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Relationship between the Financial System and Economic Development

A FINANCIAL SYSTEM consists of a set of organised markets and institutions together

with regulators of those markets and institutions. A financial system helps to increase output
by moving the economic system towards the existing production frontier. This is done by
transforming a given total amount of wealth into more productive forms.


The financial system is complex, comprising many different types of private sector financial
institutions, including banks, insurance companies, mutual funds, finance companies, and
investment banks, all of which are heavily regulated. The purpose of the financial system is to
bring the two groups – surplus and deficit units together for their mutual benefit.

The financial system is made up of surplus economic units, entities and individuals that have
excess funds, and deficit economic units, entities and individuals that need to acquire
additional funds.

 Surplus economic units : some economic units generate more income than they spend,
and have funds left over. These are called surplus economic units.

 Deficit economic units : Other economic units generate less income than they spend,
and need to acquire additional funds in order to sustain their operations. These are called
deficit economic units.


Financial Institutions are what make Financial Markets work.

Without them, financial markets would not be able to move funds from people who save to
people who have productive investment opportunities. They thus also have important effects
on the performance of the aggregate economy as a whole.

BANKS AND OTHER FINANCIAL INSTITUTIONS : Banks are financial institutions that accept
deposits and make loans. Banks are the financial intermediaries that the average person
interacts with most frequently. Because banks are the largest financial intermediaries in the
economy, they deserve careful study. However, banks are not the only important financial
institutions. Indeed, in recent years, other financial institutions such as insurance companies,
finance companies, pension funds, mutual funds and investment banks have been growing at
the expense of banks.

Basic role of a financial institution or intermediary

An intermediary is a go-between, and a financial intermediary is an institution which links
lenders with borrowers, by obtaining deposits from lenders and then re-lending them to

Financial Intermediary : An organisation which borrows funds from lenders and lends them
to borrowers on terms which are better for both parties than if they dealt directly with each

The role of financial intermediaries in an economy, such as banks, is to provide means by

which funds can be transferred from surplus units in the economy to deficit units. Surplus
units can be persuaded to lend money and deficit units will borrow money – although at a cost
(interest) and financial intermediaries develop the facilities and financial instruments which
make this lending and borrowing possible.

 Financial intermediaries channel funds from those with income in excess of their
needs to those wishing to borrow.

 They create assets for savers and liabilities for borrowers which are more attractive
to each than would be the case if the parties had to deal with each other directly.

 Financial intermediaries thus stimulate economic activity and growth in the

economy by providing credit.

EXAMPLES OF FINANCIAL INTERMEDIARIES : All the organisations listed below have one
thing in common – they all take in people’s money and use it to provide financial services and
to make profit or surplus. At the same time, they all deal heavily in the financial markets to
adjust their position and you will learn more about this in the module ‘Financial Markets’.
Examples: banks, insurance companies, leasing companies, pension funds, hedge funds,
central banks.



Intermediaries provide a route through which units in the economy with funds to lend
(surplus units) can lend money to units in the economy that wish to borrow (deficit
units). They provide convenient ways for surplus units to lend money and a ready
source of funds for borrowers.


Financial institutions transform volume for savers and borrowers by acting as a

collection point for the relatively small amounts that tend to be saved and then
aggregating these to provide a sizeable amount that can be lent. Savings from
investors in small amounts are packaged into larger loans of the size that borrowers
want. The borrower does not have the problem of finding a large number of individual
lenders to make up the full amount of the funds he wants, and the lender does not
have the problem of finding a borrower who is interested in the small amount he wishes
to lend.


Borrowers often want loans / funds for longer periods than lenders are willing to provide
them. Because of the large volume of their deposits, financial intermediaries are able to
have short-term deposits as liabilities, and transform a certain proportion of these funds
into long-term loans as assets. Maturity transformation relies on a financial institution being

For instance, what the bank would do is:
a) keep sufficient cash and liquid assets to meet demands for withdrawals by customers;
b) only lend to borrowers the proportion of the deposits it does not require in liquid form.
In practice, with a continual flow of deposits and withdrawals from customers, and
repayments of loans with interest from borrowers, a bank is able to operate with only
a proportion of its assets in liquid form. Withdrawals on any day are likely to be
considerably less than the total volume of deposits technically exchangeable for cash.

