2 The role of financial systems in the economy
This section iscusses the main functions of financial intermeiaries an financial markets, an their comparative roles. Financial systems, i.e. financial intermeiaries an financial markets, channel funs from those who have savings to those who have more prouctive uses for them. They perform two main types of financial service that reuce the costs of moving funs between borrowers an leners, leaing to a more efficient allocation of resources an faster economic growth. These are the provision of liquiity an the transformation of the risk characteristics of assets.[2]
2.1 Provision of liquiity
The link between liquiity an economic performance arises because many high return investment projects require long-term commitments of capital, but risk averse leners (savers) are generally unwilling to elegate control over their savings to borrowers (investors) for long perios. Financial systems mobilise savings by agglomerating an pooling funs from isparate sources an creating small enomination instruments. These instruments provie opportunities for iniviuals to hol iversifie portfolios. Without pooling iniviuals an househols woul have to buy an sell entire firms (Levine 1997). iamon an ybvig (1983) show how financial intermeiaries can enhance risk sharing, which can be a preconition of liquiity, an can thus improve welfare. In their moel, without an intermeiary (such as a bank), all investors are locke into illiqui long-term investments that yiel high payoffs only to those who consume at the en of the investment. Those who must consume early receive low payoffs because early consumption requires premature liquiation of long-term investments. When agents nee to consume at ifferent (ranom) times, an intermeiary can improve risk sharing – by promising investors a higher payoff for early consumption an a lower payoff for late