What Is the Role of the Financial System in Economic Development?

The economic development of any country is dependent on its financial system which includes its banks, stock markets, insurance sector, pension funds and a government-run central bank with authority. These sectors influence a nation's currency and interest rates. In developed countries, they work together to promote growth and avoid runaway price inflation. When a country is still in a developing stage, the lack of a strong, sound financial system generally works against the national economy.

Banks are the cornerstone of a national financial system. Their key services are to provide a safe haven for the earnings of individuals and to make loans to companies in need of capital, either to start operating or to stay in business. Without this source of available capital, businesses would be hard-pressed to continue growing and returning a profit to their owners and outside investors. By channeling savings into the business sector through loans – and also offering loans to individuals to buy cars and homes – banks boost overall economic growth and development.

Stock markets provide an opportunity for individuals to invest in companies. By issuing shares, public companies pay off debt or raise capital for their operations. The bond market provides another means to raise money. When an individual or an investment company buys a bond, it receives a steady stream of interest payments over a set period. The bond market is accessible to companies as well as governments, which also need a reliable stream of funds to operate. Without the bond market, a government could only raise money by levying taxes, an action that tends to dampen business activity and investment.

In any country, confidence and trust in the banking system are crucial to economic health. If banks cannot redeem savings accounts, and savers begin to fear a loss of their money, a bank run results; this quickly drains cash from the bank and can eventually cause the institution to fail. Bond and stock markets rise and fall with the demand for investment; when individuals fear risk or lose their trust in the markets, they sell their securities and cause the value of companies to fall. This, in turn, makes it difficult for businesses to raise money, either from banks or capital markets.

Issuing currency and setting interest rates is the function of government-operated central banks, such as the U.S. Federal Reserve, which are responsible for monetary policy. The central bank and the U.S. Treasury "primes the pump" by loaning new money to the banks; by controlling this flow, the central bank also keeps currency exchange rates steady, which is vital for foreign trade and new investment. Setting a higher interest rate tends to support currency value, while lowering the rate encourages lending and investment – at the risk of currency devaluation and price inflation. Reliable and consistent monetary policy fosters economic stability and growth.