Financial intermediaries also allow lenders to spread their investment risk. Risk-
spreading is possible because:

 small lenders can diversify their investments more easily. Instead of having to risk
all the funds they can afford in one or two investments, which might eventually
give poor returns, they can place small amounts through a wider variety of financial
 provided that the financial intermediary is itself financially sound, the lender should
not run any risk of losing his investment altogether. The financial intermediary will
often bear the bad debt risk of borrowers.

Impact of financial intermediation on the level of activity in an economy

 Financial Intermediation reduces the Cost of Borrowing

The cost of borrowing money is the interest (or dividends) that an investor expects to receive.
It seems logical to suppose that if a financial intermediary makes a profit on borrowing and
lending, then it would be cheaper for a borrower to try to raise money direct from the lender.
However, in practice, financial intermediation reduces the cost of borrowing.

Efficient financial intermediation should have an effect on the cost of borrowing, i.e. on the
interest rate charged on loans and the overall return required on shares through dividends and
capital gains.

If the requirements of savers for liquid, low-risk funds are met as far as possible, then savers
will be satisfied to provide funds for a relatively small return.

A lender will normally accept a much lower rate of interest from a financial intermediary in
return for the: (i) risk-free nature of the investment;
(ii) liquidity of his deposits and;
(iii) convenience.

If funds are available at relatively low rates, investment should be stimulated. Overall, the
amount of activity in the economy should be higher than without intermediation.

Banks are deposit-taking institutions (DTIs) and are also known as monetary financial
institutions (MFIs). Monetary financial institutions play a major role in a country’s economy as
their deposit liabilities form a major part of a country’s money supply and are therefore very
relevant to governments and central banks for the transmission of monetary policy. Banks’
deposits function as money; as a consequence, an expansion of bank deposits results in an
increase in the stock of money circulating in an economy.

In order to better understand how banks work, we need to examine their assets and liabilities.
Please note that the financial statements (the ‘balance sheet’ and ‘profit and loss account’ ) of
The Mauritius Commercial Bank Ltd will be analysed in class.

A simplified bank balance sheet

Liabilities Assets
Customer deposits Cash
Equity Liquid assets
Other investments
Fixed assets
Total Total

BANKING PRODUCTS AND SERVICES fall into three main categories:

 Money transmission products, which allow customers to pay and suppliers to be

paid for goods and services of all kinds;
 Savings products, i.e. accepting deposits from customers who want to save;
 Loan products, i.e. lending to customers who want to borrow.
In addition to these categories, retail banks generally offer a range of related services including
cash-dispensing machines, money management services, foreign exchange, investment
services, and insurance products.
Another major area not directly related to deposits and lending is the provision of financial
advice which includes, for instance, advice for small businesses on start-up, business plans
and appropriate funding. Advice is also given on the choice of investments, insurance policies
and pensions, and assistance in purchasing these products is available through stockbrokers
and financial advisers.


Money transmission includes the provision of cash, cheque clearing, direct debits and standing
orders, credit and electronic transfers and credit card services. Where branch networks exist,
these allow customers to visit the banks to make their transactions and see their personal or
business manager. However, various other methods of delivery are now also provided, these
include automatic teller machines (ATMs) for cash dispensing, as well as telephone banking
and online banking for account management and payment of bills.

 Current accounts enable money to be paid in or taken out as cash, by cheque or

electronically. Some banks also offer a packaged current account that gives a number
of additional benefits such as travel insurance or car breakdown cover. Some current
account pay interest but may charge a fee.

