Role of Banks & Capital Markets in Resource Allocation

Topics: Economics, Financial market, Financial services Pages: 7 (2387 words) Published: March 25, 2011
The Role of Banks and Capital Markets in resource allocation between surplus and deficit units in an economy.

By: Adetokunbo Olu. Aofolaju

The issue of how scarce societal resource should be apportioned to different uses has always remained the central focus of economics. Given that the wants of a society are insatiable, the policy thrust of managers of any economy is establishing an appropriate framework for ensuring the deployment of resources to areas of needs that ultimately increases the general wellbeing of the people, which in other words is tantamount to economic growth. Whether in a free-enterprise economy or centrally planned one, the financial system, made up of all financial markets, instruments, and institutions, provides the mechanism through which a society mobilizes resources to their ‘highest-valued uses’. The system gives the medium of funds channeling from those who do not have immediate need for them (surplus units), to households and firms whose resources are not adequate for the economic activities they intend pursuing (deficit units). How the system performs this task is the focus of this paper. Resource Allocation Role

Cost of Information processing.
Making funds available to would be users who need them for productive activities is the central issue under consideration. The question then is would individuals and firms with surplus funds (that is having funds not immediately required for consumption purposes) have the capacity to search out for varied economic agents who do not have adequate funds to pursue value adding projects? The major constraint would be the cost of such exercise! And even where the surplus agents are prepared to bear the cost of the search, granted that technology today has made information gathering and dispersal less tasking, how will the surplus agents consummate an arrangement that will ensure the return of their funds as and when agreed upon? Would they be well informed to analyses fully the economic benefit to which the funding would be utilized for, and ensure growth for the society at large? In providing answers to these questions, Coval and Thakor (2005) divided the economy into three types of agents: (i)the optimistic agents constituting the deficit units

(ii)the pessimistic agents being the surplus units; and
(iii)the rational agents where we find the banks and capital markets. Whereas the optimists have determined the projects they want to execute but do not have sufficient financial resource to expend, they need to approach either the pessimist or the rational agents for additional funding. In the words of Coval and Thakor (ibid) ‘the success probability of projects is correctly estimated by a rational agent, overestimated by an optimist, and underestimated by a pessimist’. In other words, the rational agents standing between the optimists and the pessimists, take on the role of analytical review of investment opportunities requiring funding in order to ensure optimal usage of scarce resource. To give confidence to the pessimists who may be wary of the safety of their hard earned finance, the rational agents take on the responsibility of screening who among the optimists qualify to be entrusted with the finance supplied by the pessimists. These responsibilities entail substantial cost outlay which the rational can moderate through economy of scale. Allowing each borrower to search for surplus units ready to part with their finance for a period of time, or the surplus units engaged in searching for credible borrowers will entail duplication of efforts at substantial cost. This will constitute a waste to the economy at large, not withstanding the role of technology in making information readily available. As noted by Coval and Thakor (2005) a financial intermediary arises to provide screening service so commonly ascribed to it, even though it possesses no special advantage in doing so since advances in technology have led to...
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