The Important Function of Banks and Markets in an Economy

In the view of many individuals, the crisis has discredited the financial markets. Many individuals are demanding that the markets be shackled. That functioning financial markets are extremely important for the prosperity of individuals is usually overlooked. In an economy, simply speaking, there are consumers and producers. Producers manufacture goods and services. In order to finance investments in their production facilities, they usually need external funds. Consumers make these funds available to them in the form of their savings. For this refraining from consumption and assuming or risks, they receive interest and dividends from the producers. The task of a financial system thus consists of passing on the savings of consumers to those producers who can use them best – thus, who can obtain the highest investment return.

Thus, a functioning financial system brings savings and investments into balance in an efficient way. If there were no banks or markets, then each individual saver himself would have to engage in a search for companies to which he can entrust his money. Conversely, each company would have to negotiate with countless savers in order to finance the typically high investment sums. That would be quite complex. Many companies would not receive the necessary funds, investments would remain unmade, technical progress and prosperity would remain at a distance.

Investment options
A financial system overcomes the barriers between savers and companies by supporting several functions. First, it makes available information regarding investments that are potentially rewarding. From their own point of view, savers know only a few companies. In contrast, markets offer the option of making funds available to a multitude of companies (even foreign) through the purchase of shares or bonds. This is because, from many years of experience, they know many companies, and thus can identify numerous investment options for the funds of savers. Second, a financial system monitors whether the funds of the savers are used sensibly. The interests of savers (high returns and secure repayment) and managers (high compensation) do not necessarily conform to one another. This is shown not least in the discussion regarding high bonuses at Anglo-Saxon investment banks. A functioning financial system protects the interests of savers. Thus, stock markets put investors in the position of exercising pressure on management through the sale of shares, which, in their view, does not sufficiently protect their interests.

Third, a financial system transforms short-term capital into long-term credits. Companies are often dependent on investments that are quite long-term, because, with the development of new drugs or technologies, profits sometimes flow only after ten or more years.

Term transformation
However, not every saver can provide assets for such long periods of time. Markets for shares or corporate bonds provide the opportunity for savers to withdraw from an investment for a shorter period of time, by selling their securities to others. A bank achieves this transformation by partially making available the short-term capital of its customers to companies in the form of long-term credits.

Beneficial effects
Naturally, a financial system can obtain the beneficial effects formulated by economic theory only if the state efficiently designs it. Here, as a matter of fact, reforms are necessary, as the financial markets crisis shows. These should lead to not more, but better, regulation of the financial markets.

by Dr. Jörg Krämer, chief economist of Commerzbank