Brown University

Financial systems support and spur economic growth. But does financial innovation foster financial development? While recent innovations have done damage, this chapter says the long-run story is that financial innovation is essential for economic growth. Finance is powerful. The financial system can be an engine of economic prosperity – or a destructive cause of economic decline and misery. The impact of the financial system on the rest of the economy depends on how it mobilises savings, allocates those savings, monitors the use of those funds by firms and individuals, pools and diversifies risk, including liquidity risk, and eases the exchange of goods and services. When financial systems perform well, they tend to promote growth and expand economic opportunities. For example, when banks screen borrowers effectively and identify firms with the most promising prospects, this is a first step in boosting productivity growth. When financial markets and institutions mobilise savings from disparate households to invest in these promising projects, this represents a second crucial step in fostering growth. When financial institutions monitor the use of investments and scrutinise their managerial performance, this is another essential ingredient in boosting the operational efficiency of corporations, reducing waste and fraud, and spurring economic growth. When securities markets ease the diversification of risk, this encourages investment in higher-return projects that might be shunned without effective risk management vehicles. And when financial systems lower transaction costs, this facilitates trade and specialisation, which are fundamental inputs into technological innovation and economic growth.

But when financial systems perform poorly, they tend to hinder economic growth and curtail economic opportunities. For example, if financial systems simply collect funds with one hand and pass them along to cronies, the wealthy, and the politically connected with the other hand, this produces a less efficient allocation of resources, implying slower economic growth. If financial institutions fail to exert sound corporate governance, this makes it easier for managers to pursue projects that benefit themselves rather than the firm and the overall economy. Similarly, well-functioning financial systems allocate capital based on a person’s ideas and abilities, not on family wealth and political connections. But, poorly functioning financial systems become an effective tool for restricting credit – and hence opportunity – to the already rich and powerful.