Submission to the Financial System Inquiry 1. The Role of the Financial Sector

A good starting point for evaluating the Australian financial and payment systems is to consider the desired role of finance in our society. This Chapter provides an introductory discussion of the core functions of the financial sector, and the characteristics that set it apart from other sectors of the economy.

1.1 Core Functions of the Financial Sector

Although they are often thought of as recent phenomena, financial and payment systems have evolved over several thousand years. The manner in which transactions occur has changed remarkably over that time, but the underlying objectives have not. The economic functions performed by the first modern banks of Renaissance Italy, for instance, still apply today (Freixas and Rochet 2008).

At least four core functions can be identified.^[1] The financial sector should provide the following services:

1. Value exchange: a way of making payments.
2. Intermediation: a way of transferring resources between savers and borrowers.
3. Risk transfer: a means for pricing and allocating certain risks.
4. Liquidity: a means of converting assets into cash without undue loss of value.

These are all valuable tools for a community to have. The modern economy could not have developed without the financial sector also developing these capabilities. Moreover, these core functions require the financial sector to have certain supporting capabilities, such as the ability to screen and monitor borrowers. In principle, each of these functions could be performed by individuals. But there are efficiency benefits from having institutions perform them, particularly in addressing some of the informational asymmetries that arise in financial transactions.

The provision of these core functions can overlap and interact in important ways. For example, some financial products, such as deposits, combine value exchange, intermediation, risk transfer and liquidity services. With these interactions in mind, each core function is considered in more detail below.

1.1.1 Value exchange

A safe and efficient payment system is essential to support the day-to-day business of the Australian economy. There are approximately 43 million transactions in Australia every day, including cash and non-cash payments as well as transactions in financial assets. With so many payments, even relatively small inefficiencies can have significant implications for the broader economy and the living standards of Australians.

In this regard, the payment system has progressed a long way since the early Australian colonies, where the predominant means of exchange for many years was rum (Shann 1930). Today, we enjoy access to a range of convenient payment options, including cash, card and internet transfer. While future innovations are by nature uncertain, it is possible to identify some desirable qualities of an efficient payment system. It should be:

• Timely: while not all transactions are urgent, the possibility of giving recipients timely access to funds is useful.
• Accessible: everyone who needs to make and receive payments should have ready access to the payments system.
• Easy to integrate with other processes: this includes the reconciliation and recording of information by the parties involved (which should also be timely and accessible).
• Easy to use: this is not only an issue of convenience but also of minimising errors.
• Safe and reliable: end users of a payments system need to be confident that the system is secure; that is, that their confidential information is protected. They also need to have confidence that the system will be available when needed.
• Affordable and transparent: users can make well-informed choices about payment methods according to their cost and convenience.

Of course, there can be tensions between these objectives. For instance, making a payments system fully accessible and easy to use absorbs resources that might increase its cost.

1.1.2 Intermediation

The financial sector plays an important role in the functioning of the economy through intermediation. Simply put, the financial sector sits between savers and borrowers: it takes funds from savers (for example, through deposits) and lends them to those who wish to borrow, be they households, businesses or governments.

Intermediation can take on many forms beyond the traditional banking service of taking deposits and making loans. For example, investment banks intermediate between investors and bond issuers. Brokers perform a similar function in connecting the buyers and sellers of equities. The common thread is that a financial institution stands between the counterparties to a transaction. Depending on the nature of the transaction, a number of supplementary functions may be required to intermediate between savers and borrowers, including:

• Pooling resources: for example, a bank can combine a number of small deposits to make a large loan.
• Asset transformation: financial intermediaries provide a link between the financial products that firms want to issue and the ones investors want to buy (Freixas and Rochet 2008). This includes issuing securities to savers at short maturities, while making loans to borrowers at long maturities – a process known as maturity transformation.
• Risk assessment and information processing: financial intermediaries have expertise in screening potential borrowers to identify profitable lending opportunities, taking into account the risks that these entail (Diamond 1984).
• Monitoring borrowers: financial institutions take steps to limit the misuse of savers' assets. This function is critical to the decision by savers to lend their money in the first place, and hence for facilitating investment in the economy.
• Accurate accounting: together with a legal system that enforces property rights, prudent measurement is vital in enabling depositors, shareholders and investors to be paid what they are entitled to.

