Revision on financial intermediaries

Use the main theories of financial intermediation to explain the existence of financial intermediaries?

Financial intermediation theories explain why financial intermediaries exist and how they contribute to the financial system.

Transaction cost theory

Financial intermediaries exist to reduce transaction cost associated with lending and borrowing

Direct transactions between borrowers and lenders can be costly due to search, contracting, and enforcement expenses. Intermediaries like banks aggregate savings and allocated loans, lowering costs per transaction through economies of scale.

Example banks offer standardised loan contracts and payment systems, minimizing individual negotiation cost.

2. Delegated Monitoring Theory:

Explanation: Intermediaries act as delegated monitors to reduce the cost of monitoring borrowers.

Rationale: Individual lenders lack the expertise or resources to constantly monitor borrowers’ activities. Financial intermediaries, like banks, gather information and ensure compliance, thus minimizing risk.

Example: Banks continuously evaluate credit risk, reducing the need for individual lenders to monitor directly.

3. Liquidity Transformation Theory:

Explanation: Financial intermediaries provide liquidity by transforming short-term liabilities (like deposits) into long-term assets (like loans).

Rationale: Depositors prefer liquidity, while borrowers require long-term funding. Intermediaries balance this mismatch using diversified portfolios.

Example: A bank holds liquid reserves to meet withdrawal demands while issuing long-term loans.

4. Information Asymmetry and Adverse Selection Theory:

Explanation: Financial intermediaries mitigate problems arising from information asymmetry between lenders and borrowers.

Rationale: Adverse selection occurs when borrowers with higher risk are more likely to seek loans. Intermediaries screen borrowers effectively, reducing the risk of lending to unsuitable clients.

Example: Banks use credit scores and financial history to assess borrower credibility.

5. Moral Hazard and Incentive Problems:

Explanation: Financial intermediaries help address moral hazard, where borrowers take on excessive risks after obtaining funds.

Rationale: By monitoring borrower behavior and imposing covenants, intermediaries reduce the likelihood of reckless actions that could lead to defaults.

Example: Banks may require collateral or impose debt covenants to align borrower incentives.

6. Risk Transformation Theory:

Explanation: Intermediaries diversify and pool risks to make lending safer.

Rationale: Individual investors might be unable to assess or bear significant risks, but intermediaries can manage and spread risks through diversified investment portfolios.

Example: Mutual funds pool capital from various investors to invest in a diversified asset portfolio, reducing individual exposure.

7. Economies of Scale and Scope Theory:

Explanation: Financial intermediaries benefit from economies of scale and scope, reducing the average cost of providing financial services.

Rationale: Larger institutions can offer a wide range of services (scope) and process large volumes of transactions (scale) more efficiently than individuals.

Example: Commercial banks offer deposit-taking, lending, and payment processing at lower costs per transaction compared to smaller institutions.

What are the costs and benefits of having financial intermediaries for lenders, borrowers and the society?

Lenders

Benefits

• Risk diversification - financial intermediaries pool funds from many investors, reducing individual risk

• Liquidity provision - Depositors can withdraw funds on demand, offering flexibility and convenience

• Lower transaction cost - intermediaries handle credit evaluation, monitoring, and enforcement saving individual lenders time and money

• Safety and insurance - deposit insurance protects savers from bank faliuers

Cost

• Lower Returns - the intermediaries charge fees or offer lower interest rates compared to direct lending

• Intermediation risk - bank failures or mismanagement can jeopardise deposits or investments

• Loss of control - investors have limited say in how their funds are allocated

• Agency cost - conflicts of interest between managers and investors may arise

Borrowers

Benefits

Easier Access to Capital: Intermediaries simplify borrowing through streamlined processes and established networks.

Credit Screening and Advising: Banks assess creditworthiness and may offer tailored loan products.

Lower Cost of Credit: Competition among intermediaries can lead to lower interest rates compared to informal lending.

Flexible Loan Structures: Options like fixed or variable interest rates and repayment plans accommodate different needs.

Reputation Building: Regular repayments build credit history, easing future borrowing.

Costs:

Interest and Fees: Borrowers must pay interest and other service fees, which can be substantial.

Collateral Requirements: Many loans require assets as security, increasing the risk for borrowers.

Credit Restrictions: High-risk individuals may face higher interest rates or be denied credit.

Moral Hazard Monitoring: Banks may impose stringent monitoring, affecting financial flexibility.

3. Society

Benefits:

Economic Growth: Financial intermediaries channel savings into productive investments, boosting GDP.

Financial Stability: By managing risk and pooling resources, intermediaries help stabilize the financial system.

Efficient Capital Allocation: Capital flows to projects with the highest returns, promoting innovation and development.

Employment Generation: Intermediaries support businesses with capital, fostering job creation.

Monetary Policy Implementation: Banks facilitate central bank policies, like interest rate adjustments.

Costs:

Systemic Risk: Large intermediaries can become "too big to fail," leading to bailouts during crises.

Economic Inequality: Access to financial services may be limited for marginalized groups, widening wealth gaps.

Misallocation of Resources: Risky investments (e.g., subprime lending) can destabilize the economy.

Moral Hazard: Government guarantees (like deposit insurance) may encourage risky behavior by intermediaries.

Financial Crises: Intermediary failures can have cascading effects on the entire financial system.