Dave C.

Reroma

Financial Economics

9 July 2011

A Look at the Financial System from a Functional Standpoint Introduction The financial system is a complex of institutions, including especially banks and the government and international institutions that regulate them, that facilitate payments and link lenders with borrowers and investors with the assets they invest in. (Economics-Dictionary) A financial system is essential in the efficient allocation of resources in the economy. Integral to introduction to financial economics is an understanding of the financial system. Hence, the importance of directing focus of this paper on the financial system. There are two ways to proceed: regarding financial systems by way of institutions or looking at them from a functional perspective. According to Thorstein Veblen, Institutions are products of the past process, are adapted to past circumstances, and are therefore never in full accord with the requirements of the present. (cited in Canterbery, 2010) Institutions undergo changes throughout time and, in fact, generally differ across borders. (Bodie, Merton and Cleeton, 2009) It is because of the inconsistencies in the nature of institutions that a functional approach is taken in the following exposition. Review of Related Literature and Discussion In their book Financial Economics, Bodie, Merton and Cleeton (2009) identified certain core functions of a financial system. The foremost function of a financial system is it settles payments to facilitate the exchange of goods and services. In the modern world, paper currency, cheques, credit cards, and electronic funds transfer have been created to increase efficiency in making payments. It is no longer a novelty nowadays how funds can be transferred across geographic locations. This is largely due to the ever increasing global scope of the financial system. In addition, it can also facilitate intertemporal transfers of resources. (Bodie, Merton and Cleeton, 2009) This means that a businessman does not have to wait until he has sufficient wealth to be able to start a business or that a family does not need to postpone buying a home until they have saved enough money. What could have only been a distant possibility has become a present reality. Transaction costs in obtaining a loan can also be reduced in an efficient financial system. Mishkin (2007) cites an example where a bank taking advantage of its economies of scale can hire a lawyer to draw up a solid loan contract which can be used in many of its loan transactions. This significantly lowers the cost of having to pay a lawyer to draft a different contract each time there is a new loan agreement. Some assets possess risk characteristics of varying degrees. A financial system provides ways to spread out the risk. There is opportunity for converting risky assets into safer ones. 1 of 2

The financial system is also a good source of information about prices of financial instruments and values of assets. Such information is necessary in order for an individual to make a sound economic decision. Take the case of a person who plans to lend money. Bearing in mind the time value of money, he has to impose interest on top of the principal. But at what rate? He can turn to the financial market to find the answer. Knowledge of the inflation rate and the prevailing rate of return of alternative assets can prove invaluable in his decision-making. Along the lines of information lurks the problem of incentives. It can be expected that participants in a financial transaction may not share the same incentives. A person applying for a loan knows more than anyone else his own capability of repaying the loan in the future. Because of the nature of the financial service of a loan, people who lack funds are more likely to apply for one than those who have the financial resource. This raises the risk of default in the future. To minimize adverse selection, banks can stipulate conditions in the contract. Thus, the financial system as a whole has a way of weeding out high risk individuals. Conclusion Indeed, the financial system is dynamic in that it evolves over time. Institutions come and go. Policies may be redirected in response to new developments. Nevertheless, the functions discussed herein may remain primary to the existence of the financial system. References Bodie, Z., Merton, R. C., & Cleeton, D. L. (2009). Financial Economics. Upper Saddle River, NJ: Pearson Education, Inc. Canterbery, E. R. (2001). A Brief History of Economics: Artful Approaches to the Dismal Science. Singapore: World Scientific Publishing Co. Pte. Ltd. Financial system. In Economics-Dictionary. Retrieved July 6, 2011 from http://www.economics-dictionary.com/definition/financial-system.html Mishkin, F. S. (2007). Economics of Money, Banking and Financial Markets. USA: Addison Wesley.

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