An efficient financial system ensures that savings can flow to the most productive industry or economy. Pooling of risk . It is risky for an individual to invest all his savings in a single firm, because it could go bust. Financial intermediaries such as mutual funds allow individuals to reduce their risks by diversifying their investment portfolios. By pooling the risks of millions, insurance companies are able to sell protection against future loss whether through fire, burglary or death.
Derivatives can also help firms to manage their risks.
For example, a risk-averse firm might use derivatives to hedge against a possible rise in interest rates by shifting the risk to an investor more willing to take it. Reduce information costs . The financial system communicates information about borrowers creditworthiness. Prices of securities provide signals that assist managers in making investment decisions and households in making savings decisions, helping to ensure that funds are efficiently allocated. Banks and capital markets help to reduce information asymmetries caused because a borrower tends to know more about his prospects than a lender.