Financial Developments

In the last thirty years, financial systems around the world have undergone revolutionary

change. People can borrow greater amounts at cheaper rates than ever before, invest in a

multitude of instruments catering to every possible profile of risk and return, and share risks

with strangers from across the globe. Have these undoubted benefits come at a cost? How

concerned should central bankers and financial system supervisors be, and what can they do

about it? These are the issues examined in this paper.

Consider the main forces that have been at work in altering the financial landscape.

Technical change has reduced the cost of communication and computation, as well as the

cost of acquiring, processing, and storing information. One very important aspect of technical

change has been academic research and commercial development; Techniques ranging from

financial engineering to portfolio optimization, from securitization to credit scoring, are now

widely used. Deregulation has removed artificial barriers preventing entry, or competition

between products, institutions, markets, and jurisdictions. Finally, the process of institutional

change has created new entities within the financial sector such as private equity firms and

hedge funds, as well as new political, legal, and regulatory arrangements.

These changes have altered the nature of the typical transaction in the financial sector,

making it more arm’s length and allowing broader participation. Financial markets have

expanded and become deeper. The broad participation has allowed risks to be more widely

spread throughout the economy.

While this phenomenon has been termed “disintermediation” because it involves moving

away from traditional bank centered ties, the term is a misnomer. Though in a number of

industrialized countries, individuals do not deposit a significant portion of their savings

directly in banks any more, they invest indirectly in the market via mutual funds, insurance...