Custom Search

OTHER FUNCTIONS OF FINANCIAL MARKETS AND INSTITUTIONS

Financial markets and institutions provide financing for business. They also contribute in many other ways to our individual well-being and the smooth functioning of the economy. Here are some examples.7

The Payment Mechanism. Think how inconvenient life would be if you had to pay for every purchase in cash or if General Motors had to ship truckloads of hundred-dollar bills round the country to pay its suppliers. Checking accounts, credit cards, and electronic transfers allow individuals and firms to send and receive payments quickly and safely over long distances. Banks are the obvious providers of payment services, but they are not alone. For example, if you buy shares in a money-market mutual fund, your money is pooled with that of other investors and used to buy safe, short-term securities. You can then write checks on this mutual fund investment, just as if you had a bank deposit.

Borrowing and Lending. Financial institutions allow individuals to transfer expenditures across time. If you have more money now than you need and you wish to save for a rainy day, you can (for example) put the money on deposit in a bank. If you wish to anticipate some of your future income to buy a car, you can borrow money from the bank. Both the lender and the borrower are happier than if they were forced to spend

cash as it arrived. Of course, individuals are not alone in needing to raise cash from time to time. Firms with good investment opportunities raise cash by borrowing or selling new shares. Many governments run at a deficit.

In principle, individuals or firms with cash surpluses could take out newspaper advertisements or surf the Net looking for counterparts with cash shortages. But it is usually cheaper and more convenient to use financial markets or institutions to link the borrower and the lender. For example, banks are equipped to check the borrower`s creditworthiness and to monitor the use of the cash. Almost all financial institutions are involved in channeling savings toward those who can best use them.

Pooling Risk. Financial markets and institutions allow individuals and firms to pool their risks. Insurance companies are an obvious example. Here is another. Suppose that you have only a small sum to invest. You could buy the stock of a single company, but then you could be wiped out if that company went belly-up. It`s generally better to buy shares in a mutual fund that invests in a diversified portfolio of common stocks or other securities. In this case you are exposed only to the risk that security prices as a whole may fall.8

6 National Association of Security Dealers Automated Quotation system.

7 Robert Merton gives an excellent overview of these functions in ¬A Functional Perspective of Financial Intermediation, ­

Financial Management 24 (Summer 1995), pp. 23 Ј41.