THE CONTRIBUTION OF THE FINANCIAL SECTOR

CONTRIBUTION OF FINANCIAL SECTOR

In the wake of the recent crisis, it is perhaps not surprising that many have focused on the capacity of the financial sector, and banks in particular, to impose negative externalities on the rest of the economy (Haldane, 2010). Such negative externalities encompass both the direct fiscal costs of supporting financial institutions at risk of failure, and the indirect costs from the recessions that almost invariably accompany large-scale financial distress. If costly crises are seen as the financial sector’s main impact on the rest of the economy, it follows that more or less any actions to limit risk-taking by financial institutions can be justified. In fact, of course, a well-functioning financial system plays an essential role in generating high levels of saving, promoting the efficient allocation of investment, and smoothing economic fluctuations stemming from non-financial causes.  


 By facilitating informed risk-taking, it is a key element in achieving optimal levels of productivity growth, and rising living standards. The importance of this contribution can be seen in the divergence in economic performance between countries with open and those with repressed financial systems (Caprio and Honohan, 2001). Such a comparison suggests that the contribution of finance to economic performance should be measured by the enhancement of total factor productivity to which the financial system gives rise. It is, however, extraordinarily difficult to quantify this, and to disentangle the individual contributions made by different aspects of the financial system. Still, this does not prevent identifying some of the ways in which the effectiveness of the financial sector is likely to be related to economic performance. 


The first, and least controversial, is in the provision of a payment system. No market economy can function without a payment system, and it has long been accepted that banks are the most efficient way of providing this. Some have tended to see this function of the banking system as uniquely important, and the only one that needs to be protected by public policy intervention. This is the fundamental starting point of the “narrow banking” school, whose advocates argue that if the payment mechanism is fully protected, there is no special public interest in how the rest of the financial system is organised.



 Insulating the payment system, however, does not by itself guarantee either the stability or the efficiency of the credit supply mechanism. Typically, it is interruptions in credit supply that transmit financial stress to the real economy. And it is inefficiencies in credit allocation that hold economies back from achieving optimal growth. Bubbles and their subsequent bursting are the most obvious manifestation of this. But more than just being a channel for credit intermediation and making payments, the financial system adds value in at least three other substantive ways. First, by converting illiquid and uncertain claims into liabilities that better match the asset-holding preferences of savers, a financial system can both add to the liquidity of non-financial sectors, and increase the overall level of saving within an economy. Maturity transformation is a key way in which the financial system adds value to the rest of the economy, but, as we have seen in the recent crisis, the leverage with which it is typically associated can also be a major source of vulnerability. 


In designing a financial system for the 21st century, therefore, we should seek to preserve the benefits of maturity transformation for users of financial services, while at the same time making the system robust to a unexpected erosion of liquidity, caused for example by sudden loss of confidence. Second, and perhaps most important, the financial system is the basic way in which an exchange economy deals with problems of asymmetric information. The extension of credit from ultimate lenders to ultimate borrowers is rife with asymmetric information. Before a loan is made, adverse selection results from the fact that a potential borrower has better information than a potential lender about the risks and returns from an investment. 



The growth of a financial system is the social mechanism for overcoming problems of asymmetric information and thus permitting a higher level of utility-enhancing exchange. A bank or other intermediary interposes itself between ultimate borrowers and ultimate lenders who would otherwise be discouraged from contracting by asymmetric information. The financial intermediary does this by putting its own capital at risk. Its incentive to do so is the spread it makes between borrowing and lending rates. Its ability to do so comes from the specialised resources it can apply, as a “delegated monitor” (Diamond, 1984), to assess credit risks, and to enforce restrictions on borrower behaviour. A financial institution can survive and prosper if the value of the additional information it generates exceeds its cost, and if it is able to derive private value from this information. The interposition of a financial intermediary is not the only way of transforming maturities, or generating information on creditworthiness. Securities markets can perform a similar function. Just as with banks, however, the effectiveness of securities markets relies on the availability of high-quality information. Also like banks, information will only become available if those that generate it are compensated for the costs of doing so. In securities markets, however, information provision can be impeded by “free rider” problems, about which I will have more to say later. And although specialised information providers, such as the accounting profession and rating agencies, attest to valuations and creditworthiness, they can be subject to conflicts of interest, as we have seen. Moreover, excessive reliance on external information providers can nurture “herding” behaviour. A central role therefore remains for the proprietary activities of trading entities, whose individual views combine to reveal a fair market price. Having a multiplicity of strong institutions making continuous prices is an essential component of efficient capital markets. A third way in which the financial system can promote high-quality growth is by providing a means of hedging against some of the uncertainties of investment. 



We know that physical loss insurance is a necessary backstop for virtually all real economic activity. Without such insurance, uncertainty would result in a reduction in productive investment and lower rates of economic growth. In addition, however, financial risks in high-value projects can be productively hedged through the use of derivative instruments. These include standardised products to cover interest and exchange rate risk, as well as the risk of commodity price fluctuations. They may also include customised structured products to cover more complex or idiosyncratic risk. It will be important that a reformed financial system does not place obstacles in the way of the appropriate use of instruments that reduce financial risk..