Benefits of the financial system for the economy

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 details. 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 money and we probably get higher return on our investments.

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 make easily payments between themselves. When the financial system is well developed, companies can easily receive and make payments for rent, supplies, wages, and taxes. The rapid and inexpensive settlement of payments allows the economy to function more smoothly.

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