Ebook The Role of the Financial Sector in Economic Performance
The impact of the financial sector on the real economy is subtle and complex. What distinguishes 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. Nonetheless, 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 more importantly products which enable 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 standards of living.
This paper examines the relationship between the financial sector and economic performance highlighting the role of government in maintaining an efficient financial system. It does so in several stages. In the first section, in order to provide a clear standard for comparison, we begin by considering how an economy would perform without a financial sector. In the second section, we proceed to introduce a simplified financial sector with direct financial transactions between savers and investors. We then introduce financial intermediaries which transform the direct obligations of investors into indirect obligations of financial intermediaries which have attributes that savers prefer. This section emphasizes how the financial sector can improve both the quantity and quality of real investment and thereby increase income per capita.
The third section considers the role of government in supporting an efficient financial sector. We explain why some financial institutions may be vulnerable to collapse and the consequence this may have for the functioning of the economy. Then we review the system of circuit breakers which societies have developed to prevent a shock to one part of the financial system from destroying other financial institutions and damaging the real economy. In addition we consider the role of government in fostering efficient financial markets.
The fourth section recognizes that not all government intervention in the financial sector is beneficial. We review the potentially detrimental effects of regulation on both the financial structure and the real economy. We also emphasize the competitive forces that influence the ultimate impact of regulations. Before advances in technology and financial theory stimulated financial innovations and before advances in telecommunications lowered the cost of cross-border transactions, national regulators enjoyed considerable autonomy in regulating domestic markets and institutions. Under current conditions, national regulators may continue to behave autonomously; but, the main result of more burdensome regulations may be to induce users and providers of financial services to shift to less heavily regulated products or locations, thus undermining the objectives which motivated the change in regulations. This dynamic process has become increasingly competitive as regulators in some countries have actively sought a greater share of international financial business. Technological trends in telecommunications and computation seem likely to increase the ease with which users and providers of financial services can circumvent burdensome regulations. 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 fifth section begins with an examination of how to quantify the gains to the economy from improving the efficiency of the financial sector. We also consider the evolving structure of financial institutions in the contemporary world economy and review the trend toward the formation of financial conglomerates and specialized firms with an emphasis on identifying the forces which are causing structural changes. We examine the potential social gains as well as costs which may result from the formation of financial conglomerates. We then analyze appropriate policies and regulations which will enable society to realize the potential benefits of the optimal organizational structure of financial firms.
The sixth section discusses pressures for international harmonization of financial regulation. Institutional regulation is contrasted with functional regulation. The collapse of the Drexel Burnham Lambert Group is examined for its implications for the efficacy of functional regulation. Section VII provides a brief summary and concluding comments.
CONTENTS
Introduction
I. Savings, Investment and Economic Performance Without a Financial Sector
II. The Workings of a Simplified Financial Sector
- II.A. A Financial Sector With Direct Financial Claims
II.B. A Financial Sector With Financial Intermediaries
II.C. Completing the Financial Sector: Adding the Government and Foreign Sectors
III. Policies Supporting Financial Flows
- III.A. Stable Macroeconomic Policies
III.B. Why Depository Institutions Warrant Official Oversight
III.C. The Role of the Safety Net
III.D. Why Financial Markets Warrant Official Oversight
III.E. Policies to Enhance the Efficiency of Financial Markets
- III.E.1. Capital Requirements and the Transmission of Shocks
III.E.2. The Integrity of Clearing and Settlement Arrangements
III.E.3. Protection of Customers from Better-Informed Securities Firms
III.E.4. Protection of Investors from Better-Informed Issuers of Securities
III.F. Accommodating Socially Useful Financial Innovations
IV. Excessive Regulation and Regulatory Avoidance
- IV.A. Inefficient Regulation of Financial Institutions
IV.B Inefficient Regulation of Securities Markets
IV.C. Regulatory Avoidance
IV.D. Regulatory Competition
IV.E. International Harmonization of Regulation
IV.F. Market Alternatives to Harmonization
V. The Gains from an Efficient Financial System
- V.A. Quantification of Efficiency Gains
V.B. Potential Benefits from a More Flexible Financial Structure
V.C. Implications of Flexibility for Market Structure and Efficiency
VI. Prudential Supervision in the World Financial Market
VII. Summary and Conclusions
References
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