FINANCE THEORY

Role and performance of banks in both financial systems

Role and performance of banks in both financial systems

Introduction

Financial experts and economist are facing several problems in analyzing various roles played by banks and their fundamental importance. Banks are considered as one of the source through which individual used their savings for the development and growth of the society. Functioning of the financial system of the country is clearly described from the below figure which indicates that out of lending money majority of the investment comes from household and organizations operating in the country. Government and household are considered as powerful lenders as they have the capability of providing capital to unlimited borrowers using two common principles (Allen & Carletti, 2008).

Figure 1: Financial structure (Allen & Carletti, 2008)

Firstly, through the appropriate use of financial markets, that generally includes money markets, bond markets, and equity markets, secondly, through banks and other financial institutions. In spite of prevailing trend of globalisation, banks are considered to be of diversified importance in different countries and their economic structure. Role of banks in countries such as Europe, America, and Asian economic structure is clearly describes in below figure

Figure 2: performance of financial markets (Allen & Carletti, 2008)

Importance of banks in the economy can also be viewed by analyzing its role in household assets. As explained in the figure that economies of the world are different in various aspects for instance in European state assets owned by household communities is relatively less as compare to assets owned in other countries. Role and importance of the banks played in different economies is briefly discussed in the next section.

Figure 3: difference in use of banking services (Allen & Carletti, 2008)

Discussion

Delegated Monitoring and Banks

A favourable argument that is raised by majority of experts that bank based financial system is effective in solving various information problems. For instance, the most common problems faced by the borrowers are they must be allowed to take appropriate action to ensure proper and significant use of the capital they have borrowed. Basic objective of this action could be allowing borrowers to participate in decision-making process of their investment. However, similar problem cannot be resolved in financial markets due to presence of small lenders that does not consider the need of monitoring the activities of borrowers.

Economists have suggested of hiring a single monitoring service with the prime responsibility of frequently monitoring the activities of borrowers but then the question arise that that will monitor the activities of monitoring department. This is considered as most common problem in financial system and several economists have formulated different economics and financial models to reduce the prevailing problem. For instance, (Boot & Thakor, 1997) construct a financial model that emphasis the importance of formulating monitors similar to banks. According to them there are three common information problems faced by the lenders, firstly, borrowers have incomplete information about the future planning of the firms and their investment decision.

Secondly, lenders in financial system cannot analyze whether borrowers have invested the borrowed money ...