Modern finance is an economic discipline that applies science to financial markets. The discipline is rooted in mathematics and statistics. Many of its theories and models are based on these fields. However, human emotion also plays a major role in the world of finance. This is why it is difficult for modern finance to be completely understood by laypeople.
The focus of modern finance is on creating value. This includes proactive decision making and improving the controls and transaction-related processes. In this way, modern finance can enhance the ability of organizations to adapt to changing circumstances and make smarter decisions. It also involves the advancement of human capital and technology. For example, it emphasizes the importance of a financial institution’s governance.
Modern finance theory is widely accepted by regulators and practitioners. Its convergence with economic globalisation has led to the resumption of global trade. This enables more countries to access global markets. Furthermore, the practice of modern finance has become increasingly global. For example, the ratio of global trade to world GDP increased fivefold between 1970 and 2004, and foreign assets and liabilities increased fivefold.
The rise of modern finance has its roots in the evolution of the financial system. Alexander Hamilton, the first Treasury secretary of the United States, recognized the importance of financial institutions and argued for state involvement in finance. In 1790, the young country had just five banks and few insurers. Hamilton envisioned a state-of-the-art financial system, similar to that of Britain. In addition, Hamilton wanted to have a central bank that was publicly owned, which would allow the government to borrow cheaply.
The rise of modern finance theory can lead to the creation of alternative social and technical arrangements. For example, it can lead to the creation of socially responsible investing and abatement markets. However, modern finance theory also has its downside risks. Modern finance is rooted in a highly-financialized form of thermo-industrial capitalism, and it is prone to creative self-destruction.
Modern finance is about allocation of limited resources between competitive uses. Firms must determine whether to invest in projects that create profits, revenues, or savings. Profits are distributed to shareholders or retained by the firm for reinvestment. Managing money flows is essential for the survival of a business. If this is not done properly, the firm may become insolvent.
During the early 20th century, the United States had a completely different approach to finance. Unlike the UK, Americans thought the banks could look after themselves. Their approach to banking resulted in the creation of the FDIC, which insured depositors. The FDIC eventually removed bank runs. This helped banks reduce their cost-inefficient equity buffers. As a result, the financial system became more dependent on government support.
Herd behavior is another phenomenon that has become prevalent in modern finance. This theory says that people tend to mimic the actions and decisions of other people. This can be rational or irrational. However, it is a major reason for financial panics and stock market crashes.