Lesson 1 of 7 · 14 min
What the financial system does, and what makes it work well
The financial system moves money through time, moves risk to those willing to bear it, and swaps assets; it works well when markets are complete, cheap to trade in and priced on good information, and regulation keeps it that way.
In short
- People use the system for six purposes: saving, borrowing, raising equity, managing risk, exchanging assets (spot trades) and information-motivated trading.
- Its three main functions: help people achieve those purposes, find the equilibrium interest rate that equates total saving with total borrowing, and allocate capital to its best uses.
- Investors expect only a fair return for risk and time; information-motivated traders expect to beat that return; hedgers trade to offset risks they already face.
- A well-functioning system has complete markets, is operationally efficient (low trading costs) and is informationally efficient (prices reflect fundamental values).
- Regulation aims to control fraud and agency problems, promote fairness, set common standards, keep financial firms adequately capitalised and make sure long-term liabilities are funded.
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