In today’s article, I present an introduction of the financial sector and its role within the broader economy. Therefore, it is presented within the framework of an academic and theoretical underpinning. This will of course be followed by a series of a few practitioner-based articles in the coming weeks.
Generically, the financial sector includes everything from banks, stock exchanges, insurers, to money lenders, microfinance institutions, and credit unions. In other words, the financial sector is all the wholesale, retail, formal and informal institutions within an economy, offering financial services to firms (businesses), consumers (householders) and other financial institutions.
In order for there to be a well-functioning economy, central to this concept is an efficient financial sector. Thus, it should serve in improving the efficiency of the economy as well as increasing its productivity. Put differently, the financial sector is the heart of the real economy, and hence, if the financial sector crashes or hits a crisis, the economy will also follow suit.
The financial sector, according to Umberto Pisano et,al (2012), generally has “a very straightforward set of tasks: Firstly, it has to allocate capital, ie making sure that capital goes to areas where its return is highest. Secondly, it should manage risk in a way that, using the ability to absorb risks, it allows capital to go where higher return on investments can be made. It is also supposed to perform these tasks efficiently – therefore at a relatively low cost (Stiglitz, 2010).”
The structure of the financial sector constitutes three components – financial markets, financial institutions and financial regulators. Each of the components plays a specific role and has singular characteristics, but most important is constantly involved with the others within the political, social and economic frameworks in which the system operates. Each component also has a function: financial markets provide liquidity and price discovery to funds used in finance and investments by households, firms and governments; financial institutions are the most important participants in the financial markets as they are intermediaries that gather data and coordinate the allocation of assets between suppliers and users of funds; and financial regulators are in charge of providing stability to the system by creating the necessary legal framework and ensuring that market participants comply with its rules and regulations.
With respect to financial sector development and growth, modern growth theory identifies two specific channels through which the financial sector might affect long-run growth: the first being through its impact on capital accumulation including human as well as physical capital and; through its impact on the rate of technological progress. These effects arise from the intermediation role provided by financial institutions which enable the financial sector to mobilise savings for investment; facilitate and encourage inflows of foreign capital (including FDI, portfolio investment and bonds, and remittances); and optimise the allocation of capital between competing uses, ensuring that capital goes to its most productive use.
Levine (1997) identifies five basic functions of financial intermediaries which give rise to these effects: savings mobilisation; risk management; acquiring information about investment opportunities; monitoring borrowers and exerting corporate control; and facilitating the exchange of goods and services.
Financial sector development and poverty reduction
In the same way that financial services increase income growth generally, expanding the supply of financial services which can be accessed by the poor will increase income growth for the poor, thus having a direct impact on poverty reduction (Jalilian & Kirkpatrick, 2001). The provision of savings facilities can enable the poor to accumulate funds in a secure place over time in order to finance a relatively large, anticipated future expenditure or investment, and can sometimes provide a return on their savings.
The mobilisation of savings also creates the opportunity for re-lending the collected funds into the community. The availability of credit can strengthen the productive assets of the poor by enabling them to invest in productivity-enhancing new ‘technologies’ such as new and better tools, equipment, or fertilisers, etc, or to invest in education and health, all of which may be difficult to finance out of household income, but which could provide for a higher income in future.
The availability of credit can also be an important factor in creation or expansion of small businesses, thus generating self-and-wage-employment and increasing incomes. Further, access to credit can reduce the vulnerability of the poor to shocks in the absence of savings or insurance which could have knock-on benefits. Eswaran and Kotwal (1990) argued that just the knowledge that credit will be available to cushion consumption against income shocks if a potentially profitable but risky investment should turn out badly, can make the household more willing to adopt more risky technologies. Such behaviour may increase the use of modern technologies with productivity –increasing, and hence income enhancing benefits.
Finally, remittances from abroad and domestic transfers are an important source of income for the poor, and provide an additional means for them to diversify their sources of income, thus reducing vulnerability. Where financial sector development leads to lower costs, more secure and rapid transfers, and easier access to transferred funds, this would be of significant benefit to poor recipients. However, in developing countries (like Guyana) often do not have access to ongoing, formal financial services and are forced to rely on a narrow range of often expensive and more risky informal services. This constrains their ability to participate fully in markets, to increase their incomes and to contribute to economic growth.
