Any modern financial system contributes to economic development and the improvement in living
standards by providing various services to the rest of the economy. These include clearing and
settlement systems to facilitate trade, channelling financial resources between savers and
borrowers, and various products to deal with risk and uncertainty.
In principle, these various functions can be provided by banks or other financial institutions or
directly through capital markets. Banks and other financial intermediaries exist because they are an
efficient response to the fact that information is costly. Banks specialise in assessing the credit
worthiness of borrowers and providing an ongoing monitoring function to ensure borrowers meet
their obligations. They are rewarded for these services by the spread between the rates they offer to
the accumulated pool of savers, and the rates they offer to potential borrowers. This process is
known as ‘maturity transformation’ and is at the heart of modern banking. Banks offer a repository
for savings, and then transform them into long-lived (illiquid) assets – housing loans and lending to
businesses. In addition, banks play a role in providing payment and settlement services which are
necessary for households, business and other financial institutions to settle day-to-day transactions.
As a country becomes more developed, one typically sees the capital markets playing a greater role
in supplying financial products and services relative to that supplied by the banks. In many advanced
economies, for example, raising business debt through securities rivals or exceeds that provided
though the banking system. Unusually, New Zealand has a large banking sector, while the role
played by the capital markets and non-bank financial institutions is small.