A central purpose of the financial system is to direct the resources of savers into the hands of borrowers who have investment projects to finance. Sometimes this task is done directly through the stock and bond markets. Sometimes it is done indirectly through financial intermediaries such as banks.
Another purpose of the financial system is to allocate risk among market participants. The financial system allows individuals to reduce the risk they face through diversification.
Financial arrangements are rife with asymmetric information. Because entrepreneurs know more about the inherent quality of their ventures than do those providing the financing, there is a problem of adverse selection. Because entrepreneurs know more about the decisions they make and actions they take, there is a problem of moral hazard. Financial institutions such as banks mitigate (but do not completely solve) the problems that arise from asymmetric information.
Because the accumulation and allocation of capital are a source of economic growth, a well-functioning financial system is a key element of long-run economic prosperity.
Crises in the financial system begin when a decline in asset prices, often after a speculative bubble, causes insolvency in some highly leveraged financial institutions. These insolvencies then lead to falling confidence in the overall system, which in turn causes depositors to withdraw funds and induces banks to reduce lending. The ensuing credit crunch reduces aggregate demand and leads to a recession, which, in a vicious circle, exacerbates the problem of rising insolvencies and falling confidence.
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Policymakers can respond to a financial crisis in three ways. First, they can use conventional monetary and fiscal policy to expand aggregate demand. Second, the central bank can provide liquidity by acting as a lender of last resort. Third, policymakers can use public funds to prop up the financial system.
Preventing financial crises is not easy, but policymakers have tried to reduce the likelihood of future crises by focusing more on regulating shadow banks, by restricting the size of financial firms, by trying to limit excessive risk taking, and by reforming the regulatory agencies that oversee the financial system.