Why Financial Institutions are Necessary in an Economy Finance Essay

It is no doubt that the existence of any developed economy must leans on a well operated financial system (Moore et al 1990). A financial system was defined by Viney (2003) as a system which can comprise a range of financial institutions, instruments markets that facilitate transactions for goods and services and financial transactions. An efficient financial market makes the exchange of value for goods and services much easier (Viney 2003). Due to the financial system in present society, people do not have the barter to trade (Moore et al 1990). It would be extremely difficult to trade value without financial system and markets. Modern financial institutions, instruments and markets are the foundation of current business transaction. In present society, financial markets are performing a vital role of channeling funds. Basically, in financial markets, funds are transferred from people who have superfluous money to those people who have a shortage (Mishkin and Eakins 2009). Namely, savers of funds will purchase financial instruments and users of funds issue financial instruments (Edmister 1986). Therefore, the relationship between savers and users of funds creates the flow of funds and financial markets (Viney 2003). A well-functioning financial market is conducive for the development and a long term economic growth (Tennant, Kirton and Abdulkadri 2010). In contrast, a poorly organized financial market is a major reason for why many countries are still remaining poor (Mishkin and Eakins 2009). Hence, the efficiency and capability of financial institutions clearly influences the growth and development of any society and the well-being of its citizens (Bryant 1987, Yeager 1989). This essay not only identifies several functions of financial institutions, but also demonstrates the vital role of financial institutions, in order to explain why financial institutions are extremely necessary in an economy. The first function of financial intermediaries is that to help reduce the exposure of investors to actuarial risk (Mehta and Fung 2004, Mishkin and Eakins 2009). To understand this function, people ought to consider the investment risk from the perspective of a group of investors (Mehta and Fung 2004). Financial institutions achieve its risk reduction function by sharing the risk.

Financial intermediaries allow assets to be created and then sold to investors with a comfortable level of risk. Financial institutions utilize the funds which obtained by the assets they have sold to purchase other more risky assets. Due to this and their excellent investment knowledge financial institutions can enjoy lower transaction costs than individuals and thus earn profits from this transformation process. On the other hand, the profits can be paid out to investors who purchased assets from financial institutions. Therefore, risky assets are transformed into safer assets for investors by financial intermediaries (Mishkin and Eakins 2009). For instance, assume one single investor wants to invest $100 into a company whose shares are selling at $100 apiece. However, the investor faces a 10 percent chance of failure. If the company goes bankrupt, the investor will lose all his money because of this investment. If there are 100 investors want to invest to this company.

Each of them is holding $100 fund and also each of them is confronting 10 percent risk of failure. Now these 10 investors pool funds together to form a bank.

The bank will loan $1000 to the company. If the company failed, each investor faces just a 10 percent lose in their investment. Thus, financial intermediaries reduce the risk to customers and achieve profits through the specialist skills in credit risk management and monitoring system (Hogan et al 2001). Furthermore, the financial markets and institutions promote individuals to diversify in a variety of investments. Diversification means investors are able to combine different financial instruments into a portfolio (Edmister 1986). A portfolio was defined by Viney (2003) as a combination of assets and liabilities that includes a wide range of financial securities. Modern portfolio theory was first introduced by Markowitz in 1952 when he published his paper ‘Portfolio selection’ (Mitchell 2010). Ordinarily, a diversified portfolio is much less risky than a portfolio comprising a range of related and similar investments (Edmister 1986). In other words, it is conceivable that total risk will be reduced because losses in some investments are counteracted by gains in others.

Hence, in present financial system, customers are able to choose a wide range of alternative financial assets to manage investors’ risk (Hogan et al 2001). However, it is easy to confuse between actuarial risk and portfolio risk. There is a fine distinction between the two. The actuarial risk focuses on the risk sharing behavior of a group of investors, but portfolio risk is from the perspective of one investor to invest a group of financial assets (Mehta and Fung 2004). The second significant function of financial institutions is informational efficiency (Mehta and Fung 2004, Mishkin and Eakins 2009). The reason why financial intermediaries play such a crucial role in society is that one party does not know adequate information about other parties in order to make investment decision (Holod and Peek 2010). Two main problems are created by asymmetric information. The first one is called adverse selection. The second problem is moral hazard.

Adverse selection is the problem created before the financial transaction occurs (Florin and Simsek 2007). Due to asymmetric information, lenders are not necessarily well informed about the complete financial status of the funds borrowers. Although the lender desires the potential profits which may be produced by the borrower, the lender also may decide not to make any loans to the borrower, because the funds borrower is likely to create a bad credit. In comparison, moral hazard occurs after the financial transaction. From the money lender’s point of view, the borrower might be involved in some unethical activities which can cause bad credit, such as gambling. The fund lender may decide not to lend money to the borrower, because of high bad credit risk (Kostas 2009). Therefore, financial institutions are required in financial markets to avoid these two problems. Moreover, financial institutions gather the information from market and researching the investment opportunities. By the research and analysis of information, the financial institutions reduce risk and magnify return (Mehta and Fung 2004). Customers can benefit from the information which is provided by financial intermediaries. In return, individual investors just pay an amount of commission and fees.

The financial system is a principal information provider for markets and individuals who are involved with investment, because financial intermediaries are well equipped and have skillful staff to analysis market information (Viney 2003). Thus, financial institutions can mitigate impediment which created by asymmetric information to a well-functioning financial market (Hadlock and James 2003). Another function of financial intermediaries is to increase the liquidity. The liquidity of assets means the ability to sell an asset within a reasonable time, at the current market value and for reasonable transaction costs (Covitz and Downing 2007). If an investor can convert an asset into cash easily and quickly, with little or no loss of value, then the asset into has liquidity. Financial institutions are responsible for distributing funds to potential users, increasing the liquidity of funds. This is a pivotal function of financial institutions. The funds can be transferred by financial institutions from one party to another. In other words, Money will flow to the party who has particular needs through liquidity and cash flow patterns.

Nothing is more important than the capital flows for the development of a society (Chung, Elder and Kim 2010). The liquidity function of financial institutions enhances the flexibility of funds (Maug 2002). For example, an investor seeks to invest in a company without sufficient funds. However, the investor has a car and currently holding some other company’s stock. If the financial system is efficient, the financial market enables the investor to acquire cash by selling his car and other stock, in order to get a greater return by investing into the company. It is extremely difficult to manage financial transactions without the assistance of financial institutions. As we have seen, the investor needs cash to invest in the company.

However, if there is no financial institution that can help this investor to sell his car and stock, the investor has to hire a specialist to write up contracts for this transaction. The cost of hiring an agent will offset the potential profits from this new investment. This example illustrates that financial institutions can assist individual customers to step into financial markets and benefit from them. Hence, financial intermediaries can augment the liquidity of shares and promote more individuals to invest into financial markets, because financial institutions are able to substantially reduce the transaction cost (Mishkin and Eakins 2009). To conclude, there are three reasons why financial institutions are necessary in an economy.

The first reason is that financial institutions enable to reduce the risk for investment. Risky assets can be transformed into safer assets for investors by financial intermediaries. Moreover, financial institutions also help investors to create a financial portfolio to offset the risk of different financial instruments. The second reason is that financial institutions provide information for markets. This function efficiently averts adverse selection and moral hazard (Darrough and Stoughton 1986). The third reason is that financial intermediaries increase the liquidity of shares. It assists more individual investors to invest to financial markets, because financial institutions reduce the transaction cost substantially.

Due to these three reasons, financial institutions are extremely vital for the development of an economy.

Cite this page