2 The role of financial systems in the economy
This section iscusses the main functions of financial intermeiaries an financial markets, an their comparative roles. Financial systems, i.e. financial intermeiaries an financial markets, channel funs from those who have savings to those who have more prouctive uses for them. They perform two main types of financial service that reuce the costs of moving funs between borrowers an leners, leaing to a more efficient allocation of resources an faster economic growth. These are the provision of liquiity an the transformation of the risk characteristics of assets.
2.1 Provision of liquiity
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Financial markets can also transform illiqui assets (long-term capital investments in illiqui prouction processes) into liqui liabilities (financial instrument). With liqui financial markets savers/leners can hol assets like equity or bons, which can be quickly an easily converte into purchasing power, if they nee to access their savings.
For leners, the services performe by financial markets an intermeiaries are substitutable aroun the esire risk, return an liquiity provie by particular investments. Financial intermeiaries an markets make longer-term investments more attractive an facilitate investment in higher return, longer gestation investment an technologies. They provie ifferent forms of finance to borrowers. Financial markets provie arms length ebt or equity finance (to those firms able to access markets), often at a lower cost than finance from financial intermeiaries.
2.2 Transformation of the risk characteristics of assets
The secon main service financial intermeiaries an markets provie is the transformation of the risk characteristics of assets. Financial systems perform this function in at least two ways. First, they can enhance risk iversification an secon, they resolve an information asymmetry problem that may otherwise prevent the exchange of goos an services, in this case the provision of capital (Akerlof 1970).
Financial systems facilitate risk-sharing by reucing information an transactions costs. If there are costs associate with the channelling of funs between borrowers an leners, financial systems can reuce the costs of holing a iversifie portfolio of assets. Intermeiaries perform this role by taking avantage of economies of scale, markets o so by facilitating the broa offer an trae of assets comprising investors’ portfolios.
Financial systems can reuce information an transaction costs that arise from an information asymmetry between borrowers an leners. In creit markets an information asymmetry arises because borrowers generally know more about their investment projects than leners. A borrower may have an entrepreneurial “gut feeling” that can not be communicate to leners, or more simply, may have information about a looming financial risk to their firm that they may not wish to share with past or potential leners. An information asymmetry can occur ex ante or ex post. An ex ante information asymmetry arises when leners can not ifferentiate between borrowers with ifferent creit risks before proviing a loan an leas to an averse selection problem. Averse selection problems arise when leners are more likely to make a loan to high-risk borrowers, because those who are willing to pay high interest rates will, on average, be worse risks. The information asymmetry problem occurs ex post when only borrowers, but not leners, can observe actual returns after project completion. This leas to a moral hazar problem. Moral hazar problems arise when borrowers engage in activities that reuce the likelihoo of their loan being...