Question

Discuss different roles financial institutions can be expected to perform in the economy. Where relevant, explain why specific problems cannot be solved by individuals or financial markets and how financial intermediaries are contributing to the solution of each of those problems identified by you.

Answer 1

Solution

The financial institutions play multiple roles in an economy.Some of them are as below.It is not possible for an individual / financial market to perform the following important roles which are religiously / sincerely performed by the financial institutions

1.Role of a regulator - They perform the role of a regulator and also are also implementing the norms put up by the government / central bank in the financial space.Example:Monetary and fiscal policy.

2.Role of a risk absorber - They reduce the risk involved in the transaction as a whole between the lender and borrower as they can have greater risk absorption capability when compared to the single parties involved.

In this process,if there is default from any one side,as they are risk absorbers , the situation will not lead to spiraling effect in the economy.

3.Role of a third party -They evaluate both the parties involved (i.e., both the borrower and lender,so serves as a third party between both the parties involved) in the transaction between the lender and the borrower.So,their evaluation would be accurate as it is impartial.

Example : Strict / Impartial / Complex /accurate credit evaluation process / methodology / techniques followed will lead to lower NPA s (non-performing assets) which is good for a country's economy as it's credibility as a whole will increase.

4.Role of a facilitator - Financial institutions perform the role of intermediary / platform between the borrower and the lender.They connect the lenders to the borrowers (receive deposits from lenders and give out loans to borrowers).

Example: EXIM (Export-Import Bank) serves as a facilitator in various financial transactions during the trade between the lender / borrowers in India and borrower / lender in other countries.So,here it is serving like a link between 2 players present in different economies.

5.Role of a lever / magnifier - As they reduce the risk involved in the financial transactions between the parties,the scope for more credit increases in the economy. In other words,they function as a lever using which the economy can lift very heavy / huge amounts of credit.

Individuals / financial markets cannot perform this function.

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