The financial sector provides six main functions that are important both at the company level and at the level of the economy as a whole.
1. Provision of payment services. It is inconvenient, inefficient, and risky to carry enough cash to pay for purchased goods and services. Financial institutions provide an efficient alternative. The most obvious examples are checking and clearing services for personal and business checks and credit and debit cards; each is growing in importance, at least in modern sectors, even in low-income countries.
2. Coincidence 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 held by a small family business, it would be only by the wildest of coincidences that each investor saves exactly what they need. to finance a certain project. Therefore, it is important that savers and investors come together in some way and agree on the terms of loans or other forms of financing. This can happen without financial institutions; Even in highly developed markets, many new entrepreneurs derive a significant fraction of their startup funds from family and friends. However, the presence of banks, and later venture capitalists or stock exchanges, can greatly facilitate efficient matching. Small savers simply deposit their savings and let the bank decide where to invest them.
3. Generation and distribution of information. It is not always thought this way, but from the point of view of the whole society, one of the most important functions of the financial system is to generate and distribute information. Stock and bond prices in newspapers in 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 available to them about these and all other investments. Banks also collect information about the companies that obtain loans 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. Allocate credit efficiently. The channeling of investment funds towards uses of greater profitability allows for an increase in specialization and the division of labor, recognized since the time of Adam Smith as the 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 syndicated loans from banks.
6. Increased liquidity of assets. Some investments are very durable; in some cases, a hydroelectric plant, for example, such investments can 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 you want to sell, for example at retirement. Financial development increases liquidity by facilitating sale, for example, on the stock exchange or to a syndicate of banks or insurance companies.
Both technological and financial innovations have fueled 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 in their quest for economic development. But the effective functioning of the financial system requires, in turn, the precondition of macroeconomic stability.
