How do financial institutions help economies?

As promised in the past articles, I will first brief you about the need for financial intermediaries in the system and then a throw little light on how economies and financial institutions linked.

When savers have extra money to lend, it is hard for them to figure out the right borrower and the one meeting their needs, among the huge crowd available in the market.  It is also important for savers to check the background and financial health of the lenders in order to make sure they will be able to pay back the money.  Similarly, it is also crucial for savers to keep monitoring the condition of their invested value and regularly keep an eye on the borrowers.  Lenders do not usually have the time and resources to do it efficiency and that is when financial intermediaries come into the picture.

Consider for example banks. How do you think they pay you interest over investments?  You pay them certain among of money in return for a fixed rate of return. They then lend that money to somebody else, in the form of loans in return for some rate of return (usually higher than they owe you) and then pay you the part they owe, keeping the remaining themselves.  Insurance companies are other examples.  Insured person money goes to somebody who is willing to take up the future risks and they use this money to invest in financial markets expecting more returns than the probable risks from the insured person.

In the situation where finances are scarce, individuals are forced to make a choice. A certain sum of money that they hold could either for used for buying a house, or a car or a take an abroad trip for example. This competition for resources is important to ensure that the limited resources are used wisely.

Consider for example capitalist markets.  There some business holds all the power to decide what products will go the market and what prices would be paid by the customers.  On the other hand are democratic economies where multiple businesses compete with each other for similar products.  Let us take the example of soap.   There is Dove, Dettol, Cinthol,  Medimix and a number of others and all are priced very close.  Similar is the case for toothpaste and for that matter any other product.  Ever wondered why Lays and Uncle chips sell at the same price? Same products competing in the markets cannot afford to be priced higher from the other until they hold a significant advantage. This competition to be the choice of customers fosters creativity in the market and also drives down prices.  Now when businesses like these are expanding and need capital, they approach the markets for funds.  Here savers play a crucial role,

  1. They invest in businesses that have good financial history, good client base and excellent upper management. This benefits the economy as the growing big businesses could mean increasing employment, increasing variety of products to the customers, and improved quality at the best price.
  2. Some risk-takers invest in businesses that have the potential to become big through the potential in their ideas.  Some of these businesses might be trying to expand in the territory of existing businesses.  This fosters competition, which improves efficiency and drives down prices. 
  3. Savers have financial intermediaries in the system to choose the right borrower for them by using their comprehensive research database and in house skilled team of professional experts in these kinds of analytics. This ensures that resources used by individual savers in finding the right borrower are saved and they can be used for their best use.
  4. Investment industry packages the relevant information about borrowers together making it easier for lenders to give money. This hassle-free and transparent approach builds confidence in the savers and makes them more willing to participate in the markets.
  5. Investment industry also helps investors with liquidity.  It is difficult to sell land or a house immediately at your desired price in the time of need but if you have shares of actively traded companies, you can share fairly large of shares without compromising with your returns.  

Ultimately, the investment industry essentially exists as the point of connection for buyers and lenders, with regulations and systems in place. This confidence in system security and credibility helps lenders enter and actively participate in the market, crucial for the economy to grow.

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