Financial Functions and Economic Development
Functions of Facilitating Risk Management
It is generally believed that an important role of a financial system is to reduce the risk in trading and in pooling. There are two distinct types of risks: liquid and illiquid risks. For example, the liquidity of real estate is less than equities and therefore real estate has high liquidity risk. Liquidity risk arises due to the
uncertainties in the process of converting assets into a medium of exchange. Liquidity risk could rise because of asymmetries of transaction and information costs, and financial markets and institutions will arise accordingly. Thus, we can define liquid markets as the markets which involve less uncertainty in settling the trading. During the recent decades, the establishment of financial systems in response to liquidity risk has been always debated by economists, and the association of financial
The first way is introduced by Diamond and Philip that is named as the Seminal Model of Liquidity
.
According to that model, savers in markets have the possibility of receiving shocks after choosing between liquid project (High return) and illiquid project (low return), and that risk can encourage more investment in the liquid (low return) projects. Supposed that it is expensive to receive a shock in this model, so that the insurance contracts need to be ruled out and financial markets will exist, where individuals can trade securities with higher confident level. Stock markets reduce liquidity risk by facilitating the trade and thus more projects will be invested with the high return. On the basis of above discussion, information costs, with which agents can verify whether other investors receive shocks, are the main cause for the emergence of the stock market. Moreover, it is noticed that trading costs are also able to highlight the significance of liquidity. But if this economic activity is expensive, production technologies will be less attractive due to its longer period. Therefore, liquidity affects the production decisions, which can be measured in trading costs in secondary financial market and thus greater liquidity will result in transferring to longer period
and higher return technologies.
After the parts about liquidity risk, it in turn seeks to explore the association between financial intermediaries and the economic development. The definition of financial intermediaries is generally concluded as the combination of agents to provide financial services, and thus financial intermediaries can be used to strengthen liquidity, and also to reduce risk from liquidity. On the basis of the discussion in the previous part, the Diamond-Dybvig Model assumes that it is not possible to make insurance contracts in the market, and thus savers can get liquid deposits from banks. Furthermore, the liquid risk can be reduced by a completed insurance provided by the bank, while the long-term investments could be facilitated in high return projects. By reducing liquidity risk, investment can be increased in the high-return projects, which normally is described as the liquidity asset; and then the economic growth will be promoted. But all of those studies about the functions of banks are based on the assumption of lack of state-contingent insurance contracts (Diamond-Dybvig Model). But this assumption simultaneously brings a problem about describing how a bank reduces liquidity risk. In other words, if there is a market of equity, agents in the market prefer to using equities and then nobody has inventive to use financial institutions. After considering the main role of reducing the risk of liquidity, other risks associated with individual industries could also be reduced by an efficient financial system.
Indeed, one primary role of financial markets is to provide services for diversifying and trading various risks. The ability of financial system to offer the service of risk diversifications can influence the process of economic development by changing allocation of resources and by arranging the saving rates. Therefore, financial markets tend to make portfolio investment shift to the higher-returns projects (Paul; Obstfeld).
The risk diversification not only has an effect on capital accumulation, but also makes changes of the technological innovative advances. Agents in the marker are trying to make technological advances to get profits for the innovators, and thereby successful innovation can improve the process of technological advances. The ability of holding a portfolio of innovation projects is able to reduce risk, and also investments are promoted in enhanced innovative activities. In conclusion, financial systems play an important role in facilitating technological advances and promoting economic development through their effects on improving risk diversification effectively.
Functions of Financial Systems and Allocation of Resources
In order to promote economic development, it is crucially important to allocate and mobilize sufficient resources for various investments and the quality of the allocation to different investments play a critically significant role on economic development. Economists have identified various mechanisms to explain the positive influence of financial intermediation on the capital productivity. Actually the allocation of resources includes three important critical points that are associated with the establishment of financial institutions—the diversification of risks, the management of liquidity risks, and the evaluation of managers’ skills in enterprises. But since the management of risks has been discussed in the previous subsection, this subsection will only concentrate on two parts. On the basis of these three factors, different economists present various arguments about the possible influence to the economic development. For example, Greenwood and Jovanovic contends that the influence on the growth is due to an increase in the resources invested in productive capital and an
improvement in productive efficiency. Here, there are two points needed to be known:
a) the returns on investment are associated not only with some risks in the productive
process, but also with other risks associated with future product demand;
b) all intermediation activities can be carried out either by banks or financial markets.
