The Role of the Financial Sector in Economic Performance

Abstract

What distinguished financial institutions from other firms is the relatively small share of real assets on their balance sheets. Thus, the direct impact of financial institutions on the real economy is relatively minor. The indirect impact of financial markets and institutions on economic performance is extraordinarily important. The financial sector mobilizes savings and allocates credit across space and time. It provides not only payment services, but also enables firms and households to cope with economic uncertainties by hedging, pooling, sharing and pricing risks. An efficient financial sector reduces the cost and risk of producing and trading goods and services and thus makes an important contribution to raising the standard of living. The authors begin their analysis by considering how an economy would perform without a financial sector and then proceed to introduce a simplified financial sector with direct financial transactions between savers and investors. Financial intermediaries are introduced which transform the direct obligations of investors into indirect obligations of financial intermediaries which have attributes that savers prefer. This approach emphasizes how the financial sector can improve both the quantity and quality of real investment and thereby increase income per capita. The authors then consider the role of government in supporting an efficient financial sector. However, the authors show that not all government intervention is beneficial. They demonstrate the potentially detrimental effects of regulation on both the financial structure and the real economy. They also emphasize the competitive forces that influence the ultimate impact of regulations. Technological trends in telecommunications and computation seem likely to increase the ease with which users and providers of financial services can circumvent burdensome regulations, according to the authors. This has led to calls for reduction in the overall restrictions on financial firms, as well as for international harmonization of regulations regarding safety and soundness, insider trading and taxation. The authors examine how to quantify the gains to the economy from improving the efficiency of the financial sector and the potential social gains and costs which may result from the formation of financial conglomerates. The authors then consider pressures for international harmonization of financial regulation, contrasting institutional regulation with functional regulation. The authors conclude that efficient financial markets require an infrastructure of laws, conventions and regulation. Most of all, an efficient financial system requires confidence. Confidence encourages investors to allocate their savings through financial markets and institutions rather than to buy non-productive assets as a store of value. The authors suggest that such confidence can be fostered by appropriate regulation of institutions and markets to ensure users of financial services that they will receive fair treatment. According to the authors, the challenge is to foster a static and dynamically efficient financial system while maintaining sufficient regulatory oversight to promote confidence in the safety and soundness of the financial system.