THE ROLE OF FINANCIAL SYSTEM IN DEVELOPMENT

INTRODUCTION
Economic development is the sustained, concerted actions of policy makers and communities
that promote the standard of living and economic health of a specific area. Economic development can
also be referred to as the quantitative and qualitative changes in the economy.
Economic development is partially dependent on the financial system to help mediate the
transfer of money to areas of the economy that need it most. The financial system has a number
of key functions, which help facilitate these shifts in money that are important for sustainable
economic growth. These includes:
Savings
The financial system allows you to place your excess money into a savings account in a bank of
your choice. Keeping your money in a bank safeguards your savings, and the bank pays you
interest based on the amount you keep in your account.
Loans
Money in deposit accounts, like savings accounts, is used to provide loans for a wide range of
projects to people and businesses. Mortgages, car loans and student loans are financed largely by
deposits in banks, savings institutions and credit unions.
Investments
The financial system also facilitates the transfer of money from investors to businesses. When
businesses raise capital, they sell stock to investors. Investors give their money to the company
in exchange for ownership in the company.
Business Growth
Businesses may expand their operations or finance growth by issuing debt instruments called
bonds. Bonds are bought and sold through the financial system. Bond markets allow businesses
to access investor capital to finance their growth, while bond investors have an opportunity to
profit from helping finance business expansion.

Government Expenditure
Governments may finance programs or deficit spending through the financial system by issuing
bonds to raise money. Investors may buy government bonds to own a part of government debt,
and collect interest payments from the government. In turn, the government has the money it
needs to continue to function.
A financial system can be described as an organization that transfer excess funds from individuals and
organizations with a surplus to those with deficits. It consists of financial instrument, legal structure and
institutions and individuals dealing with the flow of funds.
Financial institutions perform a wide range of functions in the system but their primary role is to assist
financial resources to investments of highest return and interest rate (price per capital) is the essential
instrument in fulfilling this functions. According to Cube and Senbet (1994), an efficient financial system
is critical not only for domestic capital mobilization but also as a vehicle for gaining competitive
advantage in the global markets for capital.
The term 'financial system' is habitually utilized in a myriad of financial literature texts, yet this
expression is scarcely ever accompanied by a specific definition, giving the impression that this
expression and concept is unanimously understood and without great difficulty.
According to Goodspeed (2008:4), the financial system is comprised of "the financial markets, financial
intermediaries and other financial institutions which execute the financial decisions of households,
businesses and governments.
Howells and Bain (2005:4) define the financial system as "a set of markets for financial instruments, and
the individuals and institutions that trade in those markets, together with the regulators and supervisors of
the system." Combining these two definitions, the financial system hence describes the arrangements (i.e.
financial markets, financial intern1ediaries and control systems) which allow for the exchange of financial
instruments (i.e. financial contracts), so that funds may flow' between participants (i.e. lenders and
borrowers).
From the foregoing definitions, the financial system is composed of four common elements.
1. Participants
2. Financial Instruments
3. Financial Intermediaries
4. Financial Markets
PARTICIPANTS
The participants in the financial system are the ultimate lenders and ultimate borrowers. Ultimate lenders
are surplus economic units, hence are non-financial entities whose savings exceed their real consumption,
whilst ultimate borrowers are deficit economic units whose incomes are insufficient for financing their
current spending plans (Howells and Bain, 2005:7).
FINANCIAL INSTRUMENTS
Financial instruments are "evidences of claims against other economic units or of ownership in them"
(Goldsmith, 1969: 4) and are issued by ultimate borrowers or financial intermediaries.

