Finance and the real economy

The financial system is the blood system of the economy. It is essential for the health of the economy as allows the savings of the population to go to various projects and investments. When it performs these functions well, the economy thrives. When it doesn’t, the economy stagnates or, worse, goes into a crisis. What is actually the benefit of having a financial system and when do things go bad?

1. Financial markets and institutions – basic concepts.

Financial institutions are intermediaries between people with extra cash and other people who need money to invest in a business, buy a house, pay bills, etc. The role of the financial institutions is to pool the available cash and to allocate it to uses that promise high return and low risk. That can be done via credit or by acquiring part ownership in a company.

Credit can be allocated through banks, bond markets, leasing companies and other non-bank intermediaries. Banks are financial intermediaries that collect deposits and give credits. Bond markets also allocate credits but without a bank in the middle. Instead, the credit is extended directly from individuals or firms to other firms or a government. Think of the bond as a piece of paper on which is written that “IBM owes $100,000 plus 5 percent interest in one year to whoever owns this piece of paper.” At the end of the year, you give the piece of paper to IBM and they give you $105,000. However, you can also sell the bond to another investor before the bond reaches maturity, i.e. before the end of the year. Leasing companies provide credit to consumers to buy particular products. For example, many car companies can provide credit to customers who buy their cars. Credit can also be extended by pawn shops, friends and relatives, micro-credit institutions, etc.

Stock markets, in contrast, do not allocate credit but allow people to become part owners in companies. The ownership of each firm traded on the stock exchange is broken down in millions of shares. An investor can then buy, for example, 50 shares in General Motors, 200 shares in Apple, etc. Each share represents part ownership in the company and gives the investor a vote in the company decisions and part of the profits.
In the vast majority of countries around the world, the main form of financing is through banks. Stock markets are well developed only in advanced countries such as the U.S., the U.K., Singapore, Switzerland and several others.

Besides credit institutions and the stock market, insurance companies are another important part of the financial system. They provide compensation when something undesired happens. For example, you have a car accident and the insurance company pays for the repairs. A doctor is sued by a patient and the insurance pays the lawyer fees. The idea is that many people pay a premium to the insurance company but not all of them need a payment at the same time. We all pay for the ones in need. Tomorrow we may be in need and others pay for us.

2. Why some countries have well-developed financial systems and others don’t?

A well developed financial system means that the private sector has access to credit and stock market financing. If a firm has a promising investment idea and can prove that it has managed prudently its finances over time, it should be able to receive funding for its project. If a consumer wants to buy a home and has low debt and a stable job, he/she should be able to get mortgage credit. Unfortunately, that is not the case in many countries. Data from the World Bank shows that over 30 percent of households in the U.S., UK, Sweden, Netherlands, Belgium, Denmark, and other developed countries have mortgages while the percent of households with mortgages is less than 10 percent in most of the rest of the world. In fact, less than 5 percent of households in many countries in Africa, Latin America, and the former communist bloc have outstanding mortgages.

The most important factor for financial development is the quality of the legal system of a country. Can lenders collect their money if borrowers refuse to pay, can shareholders exercise their rights as minority owners in companies, can one trust financial documents and income statements, are legal procedures streamlined and transparent, etc.? If the answer to these questions is no, then financial institutions cannot provide credit and people would not invest in the stock market. Unless the legal system functions well, the financial system cannot develop.

3. How finance helps the economy?

There are several specific functions performed by the financial system that help economic development. As you read, please keep in mind that financial institutions may or may not perform these functions very well. If they do, the financial system flourishes and the economy does too. If they don’t, the financial system remains small and ineffective and we sometimes end up in financial crises.

Collect information about borrowers and allocate capital

To appreciate the value of banks for the economy, let’s say that you have $10,000 to invest. To select investment opportunities, you start looking at firms that need financing and at individuals who want to buy a house or a car, to pay college fees, etc. For each of those prospects, you have to determine whether they can pay back, if they would run away with your money, what interest rate to charge, and other issues. You have to collect and analyze documents and talk to the potential borrowers before deciding who gets the credit. That sounds like a lot of work. Plus, are you sure you know what you are doing?

It is simpler and cheaper to have banks do that work for all investors. We give the banks our money in the form of bank deposits. The banks then collect information about potential borrowers and decide who gets credit, how much, and at what terms. The banks specialize in the analysis of such information and become pretty good at it. As a result, we save time and we probably get higher returns on our investment.

Monitor investments and exert corporate governance

After extending credits, banks continue to watch if the borrowers use the funds as intended. It is easier and cheaper for one bank to monitor many borrowers instead of each investor to monitor many borrowers. The participants in the stock market also watch collectively how the funds are used and buy and sell company shares depending on that information. With such monitoring, the capital is used more prudently and effectively.

Facilitate diversification and risk management

Through bank deposits and the stock market individual investors can hold small pieces in a large portfolio of investments. Some of the investments would be successful while others would fail. With a portfolio of investments, however, the investor is protected against risk while receiving a decent rate of return. In addition, individual investors can sell their shares or withdraw money from their bank deposits when they need cash. The easy access to cash lowers the so-called “liquidity risk”, i.e. the risk of having only investments and no cash when you need some.

