The Price Mechanism and the Three Pillars of Finance

Abstract

If the ‘man in the street’ were asked ‘What is finance?’, some of the possible answers might be: ‘It’s to do with money’; ‘It’s about getting a mortgage’; ‘It’s what banks do’; ‘It’s about saving for retirement’. All of these answers would be correct. But what they all omit is two important words: risk and price. Finance is about assessing risk, pricing it and then transferring it through credit and capital markets. A new issue of shares, for example, is about pricing the riskiness of the company concerned and then transferring that risk to new investors through the capital markets. If that company subsequently goes to a bank to raise a loan for expansion, the bank manager’s job is to assess the risk of a loan to that particular company, price that risk as an interest rate to be charged and then transfer that risk on to the bank’s own balance sheet.