of finance. This can happen without financial institutions; Even in highly developed markets, many new entrepreneurs receive a significant portion of their start-up funding from family and friends. However, the presence of banks, and later venture capitalists or stock exchanges, can facilitate matching in an efficient manner. Small savers just deposit their savings and let the bank decide where to invest them.
3. Generation and distribution of information. One doesn’t always think of it this way, but from the perspective of society at large, one of the most important functions of the financial system is to generate and distribute information. Stock and bond prices in dailies in developing countries (and increasingly on the Internet as well) are a familiar example; These values represent the average decisions of thousands, if not millions, of investors, based on the information available to them 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 a bank’s “capital”, although it is often not recognized as such. In this regard, it has been said that financial markets represent the “brain” of the economic system.
4. Efficient allocation of credits. Channeling investment funds to utilize the highest rate of return allows for increased specialization and division of labor, which have been recognized as keys to the wealth of nations since the time of Adam Smith.
5. Pricing, Pooling and Trading Risks. Insurance markets provide protection against risk, but diversification is also possible in debt syndications from stock markets or banks.
6. Increasing asset liquidity. Some investments are very long-lived; In some cases – a hydroelectric power plant, for example – such investments can last a century or more. Sooner or later, investors in such plants want to sell them. In some cases, it can be quite difficult to find a buyer when someone wants to sell – on retirement for example. Financial development increases liquidity by facilitating sales, for example, on the stock exchange or to syndicates of banks or insurance companies.
Both technological and financial innovations have driven modern economic growth. Both were prerequisites for the Industrial Revolution because steam and water power required large investments fueled by innovations in banking, finance, and insurance. Both are essential for developing countries as they continue their struggle for economic growth. But the effective functioning of the financial system requires a precondition of macroeconomic stability.
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