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  • Print publication year: 2012
  • Online publication date: August 2012

Chapter 1 - Functions of the Financial System

from Part I - Setting the Stage



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

The importance of financial markets and fi nancial 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 marketbased systems. A specifi c 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 fi rm. Investors (the outsiders) cannot perfectly monitor managers acting on their behalf since managers (the insiders) have superior information about the performance of the company. So there is a need for certain mechanisms that prevent the insiders of a company using the profits of the firm for their own benefit rather than returning the money to the outside investors. This chapter outlines the various mechanisms in place.

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