A Very Important Part Of Finance Accounting Essay

Category: Accounting

Financial Intermediation is a very important part of Finance, in this essay we would look at the ways in which market structure, bank regulations and institution affect or the extent to which they impact the cost of financial intermediation. Before we proceed we would define some important keywords for the essay.

Definition of Terms

Financial Intermediation: can be defined as the major instrument in which funds are moved from lenders to borrowers of fund (Fethi, 2009).It can also be defined as " an organization that raises money from investors and provides financing for individuals, companies and other organizations" (Brealey, R; Myers,C;Marcus,A, 2007, p. 33). That is too say that financial intermediation facilitates financing in all aspects of lending, borrowing and investments. It could be said to be the channeling of funds from savers to investors or the movement of funds from people who need funds to people who have excess funds; it is an important part of an economy and is mainly handled by financial institutions and financial markets (Aggarwal & Goodell, 2009, p. 1770).One of the reasons why financial intermediation is important to the economy because it helps regulate money supply and demand. Examples of Financial Intermediaries include Banks, Mutual Funds, Insurance companies and Pension Funds. The banks and Insurance companies pool and invest savings, accept deposit, sell insurance policies, loan money to Individuals, businesses and organization, and they invest in financial assets. Mutual funds specialize in investing securities by diversifying in professionally managed portfolios and a Pension Fund is a way of pooling and investing savings this is set up for employee on retirement (Brealey, R; Myers,C;Marcus,A, 2007, p. 36). Financial intermediation is critical for economic performance because of the above functions it performs.

Bank Regulation: An online finance dictionary defines bank regulation as the formulation and issuance by authorized agencies of specific rules or guidelines, under governing law, for the conduct and structure of banking. Regulations are important so as to protect investors, by increasing information available to them and ensuring that activities that financial intermediaries take part in are sound, stable and solid (Fethi, 2009).Examples of bank regulatory bodies include; the Financial Services Authority, Bank of England and these regulations may come in form of entry restriction, activity requirement and reserve requirement etc.

Institutions: can be defined as behavioral rules humanly devised to govern and shape the interactions of human beings, it helps them predict what a human will do because they are laid down rules. Bank regulations and supervision is a primary institution that shapes bank behavior, other institutions include Legal, Political, Sociological, Economic institutions; these may also affect the principal-agent relationship (Breuer, 2006).

Market Structure: In economics, market structure describes the state of a market with respect to different kinds of competition, the major types include, monopolistic competition, monopoly and perfect competition.

Having defined the above terms we would the proceed to discuss their effect on the cost of financial intermediation

IMPACT OF BANK REGULATION, MARKET STRUCTURE AND INSTITUTION ON THE COST OF FINANCIAL INTERMEDIATION

Demirguc -kunt , Laeven and Levine are one of the authors that wrote on the impact of the three variables on the cost of Financial Intermediation and in his work he measured the impact of Bank regulations, Market Structure and Institution on cost of financial intermediation by Bank net interest margins which measure the gap between what a bank pays savers and what the banks receives from borrowers and the Banks overhead expenditure which is calculated by dividing the overhead cost by the total asset of the bank, the higher it is the more the cost inefficiencies and market power. In assessing the impact of bank regulation, bank concentration should be analyzed and in understanding the role of institutions and market structure the role of individual banks should be examined in their district regulatory and institutional environment (Demirguc-Kunt, Laeven, & Levine, 2004). In Nigeria, for example in 2006, the recapitalization rule set by the Central Bank of Nigeria for banks to have 25 billion naira as liquid reserves, this reduced the number of banks from 89 to 25, this is just one of many ways in which regulations can be applied and affect the market structure. Banks are more stable with strict supervision and private monitoring one of the reasons is because policies coerce intermediaries to disclose information useful to investors (Fernández, González, & Suárez, 2009, p. 3).

One common view holds that regulation in the financial sector gives rise to lack of competition as a result of low bank concentration, because regulation requirement cannot be met by other potentials (Demirguc-Kunt, Laeven, & Levine, 2004, p. 595). A bank with the largest market share may enjoy a larger net income in the sense that they can determine price and because competition is low they enjoy abnormal profit (Demirguc-Kunt, Laeven, & Levine, 2004, p. 595), (Aggarwal & Goodell, 2009, p. 1772) also supports this. (Berger, 1995, p. 404) Also supports that firms that with large market shares enjoy the benefits of market power and can also set prices and enjoy supernormal profit until other companies come into the market, this could come in form of lower deposit rates and high loan rates. Restriction on activities such as insurance, securities and non-financial firm may affect bank performance stability negatively, because strong regulated markets are less competitive (Fernández, González, & Suárez, 2009, p. 2).High concentration can be read to mean that the market is not competitive and therefore inefficient; market competition brings about in an efficient market and according to the efficient-structure theory efficient banks enjoy larger market share and lower costs (Demirguc-Kunt, Laeven, & Levine, 2004, p. 594).

