Larry is a rational, forward-looking consumer. He earns a good income of $200,000 a year but does not plan to spend all of it this year. He wants to put some of his income aside, perhaps for retirement, a future vacation, college tuition for his newborn son, or just as a precaution to prepare for future uncertainties. The part of Larry’s income that he does not currently spend contributes to the nation’s saving.

Patti is an entrepreneur starting a new business. She has an idea for a doll that she believes would enchant children around the world and therefore be quite profitable. To put her idea into action, she needs to obtain some resources: plastics, molds, fabric, sewing machines, and a building to house her small manufacturing operation. Patti’s purchases of these capital goods contribute to the nation’s investment.

In short, Larry has some income he wants to save, and Patti has ideas for investments but may not have the funds to pay for them. The solution is obvious: Larry can finance Patti’s venture. The financial system is the broad term for the institutions in the economy that facilitate the flow of funds between savers and investors. That is, the financial system brings people like Larry and people like Patti together.1

Throughout much of this book, the economy’s financial system was represented as a single market—the market for loanable funds. Those like Larry, who have some income they don’t want to consume immediately, bring their saving to this market so they can lend these funds to others. Those like Patti, who have investment projects they want to undertake, finance these investments by borrowing in this market. In this simple model, there is a single interest rate that adjusts to bring saving and investment into balance.

The actual financial system is more complicated than this description. As in the simple model, the main function of the system is to channel resources from savers into various forms of investment. But the system includes a large variety of mechanisms to facilitate this transfer of resources.

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One piece of the financial system is the set of financial markets through which households can directly provide resources for investment. Two important financial markets are the market for bonds and the market for stocks. A bond represents a loan from the bondholder to the firm; a share of stock represents an ownership claim by the shareholder in the firm. That is, a person who buys a bond from, say, Apple Corporation becomes a creditor of the company, while a person who buys newly issued stock from Apple becomes a part owner of the company. (A purchase of stock on a stock exchange, however, represents a transfer of ownership shares from one person to another and does not provide new funds for investment projects.) Raising investment funds by issuing bonds is called debt finance, and raising funds by issuing stock is called equity finance. Debt and equity are forms of direct finance because the saver knows whose investment project his funds are financing.

Another piece of the financial system is the set of financial intermediaries through which households can indirectly provide resources for investment. As the term suggests, a financial intermediary stands between the two sides of the market and helps move financial resources toward their best use. Commercial banks are the best-known type of financial intermediary.2 They take deposits from savers and use these deposits to make loans to those who have investment projects they need to finance. Other examples of financial intermediaries include mutual funds, pension funds, and insurance companies. When an intermediary is involved, the financing is considered indirect because the saver is often unaware of whose investments his funds are financing.

To continue with our example, Larry and Patti can take advantage of any of these opportunities. If Patti and Larry know each other, she could borrow money directly from him and pay him interest on the loan. In this case, she would in effect be selling him a bond. Or Patti could, in exchange for Larry’s money, give him an ownership stake in her new business, and he would enjoy a share of the future profits. In this case, she would be selling him some stock. Or Larry could deposit his savings in a local bank, which in turn could lend the funds to Patti. In this last case, he would be financing her new venture indirectly: they might never meet, or even know of each other’s existence. In all of these cases, Larry and Patti engage in a mutually advantageous exchange. Larry finds a way to earn a return on his savings, and Patti finds a way to finance her investment project.

Investment is inherently risky. Patti’s new doll might be the next toy craze, or it might be a flop. Like all entrepreneurs, Patti is starting her venture because she expects it to be profitable, but she cannot be certain of that outcome.

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One function of the financial system is to allocate risk. When Patti sells stock to Larry, she is sharing the risk of her venture with him. If her doll business is profitable, he will enjoy some of the gains. If it loses money, he will share in the losses. Patti might be eager to share the risk, rather than bear it all herself, because she is risk averse. That is, other things equal, she dislikes uncertainty about her future economic outcomes. Larry might be willing to accept some of the risk if the return he expects on this risky venture is higher than he would obtain by putting his savings into safer assets. Thus, equity finance provides a way for entrepreneurs and savers to share the risks and returns associated with the entrepreneur’s investment ideas.

