On the Role of Financial Markets and Institutions

1.1 Finance: The Time Dimension

Why do we need financial markets and institutions? We chose to address this question as our introduction to this text on financial theory. In doing so, we touch on some of the most difficult issues in finance and introduce concepts that will eventually require extensive development. Our purpose here is to phrase this question as an appropriate background for the study of the more technical issues that will occupy us at length. We also want to introduce some important elements of the necessary terminology. We ask the reader’s patience as most of the sometimes difficult material introduced here will be taken up in more detail in the following chapters.

A financial system is a set of institutions and markets permitting the exchange of contracts and the provision of services for the purpose of allowing the income and consumption streams of economic agents to be desynchronized—that is, made less similar. It can, in fact, be argued that indeed the primary function of the financial system is to permit such desynchronization. There are two dimensions to this function: the time dimension and the risk dimension. Let us start with time. Why is it useful to dissociate consumption and income across time? Two reasons come immediately to mind. First, and somewhat trivially, income is typically received at discrete dates, say monthly, while it is customary to wish to consume continuously (i.e., every day).

Second, and more importantly, consumption spending defines a standard of living, and most individuals find it difficult to alter their standard of living from month to month or even from year to year. There is a general, if not universal, desire for a smooth consumption stream. Because it deeply affects everyone, the most important manifestation of this desire is the need to save (consumption smaller than income) for retirement so as to permit a consumption stream in excess of income (dissaving) after retirement begins. The life-cycle patterns of income generation and consumption spending are not identical, and the latter must be created from the former. The same considerations apply to shorter horizons. Seasonal patterns of consumption and income, for example, need not be identical. Certain individuals (car salespersons, department store salespersons) may experience variations in income arising from seasonal events (e.g., most new cars are purchased in the spring and summer), which they do not like to see transmitted to their ability to consume. There is also the problem created by temporary layoffs due to business cycle fluctuations. While they are temporarily laid off and without substantial income, workers do not want their family’s consumption to be severely reduced.

Furthermore, and this is quite crucial for the growth process, some people—entrepreneurs, in particular—are willing to accept a relatively small income (but not consumption!) for a period of time in exchange for the prospect of high returns (and presumably high income) in the future. They are operating a sort of arbitrage over time. This does not disprove their desire for smooth consumption; rather, they see opportunities that lead them to accept what is formally a low-income level initially against the prospect of a higher income level later (followed by a zero income level when they retire). They are investors who, typically, do not have enough liquid assets to finance their projects and, as a result, need to raise capital by borrowing or by selling shares.

Therefore, the first key element in finance is time. In a timeless world, there would be no assets, no financial transactions (although money would be used, it would have only a transaction function), and no financial markets or institutions. The very notion of a (financial) contract implies a time dimension.

Asset holding permits the desynchronization of consumption and income streams. The peasant putting aside seeds, the miser burying his gold, or the grandmother putting a few hundred dollar bills under her mattress are all desynchronizing their consumption and income, and in doing so, presumably seeking a higher level of well-being for themselves. A fully developed financial system should also have the property of fulfilling this same function efficiently. By that we mean that the financial system should provide versatile and diverse instruments to accommodate the widely differing needs of savers and borrowers insofar as size (many small lenders, a few big borrowers), timing and maturity of loans (how to finance long-term projects with short-term money), and the liquidity characteristics of instruments (precautionary saving cannot be tied up permanently). In other words, the elements composing the financial system should aim at matching the diverse financing needs of different economic agents as perfectly as possible.

1.2 Desynchronization: The Risk Dimension

We have argued that time is of the essence in finance. When we talk of the importance of time in economic decisions, we think in particular of the relevance of choices involving the present versus the future. But the future is, by essence, uncertain: financial decisions with implications (payouts) in the future are necessarily risky. Time and risk are inseparable. This is why risk is the second key word in finance.

For the moment let us compress the time dimension into the setting of a “Now and Then” (present vs. future) economy. The typical individual is motivated by the desire to smooth consumption between “Now” and “Then.” This implies a desire to identify consumption opportunities that are as smooth as possible among the different possibilities that may arise “Then.” In other words, ceteris paribus—most individuals would like to guarantee their family the same standard of living whatever events transpire tomorrow: whether they are sick or healthy; unemployed or working; confronted with bright or poor investment opportunities; fortunate or hit by unfavorable accidental events.1 This characteristic of preferences is generally described as “aversion to risk.”

A productive way to start thinking about this issue is to introduce the notion of states of nature. A state of nature is a complete description of a possible scenario for the future across all the dimensions relevant for the problem at hand. In a “Now and Then” economy, all possible future events can be represented by an exhaustive list of states of nature or states of the world. We can thus extend our former argument for smoothing consumption across time by noting that the typical individual would also like to experience similar consumption levels across all future states of nature, whether good or bad.

An efficient financial system offers ways for savers to reduce or eliminate, at a fair price, the risks they are not willing to bear (risk shifting). Fire insurance contracts eliminate the financial risk of fire, while put contracts can prevent the loss in wealth associated with a stock’s price declining below a predetermined level, to mention two examples. The financial system also makes it possible to obtain relatively safe aggregate returns from a large number of small, relatively risky investments. This is the process of diversification. By permitting economic agents to diversify, to insure, and to hedge their risks, an efficient financial system fulfills the function of redistributing purchasing power not only over time, but also across states of nature.

1.3 The Screening and Monitoring Functions of the Financial System

The business of desynchronizing consumption from income streams across time and states of nature is often more complex than our initial description may suggest. If time implies uncertainty, uncertainty may imply not only risk, but often asymmetric information as well. By this term, we mean situations where the individuals involved have different information, with some being potentially better...