(Fernández, González, & Suárez, 2009, p. 2) is of the opinion that bank concentration has a negative effect on economic growth in that, bank concentration focuses on the development of lending relationship with borrowers when the poor quality of institution impedes market development and suggests that financial markets are developed better in countries with strong legal frameworks and institutions, it may not be entirely negative on growth, because it provides credit for the industrial sectors and the industrial sector enhances economic activity. The effect of institutions on the foreign ownership- bank may be different from domestic banks because they know more about the institutions and home country condition that govern activities, which would lead to them paying a lower cost of providing financial services than for foreign owned banks making them more efficient (Lensink, Robert; Meesters, Aljar; Naaborg, Ilko, 2007, p. 835).Empirical research suggest that countries with strong property right protection and creditor right protection charge lower interest to borrowers, so weak rights protection makes investors to enter private contracts and as such increases adverse selection and moral hazards (see table 1D) Banks would also give long term debts and charge less if a countries protection by law for creditor right is strong, because they anticipate and try to reduce risks. Empirical evidence on the influence on bank concentration on the availability of credit is in mixed ways, some show empirically that high bank concentration raises the cost of bank financing, some feel that it doesn't contribute to economic growth it only promotes the industrial sector (González, Víctor M; González, Francisco, 2008, p. 364).

Some of the reasons financial intermediaries exist is to reduce transaction cost, risk sharing, and asymmetric information (Fethi, 2009). Some authors argue that asymmetry of information becomes less important as securitization emerges, and suggests that we move from the emphasis on transaction and asymmetric information and focus on the roles a firm can perform such as risk management ( Allen, Franklin; Santomero, Anthony M , 1998, p. 1464). Risk management should be studied effectively in dealing with markets so that we can understand the changes in these markets and to know how to share risks ( Allen, Franklin; Santomero, Anthony M , 1998). A market without information asymmetries may result in an increase in price for acquisition of credit reduce availability and a weak legal system with poor institutional infrastructure mitigates the development of the market, in this case banks would then use their power to protect their interest .The problem of adverse selection and moral hazard in weak markets may be solved by bank concentration and thereby have a positive effect on growth; while in developed market it can be solved by financial institutions and then bank concentration wouldn't be necessary (Fernández, González, & Suárez, 2009).

In some countries Financial markets may dominate in some countries whereas in other countries financial institution may dominate and this depends on institutional environment such as cultural, social, legal, political and regulatory determinants on financial intermediation (Aggarwal & Goodell, 2009, p. 1771).For example societies that have a lot of regulations tend to be more market based although Institutions and markets exist together and they complement and compete with themselves in some countries. Banks operation may differ in different countries in the sense that in some countries, banks may not be able to conduct or trade in the stock market and while some can (Demirguc-Kunt, Laeven, & Levine, 2004, p. 595) ; In Nigeria, banks that are public companies conduct and trade in stock, they also conduct other financial services such as issuing insurance policies.

The proportion of financial services provided by bank in relation to financial markets can depend on transaction costs which involve the cost of defining property rights, putting contracts in place etc. If market exchange is high, more individuals would rather collect loans from banks (Aggarwal & Goodell, 2009, p. 1771) he suggests that financial markets and institution are related to the nature of the social and political environment, individuals value a stable environment and efficient markets are a societal solution in competition. Political institution plays a large role in that politicians may divert the flow of credit to powerfully connected firms which may bring about economic inequality as a factor that can lower public trust leading to increase transaction costs that would make individuals depend on market.

The role of financial intermediation is to provide efficient financial systems in order to have a healthy economy, and for this to happen there needs to be efficiency (Demirguc-Kunt, Laeven, & Levine, 2004, p. 603). In support of this (Berger, 1995, p. 420) , in his work studied the relationship between efficiency, profitability and market power (see Table 1b)and his findings suggest that Market share is positively related to Profitability.

Drawing from above discussions we can state that, Bank regulation can impact the cost of financial intermediation, with request for detailed report (annual reports and other financial statements) requirement by regulation increases transaction cost for financial intermediaries because financial institutions have to bear the costs of assessment, audit, examination fees, meeting with the supervisors request for data and the opportunity cost for complying with their order (Benston & Smith, 1976). Regulation can also be applied when controlling money supply in the economy or control for prices received and paid by financial intermediaries are imposed by state, ceilings may be placed on interest charged for loans, and in the event of inflation usual profit on the loan would be reduced for these intermediaries; this would in turn increase transaction cost borne by intermediaries and maybe customers. In general Regulations increases transaction cost of financial intermediation, because intermediaries cannot operate as efficiently as they otherwise would. In the above discussion we have also seen the benefit of bank regulations (Benston & Smith, 1976). Institutions also affect the cost of intermediation, using empirical findings (see table1), a strong legal institution (for example property / creditor right protection) would reduce transaction cost because they have legal backing, and risk is mitigated with this kind of institution and vice versa. In a perfect competitive environment, the cost of intermediation would reduce, because there are many banks bringing new innovation and competing for market share in order to achieve this they may make their prices or charges as customer friendly as possible, whereas if there is no competition, the they charge rates that may not be pleasing to the customer, for example higher interest rates on loans and minimal interest on deposit (Benston & Smith, 1976).

Conclusion

Access to finance is of economic importance that is how most big companies like 'Apple computer Inc.' grow strong; Financial Intermediaries aim to provide this access. This essay examines the impact of bank regulation, institutions and market structure on the cost financial intermediation. Firstly we define the key terms for analysis, we then explain the impact of the three variables on the cost of financial intermediation, We find that bank regulations increase the cost of financial intermediation; Stable institutions (for example property right protection) lowers cost of intermediation; Market structure also affects the cost of intermediation depending on the structure, if there is high bank concentration there would by lower costs because of the competitive market, with lower concentration, there will be cost of intermediation would be higher. Lastly we provide empirical work and findings that help to back up theory. Although not all the studies in the table directly focus on financial intermediation, but there are useful relationships with the variables that can be used to explain the impact of bank regulation, institution and market structure on the cost of financial intermediation. All the key points have been defined and theoretical and empirical evidence provided for the various studies that have been reviewed.

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