International Financial Markets Essay
Book: Financial Markets and Institutions (a European perspective) – Haan et al.
Author: Kim Cornelissen
Chapter 1: Functions of the Financial System
1.1. Functions of a financial system
The financial system
Figure 1.1; page 5 – Working of the financial system
Financial system: includes all financial intermediaries and financial markets, and their relations with respect to the flow of funds to and from households, governments, business firms, and foreigners, as well as the financial infrastructure. Main task is to channel funds from sectors that have a surplus to sectors that have a shortage of funds. Financial infrastructure: the set of institutions that enables effective …show more content…
Main functions (2)
Two main functions of the financial system: 1. Reducing information and transaction costs 2. Facilitating the trading, diversification, and management of risk, to explain why the financial sector may stimulate capital formation and/or technological innovation (two of the driving forces of economy)
1. Reducing information asymmetry and transaction costs
Financial system helps to overcome information asymmetry between borrowers and lenders.
Information asymmetry: * Ex-ante: before a financial contract has been agreed upon. Arises because borrowers generally know more about their investment projects than lenders undesirable outcome for lender (adverse selection). Because it is difficult and costly to evaluate potential borrowers. this may keep funds from flowing to their highest productive use.
Financial intermediaries reduce the cost of getting information and may thereby improve resource allocation. * Ex-post: after a financial contract has been agreed upon. Occurs when borrowers, not investors, can observe actual behavior. Once a loan has been granted, there is a risk that the borrower will engage in activities that are undesirable from the perspective of the lender (moral hazard).
Financial markets also mitigate the information acquisition