Financial Economics

7

FINANCIAL SYSTEMS, GOVERNANCE, AND ORGANIZATION

In this chapter and the one to follow, we explain how financial systems are organized and why they assume those forms. This material is intended to provide a practical context for the financial transactions examined in the rest of the book. Even though financial systems may initially appear to be complicated entities, financial economics offers a straightforward analytical and descriptive picture of how such systems work. A financial system performs a set of tasks, called functions. One way to study financial systems¹ involves examining the arrangements reached between financiers and their clients in a process called alignment. These alignments are studied principally in the context of financial deals that involve either commitments of financial resources (i.e., fund-raising), reallocation of risks² (risk transfer), or both.

All financial systems perform similar functions, but differ in the relative importance of the three major forms of governance they use: (1) financial markets, (2) financial intermediaries, and (3) internal allocations. Governance is the process of suitably contracting a financial arrangement at the beginning and of tailoring the arrangement to ensure, as far as possible, its profitable conclusion. Some deals depend on continuing supervision to strengthen the possibility of their profitable conclusion. At any point in time, the attributes of financial deals, the organizations funding them, and the capabilities ...