In addition, the financial system allows savers to reduce their risk by spreading their wealth across many different businesses. Larry knows that buying stock in Patti’s doll venture is risky, so he would be smart to use only some of his savings to buy stock in her business. He could also buy stock from his friend Steve, who is opening an ice-cream store. And he could buy stock in established companies, such as IBM, General Electric, and Exxon. Because the success of Patti’s doll venture is not perfectly correlated with the success of Steve’s ice-cream store, or with the profitability of IBM, General Electric, and Exxon, Larry reduces the overall risk he faces when he spreads his wealth around. Reducing risk by holding many imperfectly correlated assets is called diversification.

Various financial institutions facilitate diversification. Among the most important are mutual funds. Mutual funds are financial intermediaries that sell shares to savers and use their funds to buy diversified pools of assets. Even a small saver can put, say, $1,000 into a mutual fund and become a part owner of thousands of businesses. Because the fortunes of these many businesses are not perfectly correlated with one another, putting the $1,000 into a mutual fund is far less risky than using all of it to buy stock in a single company.

There are limits, however, to how much diversification reduces risk. Some macroeconomic events affect many businesses at the same time. Such risk is called systematic risk. In particular, recessions tend to reduce the demand for most products and thus the profitability of most businesses. Diversification cannot reduce this kind of risk. Yet it can largely eliminate the risks associated with individual businesses, called idiosyncratic risk, such as whether Patti’s doll or Steve’s ice cream proves popular. For this reason, it is wise for savers like Larry to limit how much of their savings they allocate to the stock of any one company.

As Larry considers financing Patti’s business venture, one question is paramount in his mind: Will her company succeed? If Larry offers her equity financing, he gets a share of future profits, so the fortune of the business is crucial. Debt financing is safer for Larry, because debt holders are paid before equity holders get anything, but Patti’s success is still relevant. If the doll business is a failure, Patti may not be able to repay the loan. That is, she might default. Not only might Larry not get the interest he was promised, but he might lose his principal (the amount of the loan) as well.

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Making matters worse is the fact that Patti knows a lot more than Larry about herself and her business. Economists use the phrase asymmetric information to describe a situation in which one party to an economic transaction has more information about the transaction than the other. There are two classic types of asymmetric information, both of which are relevant as Larry ponders whether to finance Patti’s venture.

The first type of asymmetric information concerns hidden knowledge about attributes. Is Patti’s doll design a good one that will have wide appeal? Is the doll market ready for a new product, or is it oversaturated? Is Patti a talented businesswoman? Patti is more likely than Larry to have reliable answers to these questions. This is generally the case: entrepreneurs have more information about whether their investment projects are good ones than those who provide the financing.

In this situation, Larry should worry about the problem of adverse selection. As we noted in Chapter 7 in a different context, the term “adverse selection” describes the tendency of people with more information (here, the entrepreneurs) to sort themselves in a way that disadvantages people with less information (here, those providing the financing). In our example, Larry may be concerned that he will be offered opportunities to finance only less desirable business ventures. If Patti was truly confident in her idea, she might try harder to finance it herself, using more of her own savings. The fact that she is asking Larry to provide financing and share some of the risk suggests that perhaps she knows something adverse that he does not know. As a result, Larry has reason to be wary.

The second type of asymmetric information concerns hidden knowledge about actions. Once Patti obtains financing from Larry, she will have many decisions to make. Will she work long hours at the job, or will she cut out early to play tennis with friends? Will she spend the money she has raised in the most profitable way, or will she use it to provide herself with a cushy office and a fancy company car? Patti can promise to make decisions in the best interests of the business, but it will be hard for Larry to verify that she in fact does so because he won’t be at the doll factory every day to observe all the decisions that she makes.