Effective intermediation requires a number of the qualities listed above in the context of an efficient payments system; it should be accessible and reliable, for instance. If the financial system is working well, it allocates funds to their most productive use. This benefits society by expanding the productive capacity of the economy, hence raising living standards.

1.1.3 Risk transfer

A well-functioning financial system also facilitates the pricing and allocation of certain risks. As discussed in ‘Box 4A: Types of Financial Risk’, these risks include the possibility that a borrower will default on their obligation (credit risk), that an asset's value will fluctuate (market risk), or that an income stream will be required for longer than expected (longevity risk). Financial contracts may also alter the financial implications of physical risks, by providing insurance against flood or fire damage to property, for example (insurance risk), or against legal liability and similar costs (operational risk). Many of the subsidiary capabilities implied by the intermediation function are also necessary for effective risk pricing and allocation, particularly the ability to assess risk and monitor borrowers.

The financial sector should allow individuals to tailor their exposure to risk to suit their preferences. A younger person, for instance, may have more scope to adjust to a sharp fall in the value of their assets than an older person, who would have less time to build up assets to fund their retirement. Given this, a younger person may choose to invest in a riskier portfolio of assets, with the prospect of higher returns.

Importantly, the role of the financial sector is not to remove risk entirely. Rather, it should facilitate the transfer of risks to those best placed to manage them. It cannot remove many of the risks within the economy, which must ultimately be borne by individuals either as holders of real and financial assets, or as taxpayers (Davis 2013). Moreover, it is not the goal of the financial sector necessarily to minimise risk. The socially optimal amount of risk is almost certainly not the minimum feasible level, given the importance of risk-taking to innovation and entrepreneurship. Of course, the characteristics of the financial system can shape the extent of risk-taking in important ways.

1.1.4 Liquidity

The financial sector provides liquidity. If the financial system is working well, individuals, businesses, and governments are able to convert their assets into cash at short notice, without undue loss of value.

The provision of liquidity is useful to individuals for meeting unexpected obligations. It is also critical to society at large. Access to liquidity allows businesses to deploy their capital in ways that increase the productive capacity of the economy. Without it, households and businesses would be forced to hold larger sums of cash to protect against unforeseen events. The result would be fewer resources for investment and the provision of fewer goods and services to consume.

Given various imperfections in the financial system, it is not optimal for the private financial sector to be the sole provider of liquidity (Holmström and Tirole 1998).^[2] Indeed, the central bank can also play an important role. In the Australian context, the Reserve Bank is the supplier of funds that can be lent or borrowed in the overnight market. From day to day, the Reserve Bank's goal is to manage supply to meet the system's demand for cash at the price – the interest rate – set by the Reserve Bank Board.

On occasion, there may be a sudden flight to liquid assets in response to acute uncertainty about the value of financial assets. One example of this occurred in many economies during the crisis of 2008 (although there are many others scattered throughout history). In these circumstances, the central bank's role is to supply the necessary liquidity to ensure the smooth functioning of the system. The provision of liquidity support by the central bank to an individual institution – as the lender of last resort – is a related, but separate form of intervention which central banks can make; this complex and important role has been discussed at length elsewhere (Goodhart 1988).

1.2 The Characteristics of Finance

Each of the four core functions that were introduced in the preceding section are vital to economic progress. But these functions are not generally ends in themselves. Put another way, the financial sector is an intermediate sector. Its activities are mainly directed at promoting efficiency in other sectors. This implies that the resources used in finance are a cost to society, because they cannot be used for one of the end purposes that members of society desire. It is therefore important that these financial services be provided in the most efficient way that is still consistent with the desired levels of safety and service.