Therefore, the development of financial markets helps agents reduce those risks with the efficient diversification of their investments, and simultaneously choosing more productive technological advances. On the basis of this view, because of the higher level of opportunity costs involved in flexible technology, the development of financial markets becomes much more attractive for investors. The dualism way of technology is able to be described as an important method of diversification of technological risk, while productive risks can not be diversified in the modern sector effectively due to less-developed financial markets and intermediaries, including stock markets and banks.
The assessments will take place in the process of monitoring the various kinds of investments, and the costs of these assessments include fixed costs basically. Supposed those fixed costs are enough high, individual investors would be encouraged from conducting that research. Furthermore, this will result in an increase
in the investment in bad risk projects and a decrease in the productive efficiency of investment, and thereby has negative influences on economy development. The emergence of those fixed costs can be described as an important incentive to found specialized financial institutions which is used to integrate the information on
investments. If such information can be collected for an enough amount of investors, financial intermediaries will spread the fixed cost among the whole participated investors. Therefore, investment projects are more productive and this has a positively critical influence on economic development accordingly.
There is another kind of view about the monitoring effect on financial intermediaries. Agents in markets have their own choices between two types of investment projects: the investment with high productivity but low risk; the investment with low productivity but high risk; the risky investment is constrained to the technological shock. Unless individual agents are able to spend more money in monitoring others, private investors can not normally observe the shock affecting their investment projects. On the basis of this view, the financial ntermediation can also be described as a systematic network, which works to connect various individual
investors and facilitate the diffusion of information on the return of individual investments, so that financial intermediaries are able to obtain information about the shocks to affect investments. In conclusion, there are two summarization points needed to understood in this subsection:
a) Due to more informed breakdown of shocks, financial intermediaries can make investment go towards the invested projects with more yields and profits;
b) agents can reduce the risks in private projects better due to monitoring the systematical shock and there will be an increase in resources allocation invested risky but productive investments. The results both accelerate economic growth, as well as promote the development of entire economies.
Functions of Mobilizations of Savings
Another important function of financial intermediaries and markets is concentrating how to mobilize available savings efficiently in an economy. Indeed, the emergence of financial systems and intermediaries provides an efficient way of mobilization and pooling of available savings, which can integrate existing financial resources from individuals to group investments. Actually more advanced technological innovations can be used in the process of production, which initially required a certainly higher level of investments. The mobilization includes some instruments, with which investors are able to keep diversified portfolios, then to spend more investments in efficient firms and to raise the degree of liquidity of financial assets. Therefore, mobilization has a definitely positive influence on the allocation of resources, by improving the diversification of risks and the size of firms.
This means the financial intermediaries can offer investors the relatively higher expected returns in the process of resource integrations, which in turn results in an increase in capital productivity and also individual household can obtain the more profitable yields. However, for every individual investor it must be very expensive to mobilize and pool the savings by himself due to much high cost involved in the process of the integration of resources. Among various costs, there are two most important costs to be studied here: a) costs of transaction, which come from pooling savings from every investor; b) costs of informational asymmetries, which make investors feel better to give up the control of their long-period savings. In facts, around the mid-1880s some bankers have already used some connections in Europe to increase capital overseas
for investments in the America, while other banks also attempted to find the connections with banks and entrepreneurs in the USA to start the steps of capital mobilization. At the same time, other banks also wanted to sell securities to individual households through some other methods—such as advertisement. Furthermore, financial intermediaries are generally required to have a good reputation, and then savers will feel comfortable about consigning their savings in the banks , since agents of conducting the mobilization have to tell the investors with the rationalization of investments. Although many transaction and information costs have to be suffered under the process of the saving mobilization, there are various financial policies to solve these frictions and to improve the ability of pooling. For example, numerous multiple contracts are made in the mobilization, and these contracts take place between productive units and agents with surplus resources.
