Role of the financial system

The role of the financial system is to transfer savings, transform risk and help achieve productive investment at least cost

A financial system provides the means to transfer savings from those with surplus capital to those in need of capital – and to transform risk – to help achieve productive investment at least cost over the investment horizon. That transfer may be undertaken publicly or privately, with the price of exchange set by financial intermediaries and/or individuals. A key role of the financial system is to minimise the problems of asymmetric information, which arise because borrowers generally know more about their investment projects than lenders.

The financial system comprises a myriad of financial instruments and services

A country’s financial system comprises a myriad of financial instruments and services offered to firms (and investors) by a range of markets, organisations (e.g. financial institutions) and individuals. Governing that system is a complex set of legal institutions (e.g. securities law) and norms (e.g. lending policies). Key components of New Zealand’s financial system include: the banking sector; the venture capital/private equity market; the corporate bond market; the public equity market (both primary and secondary); non-bank financial institutions; and the foreign exchange market.

A good financial system performs seven functions

In broad terms, a good financial system performs the following seven functions[4]:

• mobilises savings;
• allocates resources and funds new investment;
• promotes the production and discovery of information;
• monitors managers and exerts corporate control;
• promotes flexibility and innovation in the use of technology and financial instruments;
• facilitates the trading, hedging, diversifying and pooling of risk; and
• facilitates the exchange of goods and services.

The level of financial development refers to the effectiveness and efficiency with which these seven functions are performed

Specific market frictions (e.g. transaction costs and information problems) motivate the emergence of specific financial markets and specialist intermediaries that provide these seven functions. The level of financial development refers to the effectiveness and efficiency with which these functions are performed (in a collective sense) by the various financial instruments, markets and intermediaries that make up the financial system. These in turn improve the allocation of resources (in both a static and dynamic sense), the quality of governance, the rate of capital accumulation and technological innovation, and the long-run rate of economic growth. An effectively functioning financial system does not imply that all agents in need of funds necessarily receive funds (i.e. a crucial function of the system is to withhold funds from investments deemed ‘undeserving’ by informed investors).

The financial system sits in the wider economy with a range of links and complex interdependencies

The financial system sits in the wider economy, in which the saving of households, firms’ investment and the operation of fiscal and monetary policy all impinge on and are influenced by one another. Figure 1 illustrates some of the possible links and complex interdependencies connecting the financial system, saving and investment with improved firm performance and higher incomes for New Zealanders. Many of these have been subject to empirical and theoretical investigation. The diagram should be seen as indicative only, to prompt thinking about system linkages. It does not purport to be a rigorous economic model.

Figure 1 – Financial System Linkages

There is good evidence that financial-system development has a positive effect on economic growth  

A key point has emerged from recent economic research on financial system development. There is strong theoretical reasoning and empirical evidence[5] that the causal relationship between financial system development and economic growth is bi-directional. That is while strong corporate performance and associated investment demand contributes to financial system development, causality also runs from financial-system development to economic growth.

In theory, as the financial system develops and growth responds positively, there will be a point beyond which further development has a zero or negative impact on welfare. But this point is unlikely to have been reached in countries with under-developed financial systems. In their search for policies that are growth enhancing, it would therefore be sensible for such countries to consider policy options to increase their financial-system development. We turn next to an assessment of the state of development of New Zealand’s financial system.