The financial sector and the real economy

Overview

Main functions of the financial sector, maturity transformation and financial intermediary reduce risk for savers.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What are the main functions of the financial sector?

   Model answer

   It channels the savings of those with surplus funds to those who want to spend more than their current income, so that saving becomes investment rather than idle balances. It transforms maturity, turning short-term deposits into long-term loans. It pools and diversifies risk, so that no single saver bears the whole loss if one borrower fails. It screens and monitors borrowers, which reduces the information problem an individual saver could not solve alone. It operates the payments system through which almost every transaction is settled. It provides insurance against specified risks and, through foreign exchange and derivative markets, allows firms to hedge price and currency risk. And it provides price signals, since interest rates and asset prices tell the economy how scarce capital is and where it is most valued.

2. 2

   What is maturity transformation, and why is it valuable but risky?

   Model answer

   Maturity transformation is the practice of funding long-term assets with short-term liabilities: a bank takes deposits repayable on demand and uses them to make loans and mortgages lasting years or decades. It is valuable because savers want their money accessible while borrowers need certainty that funding will not be withdrawn part-way through a project or a house purchase, and without an intermediary willing to bridge that gap, long-term investment would be much harder to finance. It is risky because the bank can never repay all depositors at once: if enough of them withdraw simultaneously, it must sell illiquid assets quickly at a loss, so an institution that is perfectly solvent can be destroyed by a loss of confidence alone.

3. 3

   How does a financial intermediary reduce risk for savers?

   Model answer

   It pools the funds of many savers and lends them to many borrowers, so each saver's money is spread across a large number of loans rather than concentrated in one. Because borrowers' fortunes are not perfectly correlated, the proportion that defaults is far more predictable than whether any individual borrower will default, so the intermediary can absorb the expected losses out of the interest margin and hold capital against unexpected ones. It also specialises in assessing risk, which an individual saver could not do economically for a single small loan. The saver therefore receives a predictable return on a claim that is safer than any of the underlying loans.

4. 4

   Explain how banks reduce the information problem between savers and borrowers.

   Model answer

   A borrower knows more about the quality of a project and about his own intention to repay than any lender does, so lending directly is exposed to two problems: the lender cannot tell good borrowers from bad before the loan, and cannot observe what the borrower does with the money afterwards. A bank addresses the first by screening: it gathers credit histories, examines accounts and business plans, requires collateral, and prices the loan to reflect the assessed risk. It addresses the second by monitoring: it observes the flow of funds through the borrower's account, imposes conditions on the loan and can withdraw further credit. Because it does this for many borrowers, it spreads the fixed cost of acquiring these skills, so the cost per loan is far lower than if each saver tried to do it individually.

5. 5

   Set out the chain by which the financial sector affects output and employment in the real economy.

   Model answer

   Households and firms with surplus funds place them with banks and other institutions rather than holding them idle. Those institutions pool the funds, transform their maturity, and screen and monitor those who want to borrow. Funds are then supplied as loans to firms and households, and channelled through bond and equity markets to larger firms. Firms use the finance to buy plant, machinery, premises and stock, and households use it to buy houses and durable goods. That spending is itself a component of aggregate demand, so output and employment rise in the short run. Over the longer run the investment adds to the capital stock and to the economy's productive capacity, so potential output rises too. Meanwhile the payments system allows all these transactions to be settled cheaply, and insurance and hedging markets let firms take on productive risks they would otherwise avoid. The condition of the financial sector therefore determines how much of the economy's saving actually reaches productive use.

6. 6

   How does raising finance on capital markets differ from borrowing from a bank?

   Model answer

   A bank loan is a private contract with one intermediary that has screened the borrower and will monitor it; it can be arranged relatively quickly, tailored to the borrower and renegotiated, and it suits smaller firms whose quality cannot easily be assessed by outsiders. Issuing bonds or shares means selling claims to many investors in a public market, which requires the firm to be large enough to justify the fixed costs of issuance, disclosure and credit assessment, and to accept public scrutiny of its accounts. Market finance is usually cheaper for firms that qualify, because it removes the intermediary's margin, and equity in particular requires no fixed repayment, so it shares risk with the investor. An economy relying mainly on banks is more exposed to a banking crisis, whereas one with deep capital markets has an alternative channel if banks retrench.

Other ways to work this

The same content, four other ways.

What is inside Levo

Six ways to work the same material.