 Clearing : a key element of money transmission services is the clearing process.
Clearing refers to the process that takes place on a daily basis, in which the sums that
the banks owe to each other as a result of customers using cheques, direct debits,
debit cards and other means of money transfer are settled. The clearing process is as
follows: banks constantly receive payments from other banks as their customers
deposit cheques (and also by automated means such as direct debit); the same banks
are also being asked to pay money by other banks, for the same reasons. The net
effect of these two types of transactions is that each bank, at the end of each day’s
trading, is liable to pay a small balance – or is due to receive a small balance – from
another bank. In order to be able to settle this daily balance, each bank must hold
deposits with the Bank of Mauritius. ``

As a result of the development of more automated methods of fund transfer, such as

direct debits and debit cards, cheque volumes are falling and are expected to continue
to fall.



Banks and other deposit-takers offer a wide range of interest-bearing accounts to people
who want to grow their savings over the long term and to people who want to earn an
income from the interest paid to them. Savings accounts provide customers with a method
of storing their money safely while earning interest on the amounts deposited. Although
the interest rate varies, the capital sum is not at risk. There is a wide range of savings
accounts to cater for different needs. These accounts provide financial institutions with
some of the funds they need to finance the loans they make to their borrowers, thus
enabling them to earn a profit or spread from the margin between the interest rates at
which they lend and the rates they pay to depositors.

Interest on savings accounts is usually variable and is linked to the bank’s base rate. It is
calculated daily and is added to the account on a periodic basis. Some accounts offer
higher interest rates provided a certain minimum investment is made.


These accounts are intended for people saving over the long term, either to finance a
future purchase or to build up a retirement fund. Personal banking services are offered to
smaller savers and private banking services to high-worth individuals. Investment funds
take savers’ money and invest it in equities and bonds. The value of the investment
therefore depends on movements in the stock markets and can fall as well as rise.


 SECURED MORTGAGES are the most common method of financing the purchase
of residential and commercial property.

Property purchase loans are usually known as mortgage loans because the borrower
mortgages the property, in other words creates a legal charge over the title deeds to

the lender as security for the loan. This reduces the risk to the lender, but borrowers
take the risk of losing their home if they default on repayments.

Although the lender does not own the buildings or land, which remain the property of the
borrower, it is given rights over the property and is in a very strong position. If the borrower
defaults on mortgage repayments, the lender is entitled to take possession of the property
and to sell it to recover the money owed. There are, however, a number of drawbacks for
a lender in possessing a property, for instance, the difficulty of obtaining a good price, and
the administrative costs.

Mortgages are long-term loans typically for between 10 and 30 years. The amount of the
loan can be anything up to 100% of the property value, or even more than 100% in some
cases. It is, however, generally prudent to advance less than the market value of the
property, particularly if there is the possibility of a slump in property prices.

If the value of a property falls, a lender could find that the amount outstanding on the
mortgage loan is greater than the value of the asset on which that loan is secured; this is
known as negative equity, and can bring problems for both the lender and the borrower.
If the borrower, for example, defaults on the payments and the property is taken into
possession, the lender may be unable to sell the property for a sufficient amount to repay
the loan.


1. Personal loans: these are normally for a term of between one to five years.
The customer can use the loans for any purpose.

2. Overdrafts: an overdraft is a current account facility, commonly available that

enables a customer to continue to use the account in the normal way even
though its funds have been exhausted. An overdraft is a convenient form of
short-term temporary borrowing, with interest calculated on a daily basis.

3. Revolving credit: this refers to arrangements where the customer can

continue to borrow further amounts while still repaying existing debt. There is
usually maximum limit on the amount that can be outstanding and a minimum
amount to be repaid on a regular basis. The most common way of providing
revolving credit is through credit cards.


A government through its central bank can try to influence the level of economic activity and
inflation rate by altering interest rates or bank deposit growth in a country.

1. Money deposited by customers

Bank deposits can be used to discharge debts by means of a cheque and are thus regarded
as part of the country’s money supply. Bank deposits are initially created by customers
depositing cash in a bank which is credited to an account in their name. In simple balance
sheet terms, the bank has an asset, cash and a liability, a deposit claim against it, for an equal

2. Loans granted by banks to customers

Bank money can come into existence not only by the deposit money with a bank, but also
because banks grant loans to their customers. In such cases, it would be inconvenient if the

bank had to pay out cash. What it does is merely add the sum advanced to the account of the
customer who can now draw, in cash or by cheque, not only money, actually paid in by him,
but also that part of the account advanced by the bank. The bank has increased the customer’s
spending power and thus money has been ‘created’.

