EC230 - Economics of Money & Banking

What are financial intermediaries and what is their purpose?

• They are institutions that play a crucial role in facilitating the flow of funds from savers to borrowers in the economy

• Leads to reduced asymmetric information 

• They are a key component of indirect finance 

What is indirect finance?

The process of facilitating funds from savers to borrowers via intermediaries (e.g. banks, mutual funds, insurance companies and pension funds)

An example of this is: large firms going through financial intermediaries to borrow

What are the types of financial intermediaries?

• Banks

  • Commercial

  • Investment banks

• Mutual Funds

• Insurance Companies

• Credit Unions

• Pension Funds

What are the main functions of financial intermediaries?

• Risk Transformation: diversifying risk by pooling funds from multiple investors and offering financial products that help individuals and institutions manage risk

• Economies of Scale: reduce transaction costs as the size of the transaction increase - accessibility to good lawyers for transactions, can reutilise contracts from said lawyers (reduces legal costs)

• Information Analysis: reduce information asymmetry between borrower and lender

• Maturity Transformation: borrow short term and lend long term (how they are profitable)

What is ‘risk transformation’? 

Risk Transformation: diversifying risk by pooling funds from multiple investors and offering financial products that help individuals and institutions manage risk

What is ‘maturity transformation’? 

Maturity Transformation: borrow short term and lend long term (how they are profitable)

What is the importance of financial intermediaries? 

• Efficiency: enhance the efficiency of the financial system

• Risk Management: they provide the tools for managing financial risk and inc. the financial stability of the system

• Capital Allocation: they allocate capital to productive investment projects, contributing to economic growth

• Liquidity Provision: they ensure that funds are available for withdrawal (in case of emergency) while funding long-term investments

What are the pros and cons of financial intermediaries? 

Pros: 

• Importance of regulatory oversight for financial stability

• Regulatory bodies and agencies (e.g. Securities and Exchange Commission (SEC), Federal Deposit Insurance Corporation (FDIC), central banks)

• Protecting consumers and maintaining market integrity

Cons: 

Risk of conflict of interest and systematic risk