What is Finance?

Finance is the application of economic principles to decision-making that involves the allocation of money under conditions of uncertainty.

Finance provides the framework for making decisions as to how those funds should be obtained and then invested. It is the financial system that provides the platform by which funds are transferred from those entities that have funds to invest.

Financial Structures and Instruments

The role of the financial system is to “facilitate the allocation and deployment of economic resources, both spatially and temporally, in an uncertain environment” (Merton, 1995).

There are many examples of such deployment:
  • Issuing debt allows future income to fund current expenses.
  • Investing in financial assets allows current income to fund future expenses.
  • Diversifying one’s wealth or underwriting insurance contracts allow sustaining one’s consumption and investment in the face of adverse income shocks.

    If I invest in stocks of companies whose activity is sufficiently different from the one I work for, I cash in dividends when my labor income drops, and, in this way I protect my standard of living.

Access to finance is often key to escaping poverty: the microedit pioneered by Muhammad Yunus, a social entrepreneur and banker from Bangladesh Opens in new window who was awarded the Nobel Peace Prize Opens in new window, aims at countering the financial exclusion resulting from the fact that fixed costs and asymmetric information prevent banks from offering small loans to poor entrepreneurs.

Different financial structures have emerged across space and time. Finance can be either intermediated (or bank-based) or disintermediated (or market-based, meaning at arm’s-length from banks).

Intermediated Finance

Intermediated finance is operated by financial institutions that collect money from individuals and lend to others.

Banks take deposits and extend loans, assets on behalf of clients, and so forth. These activities create assets and liabilities on the intermediary’s balance sheet; the intermediary accompanies the investment or loan over its lifetime and monitors the success or failure of the underlying projects.

Among financial intermediaries, banks are special because they perform maturity transformation (i.e., they collect sight deposits and invest in longer term loans and financial assets).

The maturity mismatch between banks’ assets and liabilities is a key source of risk for themselves and for the economy and a key reason why they are heavily regulated, but one should not forget that maturity transformation is at the same time central to their social role.

Other financial intermediaries such as money market funds Opens in new window and open-ended investment funds may perform maturity transformation by collecting short-term savings and investing in long-term assets, and they can be considered as “shadow banks”.

Disintermediated Finance

Finance is disintermediated when individuals lend directly to one another, underwrite an IOU (“I owe you,” a document acknowledging one’s debt), or buy a promissory note (essentially the same document, but transferable to a third party who then becomes the creditor).

In the case of a company, possible debt contractors are loans, bills, and bonds (transferrable debt instruments which often pay a fixed interest rate, distributed as a coupon), or stocks (transferable property rights which pay a time-varying fraction of the company’s revenue, distributed as a dividend).

Stocks can be quoted and exchanged on a public trading venue (a stock exchange), or held as private equity. In both cases, they are representative of the company’s own funds or equity, that is, its liability to its shareholders. Marketable financial instruments (bills, bonds, and stocks) are also called securitities.

In arm’s-length finance Opens in new window, the role of financial intermediaries is limited to identifying (in financial jargon, originating) potential lenders and borrowers, to buying and selling financial assets, and to providing advisory services, remunerated with fees.

The key functions of allocating savings, monitoring projects, and exerting corporate control are also performed by capital markets outside the scope of financial intermediaries. A designated post illustrates the case of a securitization activity.

The US and UK financial sectors are predominantly market-based, with around 80% of households and companies funding themselves on markets and 20% funding themselves through banks.

Japan and continental Europe are bank-based, with broadly opposite proportions, although continental Europe is now moving toward a more market-based structure.

Demirgüç-Kunt and Levine (1999) found financial systems to be generally more developed in richer countries, with relatively larger banks and other financial intermediaries and deeper stock markets (all gauged as shares of local GDP), but institutional factors also matter.

Other things being equal Opens in new window, they found countries with French civil law tradition, poor protection of shareholder and creditor rights, poor contracts enforcement, high levels of corruption, poor accounting standards, restrictive banking regulations, and high inflation to have less deep financial systems.

Economies tend to become more market-based as they become richer. Moreover, Demirgüç-Kunt and Levine have shown that countries with common law traditions, strong protection of shareholder rights, good accounting regulations, low levels of corruption, and no explicit deposit insurance tend to be market-based rather than bank-based.

This finding echoes North and Weingast’s remark reported in the economic literature on “legal origins”. The “legal origins” approach to financial structures is only one attempt to explain their strong path dependency and dependence on institutional developments. It ignores, for example, that pre-World War I France Opens in new window benefitted from deep bond markets, as well as the role of prefunded pensions in spurring market development.

The social functions of disintermediated and intermediated finance are in principle similar.

Hence the popular term of shadow banking, which describes lending to the economy by non-bank financial intermediaries such as asset managers, money market funds, or insurance companies which operate outside the purview of bank regulation.

However, the types of contracts, and hence the way projects are monitored, the incentives of participants, and the regulation they are (or should be) subject to are quite different under different financial structures. They also affect the way monetary policy is transmitted to the economy.

In a broader sense, finance also includes the “plumbing” of the financial system (i.e., the financial market infrastructures which allow money and financial assets Opens in new window to be shipped from one place to another).

These include payment systems such as credit card schemes or the real-time gross settlement systems (RTGS) which allow banks to net out millions of payment orders in real time, transfer money, and settle their accounts at the end of the day with central bank money.

These also include custodians, which book securities on behalf of issuers and investors and keep track of their movements, and clearing houses, also called central-clearing counterparts (CCPs).

Clearing houses net out transactions on standardized securities and derivative contracts among a large number of participants, acting as the seller to every buyer and the buyer to every seller, which produces economies of scale in risk management and use of collateral.

In an even broader sense, finance includes third-party providers of information on the creditworthiness of companies and securities, such as producers of market research inside and outside of banks, and credit-rating agencies that provide standardized assessments of the solvency of individual private and sovereign borrowers.