The joint stock company shows us an example of multiple mobilization, with which a new legal entity—the
firm—can be invested by many individuals. Also pooling might take place here with intermediaries, and here many investors consign their money in intermediaries which invest in firms . The efficient mobilization and pooling of savings not only have effects on the accumulation in capital, but also have positive influences on improving the allocation of resources, as well as creating the innovation of technological advances. When
financial systems are more effective at pooling the savings from individuals, they can deeply influence economic development. In addition, the development of financial intermediation can lead to releasing the constraint of liquidity, which agents in the economy have to face when planning their consumption through the life. Consequently, when liquidity constraints could be released, the savings rate will fall down. This positive relationship between the liquidity constrains and the saving rate has been empirically evaluated by Jappelli and Pagano with a case study of OECD member countries. But here we have to underline an important assumption, since any discussions of the liquidity constraint on the economic development are based on that consumption: productivity gains are only connected to externalities in the accumulation of physical capital. However, if the liquidity constraint leads to the encouragement of savings, the negative effects will exist on economic growth.
This situation occurs if growth arises from the accumulation in human capital instead of only in physical capital, since the probability of individual borrowing in the time of schooling would be reduced. Therefore, through the affects of externalities, the emergence of liquidity constraints, based on the less-developed financial system, can make the choice of a low equilibrium with weak growth, and thereby a trap of poverty
correspondingly.
Functions of Being Payments System
Another significant distribution of financial systems to economic development comes from the establishment of an efficient and adaptable payment system. That means the influence from a financial system to the economic development can be discussed with reference to a well-performing payment system in the financial markets. Empirically, a creditable means of exchange is a necessary condition to promote the economic
development does not only imply the sustained productivity gain, but it also mean a maintained opening up of new markets and an efficient diversification of products. All of these economic activities lead to the more exchanges, which will make an economy more complicated. Then, there will be a growing demand of monetization, which should be necessary for sustaining the economic growth. Finally, there will be long-term trend towards a reduction in the money velocity and this conclusion been confirmed by many experiences from most developing countries. Furthermore, it is necessary to mention the need to reduce the opportunity cost of keeping money, which brings a stable movement trend of payment systems towards credit connections supervised by financial intermediaries, and this trend might be strengthened by the process of technological advances. But these technological advances can not only reduce the information costs that are linked to credits, but also they are easily able to make modernistic financial assets substitutable for conventional financial assets. That is initially shown by a long-term increase in the ratio of financial activities to entire GDP, and also working population in financial sectors is increasing sharply correspondingly, and thereby that will have a critically positive influence on the economic development. However, this fall seems to be confirmed by the wide money aggregates and the notion of wide money aggregates includes more complex kinds of financial assets, whose high cost implies that they only become accessible beyond a certain level of economic development.
Actually, the positive relationship between real GDP and the ratio of the financial assets to GDP (traditional
expression of monetization) was discussed and highlighted in initial studies on financial growth and economic development.
Conclusion
The above discussions have illustrated a functioning approach of the main functions of a financial system associated with economic development. But it seems to be too narrow a focus to evaluate the influence on economic development from every separate function, so that many economists encourage various functions into an integrated understanding of the functions of a financial system to help economic development. Actually it is better way to study the financial system functions with the integration of the different individual functions. In fact, by identifying the individual functions performed by the financial system, the functional approach can motivate a more complete understanding of relationship between financial growth and economic development.
There were some good studies provided by earlier economists to evaluate the associations between finance and development. For example, Schumpeter (1912) explores a board explanation of the roles of a financial system on economic development. It looks like Smith (1776) uses the key factor to explain the importance
of the process of specialization. Schumpeter uses the ties between firms and banks to explore the significance of the financial system on adopting the technological advance