Mobilize and pool savings

The financial system pools together the savings of many small investors and can fund massive projects that require large amounts of capital for a long time. A prime example is the building of railways in the U.S. in the 1800’s that was funded through the stock exchange. These types of investments create a lot of value added and make a big difference for the economy.

Ease the exchange of goods and services

Last but not least, the financial system makes it possible for individuals, firms, and governments to easily make payments between themselves. When the financial system is well developed, companies can simply receive and make payments for rent, supplies, wages, and taxes. The rapid and inexpensive settlement of payments allows the economy to function more smoothly.

When these functions are performed well, the financial system helps households, entrepreneurs, and the overall economy. There are times, however, when the system falls apart.

4. Banking crises

Banking crises are periods when many banks in the economy are on the brink of collapsing. Depositors rush to get their money out and, often, the government intervenes to save the banks to contain the problem to the “sick” banks and to keep credit flowing in the economy. It might nationalize, close, or merge banks to contain the problem. It takes about 5 years for the banking system to get back to normal.

Leading indicators of banking crises

Rapid credit growth: Banking crises are preceded by a rapid expansion of bank credit to firms and households for several years. The credit expansion is usually fueled by optimism about the economy that motivates households to buy assets (real estate) and firms to invest in plant and equipment.

Real estate bubbles: Typically, much of the new credit goes into real estate and pushes prices up. The rising prices contribute even more to the optimism.

Capital inflows: Often, the expansion of credit is funded by the inflow of international capital. In essence, foreign banks lend to domestic banks which then lend to households and firms.

Eventually, asset (real estate) prices reach very high levels and stop rising. Demand for real estate drops, prices start falling, borrowers cannot pay back the bank debts, and banks start losing money. The government intervenes to support them.

Negative effects of banking crises

Recession: When banks go into trouble they reduce drastically their lending to households and firms. Respectively, households and firms reduce their consumption of goods and services and the economy goes into recession. For example, the output loss during the 1991-95 banking crisis in Finland was equivalent to 70% of its GDP. In other words, the Finish economy underperformed for several years relative to its normal functioning. The cumulative loss to economic activity during these years was 70% of GDP.

Steep rise in government debt: The government assistance to banks requires a lot of money at a time when the economy is already in a recession and government revenues are down. Therefore, the government borrows and keeps borrowing for several years. For example, Iceland’s government borrowed and spent an amount equivalent to 13 percent of GDP to support its banks during the 2007-08 crisis.

Resolving crises

It takes 4-6 years for the effect of a banking crisis to fade away. In comparison, the average recession without a banking crisis is about 2 years long. Gradually, banks are restored to health and start lending again. Households and firms start spending and the economy picks up. The large government debt, however, that accumulates during the crisis is a long-term legacy. It has to be paid off for significantly longer than 4-6 years.

The frequency of banking crises

Two well known economists, Carmen Reinhart and Kenneth Rogoff identify 156 banking crises in 110 countries from 1963 to 2007. The frequency of banking crises has varied over time but it seems to have trended upwards. For instance, only 3 banking crisis in their dataset occurred between 1960 and 1975, whereas about 35% of all crises occurred in the 1980s and 45% in the first half of the 1990s. This trend declined in the latter years as only 16% of the crises happened after 1995, including the recent crises.

Their data also show that different regions have been affected differently by banking crises. Latin American economies have experienced a high number of banking crises. For example, Argentina, Brazil, and Bolivia represent the most extreme cases, having suffered more than 3 crises each. Many countries in Sub-Saharan Africa, Eastern Europe, and Central Asia have also suffered from multiple banking crises. Only a quarter of the countries in these regions have not experienced a banking crisis, while 13 countries experienced two crises.

Additional resources

Global financial structure database from the World Bank, the most comprehensive data on financial systems – financial database

Financial Access survey from the IMF: who has access to credit and other financial services. Available from: http://fas.imf.org/

Microcredit articles from the Economist magazine; small scale lending to fight poverty. Available from: http://www.economist.com/topics/microcredit

Rogoff, Kenneth and Karmen Reinhart “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises”. Available from: http://www.economics.harvard.edu/files/faculty/51_This_Time_Is_Different.pdf

Access to finance in Europe: who uses what financial services across Europe. Available from: http://ec.europa.eu/enterprise/policies/finance/

Recommended academic readings (advanced, with quite a bit of math)

Allen, Franklin and Douglas Gale. “Comparing Financial Systems,” available at Amazon.com.

Demirgüç-Kunt, A. and E. Detragiache. "The Determinants of Banking Crises in Developing and Developed Countries." IMF Staff Papers, 45, 81-109, 1997.

Levine, Ross. “Finance and Growth: Theory and Evidence” National Bureau for Economic Research, working paper 107-66, 2005.

Rioja, Felix and Neven Valev. “Does One Size Fit All?: A Reexamination of the Finance and Growth Relationship,” Journal of Development Economics, 429-47, 2004.


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