The Role of the Financial Sector in Economic Performance


Posted: 30 Apr 1998

See all articles by Richard J. Herring

Richard J. Herring

University of Pennsylvania - Finance Department

Anthony M. Santomero

University of Pennsylvania - The Wharton School

Date Written: July 1995


This paper examines the relationship between the financial sector and economic performance highlighting the role of government in maintaining an efficient financial system. It does so in several stages. In the first section, in order to provide a clear standard for comparison, we begin by considering how an economy would perform without a financial sector. In the second section, we proceed to introduce a simplified financial sector with direct financial transactions between savers and investors. We then introduce financial intermediaries which transform the direct obligations of investors into indirect obligations of financial intermediaries which have attributes that savers prefer. This section emphasizes how the financial sector can improve both the quantity and quality of real investment and thereby increase income per capita. The third section considers the role of government in supporting an efficient financial sector. We explain why some financial institutions may be vulnerable to collapse and the consequence this may have for the functioning of the economy. Then we review the system of circuit breakers which societies have developed to prevent a shock to one part of the financial system from destroying other financial institutions and damaging the real economy. In addition we consider the role of government in fostering efficient financial markets. The fourth section recognizes that not all government intervention in the financial sector in beneficial. We review the potentially detrimental effects of regulation on both the financial structure and the real economy. We also emphasize the competitive forces that influence the ultimate impact of regulations. Before advances in technology and financial theory stimulated financial innovations and before advances in telecommunications lowered the cost of cross- border transactions, national regulators enjoyed considerable autonomy in regulating domestic markets and institutions. Under current conditions, national regulators may continue to behave autonomously; but, the main result of more burdensome regulations may be to induce users and providers of financial services to shift to less heavily regulated products or locations, thus undermining the objectives which motivated the change in regulations. This dynamic process has become increasingly competitive as regulators in some countries have actively sought a greater share of international financial business. Technological trends in telecommunications and computation seem likely to increase the ease with which users and providers of financial services can circumvent burdensome regulations. This has led to calls for reduction in the overall restrictions on financial firms, as well as for international harmonization of regulations regarding safety and soundness, insider trading and taxation.

JEL Classification: G20

Suggested Citation

Herring, Richard J. and Santomero, Anthony M., The Role of the Financial Sector in Economic Performance (July 1995). 95-08. Available at SSRN:

Richard J. Herring (Contact Author)

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-5613 (Phone)
215-898-2067 (Fax)

Anthony M. Santomero

University of Pennsylvania - The Wharton School

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

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