Skip to main content Accessibility help
×
Home
  • This chapter is unavailable for purchase
  • Print publication year: 2009
  • Online publication date: June 2012

1 - Functions of the Financial System

from Part I - Setting the Stage

Summary

OVERVIEW

Having a well-functioning financial system in place that directs funds to their most productive uses is a crucial prerequisite for economic development. The financial system consists of all financial intermediaries and financial markets and their relations with respect to the flow of funds to and from households, governments, business firms, and foreigners, as well as the financial infrastructure.

The main task of the financial system is to channel funds from sectors that have a surplus to sectors that have a shortage of funds. In doing so, the financial sector performs two main functions: (1) reducing information and transaction costs, and (2) facilitating the trading, diversification, and management of risk. These functions are discussed at length in this chapter.

The importance of financial markets and financial intermediaries differs across Member States of the European Union (EU). An important question is how differences in financial systems affect macroeconomic outcomes. Atomistic markets face a free-rider problem: when an investor acquires information about an investment project and behaves accordingly, he reveals this information to all investors, thereby dissuading other investors from devoting resources towards acquiring information. Financial intermediaries may be better able to deal with this problem than financial markets.

This chapter discusses these and other pros and cons of bank-based and market-based systems. A specific element in this debate is the role of corporate governance, i.e. the set of mechanisms arranging the relationship between stakeholders of a firm, notably holders of equity, and the management of the firm.

SUGGESTED READING
Allen, F. and Gale, D. (2000), Comparing Financial Systems, MIT Press, Cambridge (MA).
Carlin, W. and Mayer, C. P. (2003), Finance, Investment and Growth, Journal of Financial Economics, 69(1), 191–226.
Papaioannou, E. (2008), Finance and Growth. A Macroeconomic Assessment of the Evidence from a European Angle, in: Freixas, X., Hartmann, P., and Mayer, C. (eds.), Handbook of European Financial Markets and Institutions, Oxford University Press, Oxford, 68–98.
REFERENCES
Abiad, A. and Mody, A. (2005), Financial Reform: What Shakes It? What Shapes It?, American Economic Review, 95(1), 66–88.
Allen, F., Bartiloro, L., and Kowalewski, O. (2006), The Financial System of EU 25, in: Liebscher, K., Christl, J., Mooslechner, P., and Ritzberger-Grünwald, D. (eds), Financial Development, Integration and Stability in Central, Eastern and South-Eastern Europe, Edward Elgar, Cheltenham, 80–104.
Allen, F. and Gale, D. (2000), Comparing Financial Systems, MIT Press, Cambridge (MA).
Allen, F. and Santomero, A. M. (1997), The Theory of Financial Intermediation, Journal of Banking and Finance, 21, 1461–1485.
Becht, M. and Roëll, A. (1999), Blockholdings in Europe: An International Comparison, European Economic Review, 43, 1049–1056.
Beck, T., Demirgüç-Kunt, A., and Levine, R. (2001), Law, Politics and Finance, World Bank, Policy Research Working Paper 2585.
Bekeart, G., Harvey, C. R., and Lundblad, C. (2005), Does Financial Liberalization Spur Growth?Journal of Financial Economics, 77, 3–55.
Carlin, W. and Mayer, C. P. (2000), How Do Financial Systems Affect Economic Performance?, in: Vives, X. (ed.), Corporate Governance: Theoretical and Empirical Perspectives, Cambridge University Press, Cambridge (UK), pp. 137–168.
Carlin, W. and Mayer, C. P. (2003), Finance, Investment and Growth, Journal of Financial Economics, 69(1), 191–226.
Demirgüç-Kunt, A. and Levine, R. (eds.) (2001), Financial Structure and Economic Growth: A Cross-Country Comparison of Banks, Markets and Development, MIT Press, Cambridge (MA).
Dewatripont, M. and Maskin, E. (1995), Credit Efficiency in Centralized and Decentralized Economies, Review of Economic Studies, 62, 541–555.
Djankov, S., Porta, R., Lopez-de Silanes, F., and Shleifer, A. (2006), The Law and Economics of Self-dealing, working paper.
Djankov, S., McLiesh, C., and Shleifer, A. (2007), Private Credit in 129 Countries, Journal of Financial Economics, 84, 299–329.
Driffill, J. (2003), Growth and Finance, The Manchester School, 71, 363–80.
,European Central Bank (2006), Financial Stability Review (December), ECB, Frankfurt am Main.
,European Central Bank (2007), Financial Integration in Europe, ECB, Frankfurt am Main.
Fernandez, R. and Rodrik, D. (1991), Resistance to Reform: Status Quo Bias in the Presence of Individual-specific Uncertainty, American Economic Review, 81, 1146–1155.
,Governance Metrics International (2006), Ratings on 3800 Global Companies, GMI, New York.
,International Monetary Fund (2006), World Economic Outlook, chapter 4, IMF, Washington DC.
Jensen, M. (1993), The Modern Industrial Revolution, Exit, and the Failure of Internal Control Systems, Journal of Finance, 48, 831–880.
Jensen, M. and Meckling, W. (1976), Theory of the Firm: Managerial Behavior, Agency Costs, and Capital Structure, Journal of Financial Economics, 3, 287–322.
Keefer, P. (2007), Beyond Legal Origin and Checks and Balances: Political Credibility, Citizen Information and Financial Sector Development, World Bank Policy Research Working Paper 4154.
King, R. G. and Levine, R. (1993a), Finance and Growth: Schumpeter Might Be Right, Quarterly Journal of Economics, 108, 717–737.
King, R. G. and Levine, R. (1993b), Finance, Entrepreneurship, and Growth: Theory and Evidence, Journal of Monetary Economics, 32, 513–542.
Porta, R., Lopez-de-Silanes, F., Shleifer, A., and Vishny, R. (1997), Legal Determinants of External Finance, Journal of Finance, 52, 1131–1150.
Levine, R. (1997), Financial Development and Economic Growth: Views and Agenda, Journal of Economic Literature, 35, 688–726.
Levine, R. (2002), Bank-Based or Market-Based Financial Systems: Which is Better?, Journal of Financial Intermediation, 11, 398–428.
Levine, R. (2005), Finance and Growth: Theory, Mechanisms and Evidence, in: Aghion, P. and Durlauf, S. N. (eds.), Handbook of Economic Growth, Elsevier, Amsterdam, 865–923.
Levine, R., Loayza, N., and Beck, T. (2000), Financial Intermediation and Growth: Causality and Causes, Journal of Monetary Economics, 46, 31–77.
Merton, R. C. (1995), Financial Innovation and the Management and Regulation of Financial Institutions, Journal of Banking and Finance, 19, 461–481.
Mishkin, F. S. (2006), The Next Great Globalization, Princeton University Press, Princeton.
Papaioannou, E. (2008), Finance and Growth. A Macroeconomic Assessment of the Evidence from a European Angle, in: Freixas, X., Hartmann, P., and Mayer, C. (eds.), Handbook of European Financial Markets and Institutions, Oxford University Press, Oxford, 68–98.
Petersen, M. A. and Rajan, R. G. (1994), The Benefits of Lending Relationships: Evidence from Small Business Data, The Journal of Finance, 49 (1), 3–37.
Rajan, R. and Zingales, L. (1998), Financial Dependence and Growth, American Economic Review, 88, 559–586.
Trew, A. (2006), Finance and Growth: A Critical Survey, The Economic Record, 82, 481–490.