3. Overdraft facilities granted to customers

Overdraft facilities create money as soon as the customers draw cheques against these
facilities because the cheques must be paid into a bank account somewhere, so raising the
total level of bank deposits.

In the case of a customer loan, the creation of money takes place when the bank credits its
customer account, whereas with an overdraft, money is created as soon as the cheques drawn
against the overdraft facilities are paid in, either to the same bank or to other banks.

This is the explanation of the sentence, often used by economists to explain credit/deposit
creation – ‘every advance creates a deposit’.



Understanding Deposit Expansion and the Money Multiplier

While the central bank controls the money supply, money itself is created by the banking
system. In order to understand how banks create money, we illustrate a simple model of the
credit multiplier based on the fact that modern banks keep only a fraction of the money that is
deposited by the public. This fraction is kept as reserves and will allow the bank to face
possible requests of withdrawals.

Banks operate on the Fractional Reserve System, which means that they keep only a
fraction of deposits on hand as reserves. Thus, an initial deposit (or other increase in reserves)
results in additional loans, which ultimately return to the banking system as more deposits.

The process of deposit expansion continues until the total deposits have grown by a multiple
of the initial deposit. The ‘money multiplier’ is the relationship between the initial deposit and
the ultimate change in total deposits.

Using the Fractional Reserve System, banks create money. When banks receive a new
deposit, they keep only a fraction on hand in reserve and loan out the remainder. But the loans
find their way back into the banking system, increasing deposits further and setting off a new
round of loans. When the process settles down, total deposits in the banking system have
increased by a multiple of the initial deposit.

The effect of granting a loan: a loan given by a bank to one of its customers will raise advances
on the assets side and deposits on the liabilities side of the bank’s balance sheet. As the
bank’s liquid assets are unaltered while its deposits (and assets) have risen, its overall liquidity
position or ratio will decline. Each bank must maintain a minimum liquidity ratio to retain
customer (and shareholder) confidence. If liquidity falls below this level, the bank cannot grant
further loans (or any form of advances) to its customers.

BANKS AND THE MONEY SUPPLY : To see how money is created by banks in
carrying out maturity transformation, let us take the example of a country in which there is a
single commercial bank.

Let’s assume that the reserve requirement set by the central bank is 10 per cent and that a
commercial bank’s balance sheet is as shown below:

Liabilities (Rs bn) Assets (Rs bn)

Deposits 100 Cash 10

Loans 90
Total 100 100

Let’s assume that the central bank creates a further Rs10 billion of bank notes which find its
way into the commercial bank by way of deposits by the bank’s customers. Individuals
receiving this extra money deposit it in their bank accounts. Bank’s balance sheet then looks
like this:

Liabilities (Rs bn) Assets (Rs bn)

Deposits 110 Cash 20

Loans 90
Total 110 110

Deposits have increased by Rs10 billion and so has the cash held by the bank, since this is
the form in which new deposits were made. The bank now has more cash than it needs to
support customers’ deposits. It only needs Rs11 billion cash to support Rs110 billion deposits
(i.e. 10 %), and so can lend out the surplus R9 billion cash in the form of extra loans to
customers. The balance sheet then becomes:

Liabilities (Rs bn) Assets (Rs bn)

Deposits 110 Cash 11

Loans 99
Total 110 110

However, the Rs9 billion lent out gets used to buy goods and services, and then gets deposited
back into the bank. For example, say part of the money was used to buy goods from a shop.
The shopkeeper would pay the cash into his account at the bank, thereby restoring the sum
of cash in the bank. New balance sheet :

Liabilities (Rs bn) Assets (Rs bn)

Deposits 119 Cash 20

Loans 99
Total 119 119

The bank now needs Rs11.9 billion in cash to have a 10 percent base for deposits and can
lend out Rs8.1 billion. So the process goes on until loans and deposits reach the following

Liabilities (Rs bn) Assets (Rs bn)

Deposits 200 Cash 20

Loans 180
Total 200 200

Cash is now the desired 10 percent of deposits and credit creation stops.

