Modern Financial Systems: Theory and Applications

CHAPTER 2

Financial System Functions

The unchanging functions performed by every financial system include clearing and settling payments, pooling resources, transferring resources, managing risks, producing information, and managing incentives. Although every financial system performs these functions, the organizations carrying them out are determined endogenously, in response to the characteristics of the local economic environment and currently available transactions technology. Thus the observed structures of financial systems can differ, both at any point in time and also over time.

Chapter 1 observed that in every financial system, markets, intermediaries, and internal finance complement each other. However, the proportions of funds raised internally differ across systems, as do the proportions of external funds raised in markets and through intermediaries. This book’s principal purpose is to explain why these variations occur and, as a first step, the present chapter reviews the functional approach due to Crane et al. (1995). The chapter also sketches how the original functional approach has evolved into Bodie and Merton’s functional-structural views (2005) arguing that the organizations carrying out financial system functions tend toward, but do not necessarily attain, a structure predicted by neoclassical economics. Along with market imperfections due to such features as informational asymmetries and transactions costs, Bodie and Merton stress that behavioral and institutional ...