Financial system

The financial system puts borrowers in touch with lenders and allocates risks to those who wish to take them. It is a complex interactive system, events in one component of which can have significant repercussions elsewhere. International linkages often add to its complexity by enabling developments in one country to generate consequences elsewhere. Under normal circumstances, national and international financial systems contribute to the economic efficiency of their users, but their malfunction can cause widespread economic damage.

Overview

The functioning of financial systems

A basic function of a financial system is the transfer of productive resources from those who own them but do not wish to use them, to those who wish to use them but do not own them. In the absence of that function, only a small proportion of current output would be possible. A secondary function is the transfer of risk from those who wish to limit their exposure to it, to those willing to accept it for a fee. That function, also, can make a major contribution to a community's productive capacity. Some financial transactions perform both functions. However, willingness to undertake such transactions, except to family members and close friends, depends upon confidence that the agreements involved would not be broken - which depends in turn upon the enforcement of an effective regulatory system. Major losses of economic output tend to occur when such confidence is impaired.

Theoretical developments

Financial economics

There is evidence that suggests that a well-functioning financial system contributes to economic growth .

Proposals for reform

In preparation for a meeting of the world leaders in November 2008, an ebook was published by an international group of twenty leading financial economists. They agreed on the need to augment IMF resources and to strengthen existing arrangements for global governance. Several of them also argued for new approaches to the regulation of large cross-border financial institutions.