Functional Perspective of Financial Systems – An Introduction

In a stylised sense, there are two fundamentally different perspectives for analysis of financial systems. The institutional perspective takes the institutional structure of the financial system as given, and looks to define what can be done to make those institutions perform their particular financial functions more efficiently. In contrast to the institutional perspective, a functional approach to designing and managing financial system, as proposed by Professor Robert Merton (Harvard Business School) and Professor Zvi Bodie (Boston University) in various papers over the last two decades, takes the functions performed by financial systems to be given, and studies the institutional structure that would best perform these functions.

Financial Markets and intermediaries have been rapidly evolving due to technological advances and integration of financial markets and intermediaries around the world. Financial innovation ensures that the structure of the financial system changes over time, but the functions per se of the financial system remain stable. The basic functions of the financial system are essentially the same in all economies and do not change over time. These functions ultimately set the benchmarks for innovation in financial systems. This is why a functional perspective is more reliable and long-term than an institutional one, especially in times of a rapidly changing financial environment. This functional perspective rests on these two basic premises:  ‘Financial functions are more stable than financial institutions’ and ‘Institution form follows function.’

The primary function of any financial system is to facilitate the allocation and deployment of economic resources, both spatially and temporally, in an uncertain environment. Professor Merton and Professor Bodie further distinguish six core functions performed by the financial system:

Function 1: Transferring resources across time and space.
 A well developed financial system provides a way to transfer economic resources through time and across geographic regions and industries. Loans help move resources from the future to today, and savings products help do the opposite, but the underlying function for these two seemingly different products is the same. Student loans, borrowing to buy a house and saving for retirement are all actions that shift resources from one point in time to another. The financial system also provides mechanisms to shift resources from one place to another. So, when a person sends money to a family member in a different location, the basic function the movement of resources to him to the recipient.

Function 2: Managing Risk
The financial system provides a way to manage uncertainty and control risk. Through financial securities and through private sector and government intermediaries, the financial system provides risk pooling and risk sharing opportunities, for both households and business firms. For example, suppose you want $100,000 to start a business. You get $70,000 from a private investor in equity capital in exchange for 75% share of the profits of the business, and you get a $30,000 dollar loan from the bank at 6% interest rate per year. Suppose the bank requires that you get other members of your family to guarantee the loan, thereby transferring the risk of default from the bank to your relatives. Thus the bank is now providing you with the money with minimal risk to itself and the risk of the loan is transferred to your relatives.  Just as funds are transferred through the financial system, so are risks. For example, Insurance companies are financial intermediaries that offer to transfer the risk from the customers to the investors in exchange for some premium. Many financial contracts transfer risk without transferring the funds, as in the case with most insurance contracts and derivatives.

Function 3: Clearing and settling payments
The financial system provides a payments system for the exchange of goods and services. Suppose you live in a country whose government sets a limit on the foreign currency that is accessible. In your country you will be able to pay for your goods and services with the local currency. But if you wish to travel, you will need to use other means of payment. One way of making payments is to barter, exchange goods without making payments, but this would be inconvenient. An important function of the financial system is to provide an efficient way for people and businesses to make payments for the goods and services they wish to buy. Depository financial intermediaries serve this function with wire transfers, checking accounts, and credit/cash cards. Other intermediaries such as money market mutual funds offer transaction-draft accounts and firms whose principal business is not financial, such as General Electric, offer general credit cards. The key elements for managing the costs and risks associated with the process of clearing and settling payments include netting arrangements, efficient use of collateral, delivery-versus payment, immobilization of securities, and extension of credit.

Function 4: Pooling resources and Subdividing shares
The financial system provides a mechanism for the pooling of funds to undertake large-scale indivisible enterprise or for the subdividing of shares in enterprises to facilitate diversification.

Suppose you wish to invest in a business that costs $100,000, but you only have $10,000 to invest. Since you cannot possibly divide the business to buy a part of it, you will not be able to make this investment. A financial system corrects this problem by bringing together a bunch of investors and distributing shares to them, thereby dividing the $100,000 investment into smaller economic pieces. Any money the business earns from the race will then be distributed among the shareholders.

Function 5: Providing information
The financial system provides price information that helps coordinate decentralized decision-making in various sectors of the economy. The clear function of financial markets is to allow individuals and businesses to trade financial assets. An additional function of the capital market is to provide information that assists in decision-making. For example Interest rates and security prices are information that households use in making their consumption-saving decisions.

Function 6: Dealing with incentive problems
The financial system provides a way to deal with the asymmetric-information and incentive problems when one party to a financial transaction has information that the other party does not. An efficient financial system reduces these incentive problems. Incentive problems take a variety of forms – moral hazard, adverse selection and principal-agent problems. The financial institutions develop mechanisms to help overcome these problems. For example, they develop ways to take and manage collaterals to address the moral hazard and adverse selection problems.

Applicability of this perspective is useful in different levels of analysis. It offers a useful frame of reference for analysing the country’s entire financial system, by helping assess how well the system is doing vis-a-vis its essential objectives – as understood in terms of these functions. It is also useful in the study of a particular institutional form, which can be understood in terms of the functions it is supposed to fulfil is management of risk. The functional perspective may also be applicable at an activity level. For example – Lending is a homogeneous financial activity in the private and public sector decision making. But from a functional perspective, lending falls under the two basic functional categories of ‘intertemporal transfer of resources’ and ‘risk management’. The functional perspective can also be applied at the level of an individual financial product.