Role of Financial Institutions in the Economy
Economists believe that money is essential in the smooth flow of economic activities. Countries have been making all the available efforts to engage in economic growth. The goal of every economy is to remain sustainable and at a high growth rate. Financial markets are always imperfect, and financial markets play the role of providing information where players in the economy are unable to get sufficient information. The fact that financial markets are faced high by high risks makes information crucial to the various players in the sector. Moreover, economic development requires sufficient capital and essential ways of managing investments, so that the economies can remain functional. Financial institutions play the role of providing solutions to challenges of market imperfections as well as providing investment advice.
Financial markets are imperfect in that plays operate with insufficient information. Information is crucial in ensuring that factors such as risks and investment management are given the necessary attention. Perfect markets are assumed to be inexistent, and thus, players in the financial markets do not get a chance of operating in risk-free environments (Aryeetey, Hettige, Nissanke & Steel, 2019). The imperfections in financial markets lead to the role of information provision for financial institutions. Such institutions include banks and investment companies and provide information to players in the financial markets. For example, an investor may be willing to invest in a certain type of bonds. The information on the risk involved in such a decision may not be available hence causing an imperfection. The role played by financial institutions in such a case is that information such as the creditworthiness of the potential investment companies is provided to the investor. Generally, financial institutions provide information to investors and aid in making investment decisions. Moreover, most investment choices require an intermediary.
Financial institutions act as intermediaries in investment transactions. Investors require a channel through which they can communicate with the firms in which investment has to be made. Generally, the financial sector is strictly regulated to avoid financial mishaps that may become costly with time (Merton & Thakor, 2019). Financial institutions play an additional role as acting as an intermediary between investors and potential investment opportunities. The role comes as another role to the provision of information because information on the best decisions to make may not be freely available to investors. For example, most stock exchange markets require that investors trade through brokerage firms. In such cases, financial institutions may act as brokers to customers hence becoming financial intermediaries. Financial institutions play the role of becoming lenders in a bid to ensure a changing economy.
A growing economy requires capital to be used in development and investment purposes. Capital is, however, limited in supply, and investors have to rely on lenders to finance development and investment ventures. Financial institutions use the deposits made by customers to lend to other customers at an interest (Argimon et al. 2019). Also, the role of intermediaries is combined in borrowing, where financial institutions take loans that are later re-loaned at higher interest and flexible terms. The role of lending is always aimed at balancing deficit and surplus units in the financial markets. Besides, the financial institutions continue with their intermediary roles by availing borrowers for ease access by lenders. Generally, financial institutions play a significant role in the lending and borrowing sectors. Financial institutions play a crucial role in risk management in the financial markets.
Financial markets operate under high risky environments. The role of financial institutions as intermediaries gives financial institutions a chance to perform as risk-takers on behalf of investors. Standard market conditions are always not favorable for a primary investor, and the financial institutions come in to help in the investment process. Also, diversification of investment choices is still costly and may be beyond reach for single investors (Sheedy & Griffin, 2018). Financial institutions help in diversification of risky ventures, such that risk is shared between the borrower, intermediary, and the lender. When the risk is offset, the investment portfolio goes up, leading to the growth of the economy. Therefore, financial institutions play an active role in economic growth by managing risk on behalf of less able investors. Moreover, investors are motivated to venture into an investment due to the assurance that their ventures face less risk. Thus, capital becomes readily available, and the imperfections in financial markets are, to some extent, covered. Moreover, financial institutions are responsible for financial crises.
Economies come to their lowest at times when financial markets act against them. Financial crises happen as a result of failed financial systems and impact economies heavily to the extent of breaking some economies. Financial institutions such as banks are the most common players when financial crises occur. In the year 2008, the world ran into a financial crisis that hit across different financial institutions, with banks and insurance companies being the most affected institutions (Cziraki, 2018). The outcomes of the 2008 financial crisis form a basis of the discussion on the role played by banks towards the recession. For example, the leading cause of the 2008 recession has been attributed to poor decision making in the mortgage department of top banks. Therefore, financial institutions hold the ability to trigger an economy up or down. The decision-making ability of financial institutions and their positions in determining the fate of an economy places them at the center of the financial sector.
Another role of financial institutions is the maintenance of order and direction in the financial world. Economies are developed through the exchange of goods and services, with money being the most common mode of exchange (Argimon et al. 2019). Financial institutions regulate the flow of money and protect economies from the irresponsible flow of money, which could lead to inflation. Also, financial institutions provide means of money transfer and save players in the financial sector from the burden of cash transactions. Generally, financial institutions are at the center of the financial sector and determine how fast or slow an economy grows.
In sum, financial institutions play the role of providing solutions to challenges of market imperfections as well as providing investment advice. Financial institutions provide information to investors and aid in making investment decisions. Also, investors require a channel through which they can communicate with the firms in which investment has to be made. Moreover, financial institutions play a significant role in the lending and borrowing sectors. The role of financial institutions as intermediaries gives financial institutions a chance to operate as risk-takers on behalf of investors. However, economic crises happen as a result of failed financial systems and impact economies heavily to the extent of breaking some economies. The decision-making ability of financial institutions and their positions in determining the fate of an economy places them at the center of the financial sector. Generally, financial institutions are at the center of the financial industry and determine how fast or slow an economy grows.
References
Argimon, I., Bonner, C., Correa, R., Duijm, P., Frost, J., de Haan, J., … & Stebunovs, V. (2019). Financial institutions’ business models and the global transmission of monetary policy. Journal of International Money and Finance, 90, 99-117.
Aryeetey, E., Hettige, H., Nissanke, M., & Steel, W. (2019). Informal financial markets and financial intermediation in four African countries.
Cziraki, P. (2018). Trading by Bank Insiders before and during the 2007–2008 Financial Crisis. Journal of Financial Intermediation, 33, 58-82.
Merton, R. C., & Thakor, R. T. (2019). Customers and investors: a framework for understanding the evolution of financial institutions. Journal of Financial Intermediation, 39, 4-18.
Sheedy, E., & Griffin, B. (2018). Risk governance, structures, culture, and behavior: A view from the inside. Corporate Governance: An International Review, 26(1), 4-22.