Finance is powerful. The financial system can be an engine of economic prosperity â?? or a destructive cause of economic decline and misery. The impact of the financial system on the rest of the economy depends on how it mobilises savings, allocates those savings, monitors the use of those funds by firms and individuals, pools and diversifies risk, including liquidity risk, and eases the exchange of goods and services.
When financial systems perform well, they tend to promote growth and expand economic opportunities. For example, when banks screen borrowers effectively and identify firms with the most promising prospects, this is a first step in boosting productivity growth. When financial markets and institutions mobilise savings from disparate households to invest in these promising projects, this represents a second crucial step in fostering growth. When financial institutions monitor the use of investments and scrutinise their managerial performance, this is another essential ingredient in boosting the operational efficiency of corporations, reducing waste and fraud, and spurring economic growth. When securities markets ease the diversification of risk, this encourages investment in higher-return projects that might be shunned without effective risk management vehicles. And when financial systems lower transaction costs, this facilitates trade and specialisation, which are fundamental inputs into technological innovation and economic growth.
Read Full Article »