The financial sector is, however, a critical link in the functioning of the economy: every economic interaction has a financial component, such as a payment. The spillovers to the real economy from dysfunction or operational failure in the financial and payments systems can be severe. Moreover, these spillovers can add to ‘moral hazard’, whereby financial institutions take risks under the assumption that the resulting costs would be, at least partly, borne by others (for example, their creditors or society at large). The potential for undue risk-taking is exacerbated by the problem of asymmetric information, where the party ultimately bearing the risk is not fully aware of it.

In addition, the core functions of financial intermediaries make them vulnerable to a change in customer and investor confidence, more so than for most firms. In particular:

• Because they undertake maturity transformation, financial intermediaries hold long-term assets while being subject to short-term obligations. This exposes them to the possibility of runs.
• In intermediating between savers and borrowers, financial institutions tend to be highly leveraged relative to other companies. As a consequence, depositors and other creditors have a relatively small capital buffer against unexpected losses, which can provide a strong incentive to withdraw their funds during periods of stress.
• The interlinkages between financial firms are greater than in most industries. This can be useful for allocating resources and risks. But it also means that shocks to one institution can be propagated across institutions and borders, often rapidly, as was demonstrated during the financial crisis.

The critical role of the financial sector and its inherent vulnerabilities suggest that it should be subject to more regulation than most other industries. (Although market discipline has a role to play, past experience has shown its limitations.) Even so, it is important to recognise the limits of what regulation can achieve. The financial sector is an information-intensive industry, so the financial system can change rapidly in response to technological change. As a result, regulations may be circumvented or become outdated very quickly, and will often produce unintended consequences. This does not remove the need for a good deal of regulation. But it does point to the importance of effective supervision – especially during the boom times – rather than reliance on inflexible rules.

Footnotes

The presentation of core functions of the financial sector differs within the literature, both in terms of the terminology employed and the number of functions that are identified. Merton and Bodie (1995), for example, identify six core functions. The spirit of that framework is similar to the one presented here. The main difference of presentation is that in this Chapter, the efficient allocation of resources is regarded as a by-product of a system that is performing the four core functions well, rather than as a stand-alone function. Merton and Bodie (1995) also separately list a function of governance, whereas this has been subsumed within the intermediation function in this Chapter. [1]

The private sector could potentially provide all of its own liquidity needs. But the amount of liquid holdings required to insure against a systemic event would reduce the efficiency of the financial system in normal times. Also, limited information, coordination problems, and potentially misplaced incentives, would make it difficult to act quickly enough during a flight to liquidity. For instance, on the verge of the US banking crisis of 1907, a private sector consortium considered providing liquidity to certain troubled institutions – an act that would have almost certainly lessened the impact of the crisis. They were, however, unwilling to act in time (Bernanke 2013). The role of central banks in managing the money supply and currency, make them a natural fit to be the lender of last resort. [2]

References

Bernanke BS (2013), ‘The Crisis as a Classic Financial Panic’, Speech at the Fourteenth Jacques Polak Annual Research Conference, Washington, DC, 8 November.

Davis K (2013), ‘Funding Australia's Future: From Where Do We Begin?’, Paper 1, Stage One of the Funding Australia's Future project, Australian Centre for Financial Studies.

Diamond DW (1984), ‘Financial Intermediation and Delegated Monitoring’, The Review of Economic Studies, 51(3), pp 393–414.

Freixas X and JC Rochet (2008), Microeconomics of Banking, 2nd edn, MIT Press, Cambridge, Massachusetts.

Goodhart C (1988), The Evolution of Central Banks, MIT Press, Cambridge, Massachusetts.

Holmström B and J Tirole (1998), ‘Private and Public Supply of Liquidity’, Journal of Political Economy, 106(1), pp 1–40.

Merton RC and Z Bodie (1995), ‘A Conceptual Framework for Analyzing the Financial Environment’, in DB Crane et al (eds), The Global Financial System: A Functional Perspective, Harvard Business School Press, Boston.

Shann EOG (1930), An Economic History of Australia, Cambridge University Press, Cambridge.