These issuers are confronted with very diverse combinations of transactional, enforcement and
informational frictions which motivates the creation of a variety of financial instruments with differing
characteristics such as the duration, marketability, security, contract nature, and yield of the instruments.
Financial instruments issued by ultimate borrowers, such as companies (issuing shares, promissory notes
etc.) and governments (issuing treasury bills, government bonds etc.), for the purpose of direct financing
are referred to as primary securities. While instruments issued by financial intermediaries (such as savings
accounts, negotiable certificates of deposit etc.) in the process of providing indirect financing are called
indirect securities (Goodspeed, 2008:7).
FINANCIAL INTERMEDIARIES
Financial intermediaries are institutions which intermediate between lenders and borrowers, as the
financial middlemen, and thus facilitate the flow of funds from savers to borrowers (Goodspeed, 2008:6).
These institutions arise to provide indirect finance, thus ameliorate the conflicts which exist between
lenders and borrowers regarding their requirements in terms of risk, return, and term to maturity relating
to the extension and acquisition of financing (Levine, 1997:691).
Financial intermediaries are divided into depository intermediaries and non-depository intermediaries.
I. Depository intermediaries commonly referred to as banks, expedite the flow of funds from
lenders to borrowers by accepting deposits from individuals and institutions, and making loans
with the deposited funds. These intermediaries include central banks, commercial banks, land and
agricultural banks, credit unions, mutual savings banks, and savings and loan associations.
II. Non-depository intermediaries are financial intermediaries that do not accept deposits instead
receive contractual contributions from lenders and invest the funds. Therefore, altering the
composition and nature of lenders portfolios and this way allows borrowers to access funds more
readily. Non-depository financial intermediaries include insurance companies, pension and
provident funds, unit trusts, hedge funds, exchange traded funds, finance companies, and
investment trust/companies.

Financial Markets
Financial markets are the conventions which exist allowing for direct financing, the direct transfer of
excess funds of surplus units to finance deficit units requiring funds (Fourie et al, 1996:15). These
conventions serve to bring together buyers (lenders) and sellers (borrowers) of financial instruments and
to determine the price of these instruments.
Financial markets include the equity market, bond market, money market and the derivatives market. The
foreign exchange market is however not truly a financial market as there is no flow of surplus funds to
deficit units, rather this market serves as a conduit for locals undertaking transactions in a foreign country
or to foreigners undertaking transactions in the domestic economy (Faure, 2008:8).



LITERATURE REVIEW
Empirical studies have found a positive impact of financial deepening on economic growth, statistically
and economically significant. More recently, studies have related the development of the financial sector
to other real sector outcomes, including the pattern of countries trade balance and changes in income
distribution and poverty levels.
This paper explores the role of the financial system for economic development, the causes and
consequences of financial fragility, and the politics behind financial deepening and fragility.
I survey the large theoretical and empirical literature that links a sound financial system to the process of
economic development. I discuss the theoretical and empirical literature on bank fragility and banking
crises and survey the literature on the political economy of financial deepening. Importantly, I relate these
three strands of the literature to each other and to the current crisis.
Financial institutions and markets depend critically on contractual institutions, and this survey is thus
closely related to the institutions and development literature (Acemgolu, Johnson, and Robinson, 2005).
Specifically, given the intertemporal nature of financial contracts, the financial system is one of the most
institution-sensitive sectors of the economy.
The financial sector depends as much as contractual institutions on property rights protection and thus the
political structures of societies.
This paper is related to other recent surveys. Levine (2005) surveys the theoretical and empirical literature
on finance and growth, and Beck (2009) surveys the econometric methodologies behind the empirical
finance and growth literature. Demirg-Kunt and Detragiache (2005) discuss the literature on banking
crises, and Haber and Perrotti (2008) offer a critical survey of the finance and politics literature. This
survey is also related to recent surveys on the political economy of the financial and legal system (Beck
and Levine, 2005). Compared to these previous surveys, this paper tries to bring these three literatures
together and relate them to the first global financial crisis of the twenty-first century.
The remainder of this paper is organized as follows. The next section surveys the theoretical and
empirical finance and growth literature. Then I discuss the theoretical and empirical literature on financial
fragility. Following that is a survey of the political economy literature of finance, and a final section
brings these three literatures together and concludes.