2.4 The nancial system and resource allocation

Look at the situation now from the angle of the ‘real’ economy. Prot-maximising

rms will undertake all those projects whose net present value is positive, when the

earnings are discounted at the current rate of interest. On the customary assumption

that more projects will pass this test when interest rates are low than when they are

high, the volume of investment spending will be negatively sloped as in Figure 2.1(b).

If, as in Figure 2.1(a), intermediation makes lending more attractive, increasing the

supply and lowering the price (the rate of interest), then Figure 2.1(b) shows there

will be an increase in investment, I.

In summary, the development of nancial intermediation in this example has

had no effect upon the levelof aggregate demand, but has shifted its composition.

There is less current consumption, but more saving and more investment for future

production. Seen like this, nancial intermediation can have implications for the

balance of production in an economy (between consumption and investment goods)

and upon the rate of growth of the economy if more resources are devoted to invest-

ment than would otherwise have been the case.

2.4The nancial system and resource allocation

In an ideal world, we should like to think that the nancial system functions in such

a way that it channels funds from lenders to their most productive use. Where the

funds are borrowed for real investment projects, for example, these should be the

projects which society values most. For this to happen, a number of conditions have

to be met. If we assume that they are met, we are assuming that the nancial system

has the characteristics of a perfectly competitivesystem. The assumptions are:

l	there are many lenders and borrowers;
l	all lenders and borrowers have perfect information;
l	new lenders and borrowers can enter the market without restraint;
l	there are no taxes;
l	there are no costs to be borne (or benets to be enjoyed) by people outside theloan contract.

In this setting, lenders know where they can nd the best returns. (We would

normally say ‘best returns for a given level of risk’ but with the assumption of per-

fect information there is strictly speaking no risk!) The best returns will be offered

by the borrowers whose projects earn the highest rates of prot. These high prots

will be available because of the high price which customers are prepared to pay for the

product which is produced. If there are no taxes, this price represents the marginal

benet which consumers derive from the good. With no externalities, there are no

hidden costs of production being carried by other members of society. Since lenders

know where the best returns are, they will ensure that there is a steady ow of funds

towards these activities which society seems to value highly. The supply of funds

competing for these high returns will encourage rms to expand their activities. With

expansion, the rate of prot may fall and the rate of return offered to lenders may

also fall. It may fall to a point where the existing lenders are just happy with the

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Chapter 2 • The nancial system and the real economy

return. There is no incentive for additional lenders to join in. Expansion stops, but

only after society’s need for this desirable product or service has been met. Looking

at the other end of the spectrum, rms whose prots do not enable them to pay

at least the minimum rate of return required by lenders will nd it impossible to

obtain funds for expansion and may, in the long run, be forced to contract. So long

as our assumptions hold, then we can be condent that the pressures on declining

rms represent the preferences of ‘society at large’ and that the decline is part of

the mechanism whereby funds are directed towards the activities that society values

most highly and away from those that are less highly rated.

In practice, however, life is neither so simple nor so benevolent. There are a

number of respects in which the nancial system fails to match the assumptions of

perfect competition. We shall consider just some of these. We shall then show how

the failures affect the allocation of funds and also, briey, how the failures may also

affect the allocation of management expertise.

Traditionally, nancial activity has been subject to extensive regulation by gov-

ernment. This is partly because of something called ‘asymmetric information’. In

this case, borrowers have better information about the likely risk and return from

their projects than lenders have and so some degree of regulation is necessary to

prevent lenders from being exploited. Regulation is also thought to be necessary

to prevent nancial institutions from taking on too much risk. This is because the

costs associated with the failure of a nancial rm, especially if it is a bank, are very

high. Although the tendency has been to reduce the extent of nancial regulation

in recent years, rules about the type and volume of business that nancial rms

can do remain. The next chapter provides some examples in the case of banks and

building societies.

Such regulation, drawing dividing lines between different types of institution,

reduces competition. A surplus, for example, of loanable funds in one part of the

system cannot be made available to satisfy excess demand elsewhere. For many years

(before 1986 when steps were taken to broaden the borrowing and lending powers

of building societies) it was argued that the UK nancial system was biased towards

channelling funds into the domestic property market and against supplying cheap

funds to industry. The result, it was said, was to produce a booming housing market

and a low rate of growth of productivity and output. The situation arose because

building societies offered savings products which were very attractive to house-

holds (partly because of their tax treatment). Thus building societies received large

ows of funds which they could lend quite cheaply to people who wished to buy

(largely secondhand) unproductive assets. Meanwhile rms (even rms wishing

to buy buildings) had to borrow elsewhere at higher rates of interest. As the next

chapter shows, the 1986 Building Societies Act, and later legislation, allowed build-

ing societies more freedom in their source and use of funds, but restrictions remain

and building societies still do very little ‘commercial’ lending.

In this one example, we see that information is not perfectly available to all,

lenders and borrowers are not entirely free to lend to and borrow from whomsoever

they wish, and taxes can certainly inuence decisions. As a result, the ow of funds

can be distorted.

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