Any new financial system gives economic development and the improvement in living standards by contributes some services to the the economy. That is clearing and settlement systems to facilitate trade, channelling financial resources between borrowers and savers, and some products to deal with the high risk and uncertainty. In principle, these functions can be provided by banks or other financial institutions or directly through capital markets. Banks and other financial intermediaries exist because they are an efficient response to the fact that information is costly. Banks specialise in assessing the credit worthiness of borrowers and providing an ongoing monitoring function to ensure borrowers meet their obligations. They are rewarded for these services by the spread between the rates they offer to the accumulated pool of savers, and the rates they offer to potential borrowers. This process is known as ‘maturity transformation’ and is at the heart of modern banking.
Banks offer a repository for savings, and then transform them into long-lived (illiquid) assets – housing loans and lending to businesses. In addition, banks play a role in providing payment and settlement services which are necessary for households, business and other financial institutions to settle day-to-day transactions. As a country becomes more developed, one typically sees the capital markets playing a greater role in supplying financial products and services relative to that supplied by the banks.
In many advanced economies, for example, raising business debt through securities rivals or exceeds that provided though the banking system. Unusually, New Zealand has a large banking sector, while the role played by the capital markets and non-bank financial institutions is small.
