by Financial sector development in developing countries and emerging markets is part of the private sector development strategy to stimulate economic growth and reduce poverty. The Financial sector is the set of institutions, instruments, and markets. It also includes the legal and regulatory framework that permit transactions to be made through the extension of credit. Fundamentally, financial sector development concerns overcoming “costs” incurred in the financial system. This process of reducing costs of acquiring information, enforcing contracts, and executing transactions results in the emergence of financial contracts, intermediaries, and markets. Different types and combinations of information, transaction, and enforcement costs in conjunction with different regulatory, legal and tax systems have motivated distinct forms of contracts, intermediaries and markets across countries in different times.
A well-functioning financial system has complete markets with effective financial intermediaries and financial instruments allowing:
- Investors to move money from the present to the future at a fair rate of return;
- Borrowers to easily obtain capital;
- Hedgers to offset risks; and
- Traders to easily exchange currencies and commodities.
The five key functions of a financial system in a country are:
(i) Information production ex ante about possible investments and capital allocation.
(ii) Monitoring investments and the exercise of corporate governance after providing financing.
(iii) Facilitation of the trading, diversification, and management of risk.
(iv) Mobilization and pooling of savings.
(v) Promoting the exchange of goods and services.
Financial sector development takes place when financial instruments, markets, and intermediaries work together to reduce the costs of information, enforcement and transactions. A solid and well-functioning financial sector is a powerful engine behind economic growth. It generates local savings, which in turn lead to productive investments in local business. Furthermore, effective banks can channel international streams of private remittances. The financial sector therefore provides the rudiments for income-growth and job creation.
Well-functioning financial systems are characterized by financial instruments that help people solve financial problems, liquid markets with low trading costs (operationally efficient), timely financial disclosures resulting in market prices that reflect available information (informationally efficient), and therefore prices that move primarily with changes in fundamental value instead of liquidity demands. Well-functioning markets ultimately lead to efficient allocations, which use resources where they are most valuable.
