Page 508 - Introduction to Business

482 PART 5 Finance

long-term investments. In so doing, institutions bear various risks, including the
following:
• Credit risk. The probability that loans to business firms will not be paid
• Price risk. The change in values of long-term securities as interest rates change
in the financial marketplace
• Liquidity risk. The possibility of running short of cash to meet needs of savers
or investors
• Operational risk. The problem of producing and delivering financial services
that customers want
• Strategic risk. The challenge of competing with other financial service firms
• Regulatory risk. The need to comply fully with many regulations and laws
• Reputation risk. The possibility that public confidence in the safety and
soundness of an institution will be lost
Financial intermediation not only has effects at the microlevel of individuals,
business firms, and financial institutions, but it can have important effects on the
economy as a whole too. For example, assuming that financial institutions success-
fully allocate funds to high-profit firms, total production by the business sector is
greater than otherwise. In turn, greater productivity by the business sector leads to
higher employment and better wages and salaries for workers. It is easy to see that
allocational efficiency The transfer of allocational efficiency is important for any country.
savings to the most profitable Financial intermediation can yield operational efficiency and market efficiency
investments in the economy
benefits, too. Competition among financial institutions implies that they must oper-
operational efficiency Producing ate at minimum cost to maximize profits. Operational efficiency results in low-cost
financial services at low cost for basic financial services, better quality services, and innovation of new financial serv-
individuals, businesses, and the
ices. Likewise, in competitive financial markets, institutions must accurately price
government
financial assets and liabilities, including deposits, loans, and securities. By ensuring
market efficiency The ability of prices that all information is rapidly reflected in prices, market efficiency is improved.
of stocks, bonds, and other assets to In sum, financial intermediation enhances allocational, operational, and mar-
rapidly reflect publicly available
ket efficiency in financial markets and the general economy. By channeling public
information
savings to investment, it tends to encourage saving and, consequently, boosts
investment also. Higher saving and investment leads to increased wealth and a
higher standard of living for society. Given that the ultimate benefit of a smoothly-
functioning financial system is a higher standard of living, it is important to con-
sider how best to design the structure of a financial system.

reality What kinds of financial instruments do you own? What financial insti-
CH ECK tutions do you use? What about your parents?

Structure of Financial Systems

LEARNING OBJECTIVE 2
Contrast different kinds of financial systems around the world and state how reg-
ulation can protect the safety and soundness of financial systems.

Financial systems can be classified into market-oriented systems and bank-
bank-centered systems Financial centered systems. Bank-centered systems, as in Japan and Germany, are domi-
systems that are dominated by banks nated by banking institutions as opposed to securities firms. The dominant role of
banks enables them to develop close relationships with their client firms. Such
close relationships allow banks to obtain a great deal of private information about
client firms that is valuable in better understanding lending risks. Also, the reduced
ability of firms to use public markets to issue debt means that banks have some
degree of monopoly power and extract higher loan rates (for example) from firms.

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