The Six Core Functions Performed by the Financial System

Across time and space, the primary function of a financial system is to facilitate the distribution and deployment of economic resources in an uncertain environment. Reviewing financial systems through a functional perspective is significant in the arrangement and development of financial markets and products, banking and equity products and the insurance sector.  Brodie and Merton (1995) determined the most aggregated level of the single primary function of resource allocation to further distinguish the six basic functions performed by the financial system. These are the following:

Function 1. Clearing and Settling Payments

In order to give way in the entry of goods, services and assets, a financial system should provide ways of clearing and settling payments.  The set of institutional arrangements for accomplishing this task is collectively known as the payments system. Banks and other depository financial intermediaries fulfill this function thru wire transfers, checking accounts, and credit cards. Function 2. Pooling Resources and Subdividing Shares

The mechanism for the pooling of funds in a financial system is done so that it could undertake large-scale indivisible enterprise or for the subdividing of shares to form larger amounts of capital. In modern economies, the minimum investment required to start or maintain a business is often beyond the regular means of an individual or even several individuals. From the perspective of firms raising capital, the financial system provides a variety of mechanisms (such as security markets and financial intermediaries) through which individual households can pool their money to form larger amounts of capital.

Function 3. Transferring Resources Across Time and Space

An interesting function of a financial system is its ability to transfer resources across time and space. Serving this function are intermediaries like banks involved in financing corporate investments and housing, insurance companies and pension funds in financing corporate investments and paying retirement annuities, and mutual funds.

Function 4: Managing Risk

A well-functioning financial system provides ways to handle uncertainty and risk. It facilitates the efficient allocation of risk-bearing. Through private sector and government intermediaries (including the system of social insurance), the financial system provides risk-pooling and risk-sharing opportunities for both households and business firms.

Function 5. Providing Information

Price information is important as it helps coordinate decentralized decision-making in various sectors of the economy. This is easily provided by a financial system. To manifest this function of financial markets, individuals and businesses are permitted to trade financial assets. An additional latent function of the capital market is to provide information useful for decision-making. Interest rates and security prices are information used by households or their agents in making their consumption-saving decisions and in choosing the portfolio allocations of their wealth.

Function 6. Dealing with Incentive Problems

When one party to a financial transaction has information that the other party does not, or when one party is an agent for another, the financial system could find a way to deal with these incentive problems. A well-functioning financial system minimizes the incentive problems that make financial contracting difficult and costly. These problems arise because parties to contracts cannot easily observe or control one another, and because contractual enforcement mechanisms are not costless to invoke. These contractual “frictions” take a variety of forms: moral hazard, adverse selection, and information asymmetries.

Reference

Bodie, Z. and Merton, R.C. (1995). A conceptual framework for analyzing the financial system. From Chapters 1 to 8 of The Global Financial System: A Functional Perspective, Harvard Business School Press.