In this case, the problem that arises is moral hazard, the risk that an imperfectly monitored agent will act in a dishonest or otherwise inappropriate way. In particular, entrepreneurs investing other people’s money may not look after the investment projects as carefully as those who invest their own money. Once Patti has Larry’s money in hand, she may be tempted to choose the easy life. If she succumbs to moral hazard, she will reduce the future profitability of the firm and increase the risk of default on her firm’s debts.

The financial system has developed various institutions that mitigate the effects of adverse selection and moral hazard. Banks are among the most important. When a person applies for a bank loan, he must fill out an application that asks detailed questions about his business plan, employment background, credit history, criminal record, and other financial and personal characteristics.

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Because the application is then scrutinized by loan officers trained to evaluate businesses, the bank stands a good chance of uncovering the hidden attributes that lead to adverse selection. In addition, to reduce the problem of moral hazard, bank loans may contain restrictions on how the loan proceeds are spent, and the loan officers may monitor the business after the loan is made. As a result, rather than making a direct loan to Patti, it may make sense for Larry to deposit his money in a bank, which in turn will lend it to various entrepreneurs like Patti. The bank charges a fee for serving as an intermediary, reflected in the difference between the interest rate it charges on loans and the interest rate it pays on deposits. The bank earns its fee by reducing the problems associated with asymmetric information.

In Chapter 8 and Chapter 9 we used the Solow model to examine the forces that govern long-run economic growth. In that model, we saw that a nation’s saving determines the steady-state level of capital, which in turn determines the steady-state level of income per person. The more a nation saves, the more capital its labor force has to work with, the more it produces, and the more income its citizens enjoy.

The Solow model makes the simplifying assumption that there is only a single type of capital, but the real world includes many thousands of firms with diverse investment projects competing for the economy’s limited resources. Larry’s saving can finance Patti’s doll business, but it could instead finance Steve’s ice-cream store, a Boeing aircraft factory, or a Walmart retail outlet. The financial system has the job of allocating the economy’s scarce saving among the alternative types of investment.

Ideally, to allocate saving to investment, all the financial system needs are market forces and the magic of Adam Smith’s invisible hand. Firms with particularly productive and profitable investment opportunities will be willing to pay higher interest rates for loans than those with less desirable projects. Thus, if the interest rate adjusts to balance the supply and demand for loanable funds, the economy’s saving will be allocated to the best of the many possible investments.

Yet, as we have seen, because the financial system is full of problems arising from asymmetric information, it can deviate from this simple ideal. Banks mitigate adverse selection and moral hazard to some extent, but they do not completely eliminate them. As a result, some valuable investment projects may not be undertaken because entrepreneurs cannot raise the funds to finance them. If the financial system fails to allocate the economy’s saving to its best uses, the economy’s overall level of productivity will be lower than it could be.

Government policy plays a role in helping ensure that the financial system works well. First, it can reduce the problem of moral hazard by prosecuting fraud and similar malfeasance. The law cannot ensure that Patti will put Larry’s money to its best use, but if she uses it to pay her personal living expenses, she may well end up in jail. Second, the government can reduce the problem of adverse selection by requiring some kinds of disclosure. If Patti’s doll business ever grows large enough to issue stock on a public stock exchange, the government’s Securities and Exchange Commission will require that she release regular reports on her firm’s earnings and assets and that these reports be certified by accredited accountants.

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Because the quality of legal institutions varies around the world, some countries have better financial systems than others, and this difference is one source of international variation in living standards. Rich nations tend to have larger stock markets and larger banking systems (relative to the size of their economies) than poorer nations. As always, sorting out cause and effect is difficult when examining differences across countries. Nonetheless, many economists believe that one reason poor nations remain poor is that their financial systems are unable to direct their saving to the best possible investments. These nations can foster economic growth by reforming their legal institutions with an eye toward improving the performance of their financial systems. If they succeed, entrepreneurs with good ideas will find it easier to start their businesses.