Role of Finance in the Economy

The financial system and banks of the United States are critical to the general system of the economy. In general, finance contributes to the economy in three ways.

  1. It is possible to arrange for financial assistance in the form of loans. Businesses and governments alike may smooth out their budgets by investing in infrastructure projects and lowering the cyclicality of tax receipts. Consumers can buy a home without putting up the entire down payment. Even while banks are the dominant source of financing, unlike in most other economies, financial markets are ultimately responsible for most financing.
  2. To make money available to those who need it. Having a contingency cash flow plan is essential for both organizations and homes. Liquidity is provided through demand deposits, which can be withdrawn at any time, as well as bank lines of credit. When it comes to buying and selling assets in large quantities and at low transaction costs, the financial markets rely heavily on banks and the affiliates of those institutions. Even though this position is critical, it is sometimes disregarded in the United States because of its market dominance.
  3. Reducing the danger of something going wrong. It’s possible to pool financial and commodity price risk exposures for the benefit of businesses and individuals in various ways. A significant chunk of this comes from bank derivatives transactions. Derivatives have a terrible reputation because of their abuse in the run-up to the financial crisis, yet their core functions provide valuable risk management.

Financial institutions in the United States, according to this belief, grew too large during the bubble and are still too large today. While some risk-taking occurred during the bubble period, it is challenging to achieve the correct scale for a financial system based on well-founded economic theory. Even in the most complicated sectors, trying to fix this problem by central planning and other methods has largely failed.

If a sector is given unjustifiable economic aid, it will inevitably grow too large. These subsidies may still exist, but the government has taken a series of steps to decrease them and make the financial sector more responsible.

To force significant changes in the financial structure, several notable suggestions have been put up, such as

  • Too-big-to-fail banks should be broken up or shrunk to prevent them from falling.
  • Some of the bank’s duties are restricted by the Glass-Steagall or Volcker Rule.

Many people argue that banks have an implicit government guarantee that should be dismantled because of their size or importance to our financial system. This is a common misunderstanding that should be clarified. Proposals fall into the following categories:

  • Deconstruct and dismantle the world’s most powerful banking institutions.
  • Make it illegal to exceed a specific weight limit
  • By imposing substantial fees on large banks, you can encourage them to shrink their size willingly.
  • The larger institutions’ concerns need to be addressed compellingly.

We do not endorse the idea of dissolving or significantly downsizing the banks. Economic benefits of size and scope have been demonstrated, and we expect them to grow even further as globalization, complexity, and advances in information and management systems continue to grow. There must be a few global financial institutions in the United States that can provide a wide range of connected commercial and investment banking services while operating at size in each specialized product line that is effective.

Suppose these enterprises are vital to the economy’s running. In that case, the government and regulators will likely need particular attention and assistance in extreme crisis scenarios that are unlikely to occur more than once or twice a century. Since this is the case, we may agree that it is necessary to identify and regulate financial institutions considered systemically important.

Financial Benefits of banks

We don’t believe the benefits of breaking up the large banks will be seen by society as a whole. The latest financial crisis was not caused primarily by the scale of financial institutions but rather by a systemic flaw. My point can be illustrated with a simple thought experiment. Big banks would have made similar blunders even if they had been split into 10 or 20 smaller businesses a decade earlier. All possibilities are over-investing in property-related goods, taking risks, constructing opaque and risky securitizations, etc.

Families and businesses in financial institutions are likely to have made the same mistakes that ratings agencies, governments, central banks and regulators did. It’s impossible to conceive that the disaster would have been any different if it hadn’t happened. A lack of the ability to convene 17 CEOs in one place and force them to accept TARP agreements would have made the clean-up more difficult.

Because every financial crisis is unique, it seems doubtful that a system with many medium-sized banks will be considerably safer than a system with only a few giant banks. If at all possible, except in the event of an emergency and with adequate collateral to back it up, this would be the preferred course of action. To be sure, there’s still work to be done, but Dodd-Frank goes a long way in that direction.

Since commercial banks and their affiliates play such an essential role in the economy, they have always been subject to limits on the kind of activities they can engage in.

These restrictions were dramatically expanded during the Great Depression. The Glass-Steagall Act made it illegal for a commercial bank to be affiliated with an investment bank. Deposits and loans are two of the most typical banking tasks a bank can undertake for its customers. Companies could raise money by selling stock and bonds, and investors could buy and sell those securities with the help of brokers. Brokers also traded the securities themselves.

In the 1990s, modifications to Glass-anti-affiliation Steagall’s procedures led to several vital limits that remain in place to limit transactions inside the group.

Banks’ ability to operate in the securities and derivatives markets has been progressively restricted through several measures. Others believe the anti-affiliation laws of Glass-Steagall should be brought back. In light of today’s fast-paced technological advancements, Glass-Steagall Lite has become a popular choice for some. Under the Volcker Rule, commercial and investment banks will not engage in proprietary trading.

There could be much chaos and issues if the current system is changed earlier. It would be simplest to divest banks of their investment banking divisions, but even doing so would require a large amount of change at a time when the US economy is still recuperating from financial turmoil. Mid-level securities firms aggressively pursuing market share could also result in displacement.

Stay Tuned for more Financial Tips from StubsonDemand Resource Centre.

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