The role of financial institutions

What are Financial Intermediations

act as intermediaries between savers and borrowers. This process,
called financial intermediation, is the main way funds move through the economy.
Intermediaries such as banks, insurance companies, and mutual funds are a more
important source of financing for firms than direct borrowing through stocks or bonds

Stocks are ( ) the main source of business Financing

are not (about 11% in the US)

issuing securities provides

less than half of total funding

indirect finance dominates 

less than 10% of external funding is direct 

Banks are the

most important source of funds, especially in developing countries

Is heavily regulated 

the financial system 

can easily issue securities

large well known firms

is common in debt contracts

Collateral

are complex and restrictive

debt contracts

Financial institutions solve three main problems in the Financial system

1. Transaction Costs - time and money spent completing financial deals. FIs reduce costs
thransformation).rough expertise and scale (e.g., banks, mutual funds).
2. Risk Sharing - transforming risky assets into safer ones through diversification (asset
transformation)
3. Asymmetric Information - when one party knows more than the other, leading to
adverse selection (before the transaction) and moral hazard (after the transaction).

Adverse Selection

 occurs when bad-quality borrowers or investments are more likely to
seek funds. It’s illustrated by Akerlof’s 'lemons problem' in the used-car market. Banks
mitigate this by producing and using information to screen borrowers.

Moral Hazard

is a principal-agent problem: the borrower (agent) may take hidden risks
after obtaining a loan. Example: a manager may invest borrowed funds in speculative
assets. Banks reduce this through monitoring and contract design

Why are Financial intermediaries crucial in the Financial system

They reduce transaction cost and information problems

Transaction Cost

Time and money spent completing financial eals. FIs reduce costs
through expertise and scale (e.g., banks, mutual funds)

Risk Sharing 

ransforming risky assets into safer ones through diversification (asset
transformation)

Asymmetric Information 

when one party knows more than the other, leading to
adverse selection (before the transaction) and moral hazard (after the transaction).