Additional information is available for the following registered author(s):

• Franklin Allen
• Douglas Gale

The purpose of a financial system is to channel funds from agents with surpluses to agents with deficits. In the traditional literature there have been two approaches to analyzing this process. The first is to consider how agents interact through financial markets. The second looks at the operation of financial intermediaries such as banks and insurance companies. Fifty years ago, the financial system could be neatly bifurcated in this way. Rich households and large firms used the equity and bond markets, while less wealthy households and medium and small firms used banks, insurance companies and other financial institutions. Table 1, for example, shows the ownership of corporate equities in 1950. Households owned over 90 percent. By 2000 it can be seen that the situation had changed dramatically. By then households held less than 40 percent, nonbank intermediaries, primarily pension funds and mutual funds, held over 40 percent. This change illustrates why it is no longer possible to consider the role of financial markets and financial institutions separately. Rather than intermediating directly between households and firms, financial institutions have increasingly come to intermediate between households and markets, on the one hand, and between firms and markets, on the other. This makes it necessary to consider the financial system as an irreducible whole.

The notion that a financial system transfers resources between households and firms is, of course, a simplification. Governments usually play a significant role in the financial system. They are major borrowers, particularly during times of war, recession, or when large infrastructure projects are being undertaken. They sometimes also have significant amounts of funds. For example, when countries such as Norway and many Middle Eastern States have access to large amounts of natural resources (oil), the government may acquire large trust funds on behalf of the population.

In addition to their roles as borrowers or savers, governments usually play a number of other important roles. Central banks typically issue fiat money and are extensively involved in the payments system. Financial systems with unregulated markets and intermediaries, such as the US in the late nineteenth century, often experience financial crises (Gorton (1988) and Calomiris and Gorton (1991)). The desire to eliminate these crises led many governments to intervene in a significant way in the financial system. Central banks or some other regulatory authority are charged with regulating the banking system and other intermediaries, such as insurance companies. So in most countries governments play an important role in the operation of financial systems. This intervention means that the political system, which determines the government and its policies, is also relevant for the financial system.

There are some historical instances where financial markets and institutions have operated in the absence of a well-defined legal system, relying instead on reputation and other implicit mechanisms. However, in most financial systems the law plays an important role. It determines what kinds of contacts are feasible, what kinds of governance mechanisms can be used for corporations, the restrictions that can be placed on securities and so forth. Hence, the legal system is an important component of a financial system.

A financial system is much more than all of this, however. An important pre-requisite of the ability to write contracts and enforce rights of various kinds is a system of accounting. In addition to allowing contracts to be written, an accounting system allows investors to value a company more easily and to assess how much it would be prudent to lend to it. Accounting information is only one type of information (albeit the most important) required by financial systems. The incentives to generate and disseminate information are crucial features of a financial system.

Without significant amounts of human capital it will not be possible for any of these components of a financial system to operate effectively. Well-trained lawyers, accountants and financial professionals such as bankers are crucial for an effective financial system, as the experience of Eastern Europe demonstrates.

The literature on comparative financial systems is at an early stage. Our survey builds on previous overviews by Allen (1993), Allen and Gale (1995) and Thakor (1996). These overviews have focused on two sets of issues.

Normative: How effective are different types of financial systems at various functions?

Positive: What drives the evolution of the financial system? The first set of issues of considered in sections 2-6, which focus on issues of investment and saving, growth, risk sharing, information provision and corporate governance, respectively. Section 7 considers the influence of law and politics on the financial system while Section 8 looks at the role financial crises have had in shaping the financial system. Section 9 contains concluding remarks.

Download Info

To download:

If you experience problems downloading a file, check if you have the proper application to view it first. Information about this may be contained in the File-Format links below. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

Publisher Info

Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 01-15.

Download reference. The following formats are available: HTML (with abstract), plain text (with abstract), BibTeX, RIS (EndNote, RefMan, ProCite), ReDIF
Length:
Date of creation: Apr 2001
Date of revision:
Handle: RePEc:wop:pennin:01-15

Contact details of provider:
Postal: 3301 Steinberg Hall-Dietrich Hall, 3620 Locust Walk, Philadelphia, PA 19104.6367
Phone: 215.898.1279
Fax: 215.573.8757
Email:
Web page: http://fic.wharton.upenn.edu/fic/
More information through EDIRC

For technical questions regarding this item, or to correct its listing, contact: (Thomas Krichel).

Related research

Keywords:

Other versions of this item:

Did you know? You too can volunteer for RePEc, for example by encouraging others to use our services.

This page was last updated on 2009-11-10.