Considering that most banking systems operate with more than one bank, we can assume
that if bank A gets a Rs10 billion increase in its deposit, 10 per cent will be kept as reserves
and the remaining Rs9 billion will be lent out and will find its way to another bank. Suppose
such an amount is lent to an individual who deposits it in bank B. At each stage the growth in
deposits is exactly 90 per cent of what it was at the previous stage.

The banking system under a 10 per cent reserve ratio (Rs bn)

Δ Deposits Δ Loans Δ Reserves

Bank A 10 9 1
Bank B 9 8.1 0.9
Bank C 8.1 7.29 0.81
Bank D 7.29 6.56 0.73
---- ----- ------ -------
Total all banks 100 100 10

Since the deposit multiplier equals the reciprocal of the required reserve ratio (1/0.1), then
following an injection of Rs10bn in the cash system (i.e. new deposits), the process will end
(achieve equilibrium) when an additional Rs100bn of deposits has been created.


The point of all this is to appreciate how much the money supply consists of money created
by banks and how little it consists of cash. In the example above, Rs100 billion of money has
been created from the relatively small original increase of Rs10 billion in cash. The factor by
which the total money supply grows as compared to an initial increase in cash is called ‘the
money multiplier’, and in the example above was 10 (Rs100 billion / Rs10 billion).

 The final deposit expansion = initial deposit / reserve ratio

Because there are no other leakages, the money multiplier equals 1 / reserve ratio.

However, the credit multiplier explained above has several drawbacks. As with most theories,
the assumptions behind this simple model are not realistic. The creation of deposits is much
less ‘mechanical’ in reality than the model indicates and decisions by depositors to increase
their holdings in currency or of banks to hold excess reserves will result in a smaller expansion
of deposits than the simple model predicts. Further, there are leakages from the system: for
example, money flows abroad; people hold money as cash or buy government bonds rather
than bank deposits. These considerations, however, should not deter from the logic of the
process, which is : bank deposits ‘create’ money.

Note: The monetary function of bank deposits is often seen as one of the main reasons why
deposit-taking institutions (DTIs) are subjected to heavier regulation and supervision than their
non-deposit-taking institutions (NDTI) counterparts (such as insurance companies, pension
funds, and investment companies).

Limitations on bank deposit creation :

The creation of bank deposits which generate more bank profits is subject to the following
 Sufficient demand for loans and overdrafts, i.e. advances, must exist.

Demand must come from safe credit-worthy customers with the ability to repay
advances. One of the factors that may contribute to the depth and length of an
economic recession could be the lack of safe borrowers offering adequate collateral/

 The liquid asset position of banks must be adequate.

Banks must maintain adequate liquid assets – cash, bills of exchange etc, to meet
repayment of deposits.

 Lending controls.

In the past many central banks have instructed banks to restrict their lending to a
specific rate of growth per annum. Such controls limit the ability of banks to create
credit and expand deposits.

 Open market operations.

Through its activities in the securities markets, a central bank can influence the amount
of cash in the banking system.

 The need for banks to keep in line.

No individual bank can afford to expand its lending faster than other banks unless it is
able to attract extra deposits from the public. In a five bank system, a bank with only
20% of the market would expect 80% of its loans be redeposited with other banks
which would require a transfer of cash from it to other banks. There would be transfers
back as the loans created by competitors were redeposited with it. If the bank created
loans at a faster rate than its competitors, there would be an imbalance in these
transfers and a loss of cash for the bank.

 The total amount of cash in the country.

The amount of cash available to the banks to support the expansion of their deposits
will be influenced partly by the total amount of cash in the country. The more cash
there is, the more cash is likely to be left with the banks. The desire of the public to
hold its money in the form of cash rather than as bank deposits will also influence
deposit creation in the economy.