The financial system plays a key role in the smooth and efficient functioning of the economy. The most fundamental contribution that any financial system makes is to channel resources from individuals and companies with surplus resources to those with resources deficits. There are two ways in which funds are channeled from savers/lenders to spenders/borrowers. The first is called direct finance. In direct finance, borrower-spenders borrow funds directly from lenders in the financial markets by selling them securities and the second way in which funds are channeled is called indirect finance. In indirect finance a financial intermediary stands between the lenders-savers and the borrower-spenders thus the intermediary helps to transfer funds from one to the other. The main problem in direct financing is transaction cost which is the cost incurred by participants in an exchange in order to initiate and complete the transaction and such cost occur to some degree in all real-world transactions and thus affect all real markets and transaction costs take many forms but some of the main types are search costs, verification costs, monitoring and auditing costs and also enforcement costs.
Search costs are the costs of finding interested partners to the transaction.
Verification costs occur when lenders incur costs to verify the accuracy of the information provided by borrowers.
Monitoring costs are the efforts participants must make to observe the transaction as it occurs and to verify adherence to the terms of the transaction.
Enforcement costs are costs acquired in case the borrower is unable to meet the conditions of the contract as result the lender will need to ensure their enforcement.
Another problem arising includes asymmetric information which is a situation where one party has less information than the other party in a transaction and thus is unable to make an accurate decision.
Asymmetric Information leads to two main consequences which include:
Adverse selection which is a problem created by asymmetric information. Potential borrowers who are most likely to default on a loan are the ones actively seeking out a lender. The probability of giving loan to a bad credit risk is high and lenders may decide not to give any loans at all as a precaution even to those with good credit risk.
Moral hazard is another problem that arises. Investors tend to behave differently when using borrowed funds rather than their own funds. The borrower engages in undesirable activities which the lender may be deemed as risky and again the lenders may decide not to give any loans at all.
What Financial Intermediaries actually do? Support your answer with real life examples.
Financial Intermediation consists of channeling funds between surplus and deficits agents. A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of financial intermediary is a bank that transforms bank deposits into bank loans. In the U.S a financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers that is savers (lenders) give funds to an intermediary institution (such as a bank) and that institution give those funds to spenders (borrowers). Through the process of financial intermediation certain assets or liabilities are transformed into different assets or liabilities. Financial Intermediaries exist to solve or reduce market imperfections such as differences in the preferences of lenders and borrowers (in terms of maturity, size, liquidity, risk), presence of transaction costs, shocks in consumers' consumption and asymmetric information which gives rise to both adverse selection and moral hazard. Several theories have been developed to explain how financial intermediaries reduce or solve these market imperfections. They are the theories of:
Asset transformation
Transaction costs reduction
Liquidity insurance
Information economies of scale and delegated monitoring
Asset Transformation
Financial Intermediaries play a major in transforming particular types of assets into others. Borrowers' needs are a long-term capital and permanent capital and also the desires of many lenders are a high degree of liquidity in their asset. Financial intermediaries simultaneously satisfy both borrowers' needs and desires' lenders by the process of asset transformation. They transform the primary securities issued by firms into the indirect securities required by lenders. Specially they issue liabilities (deposit claims) with the characteristics of low risk, short term, high liquidity and use a proportion of these funds to acquire the larger size, high risk and illiquid claims by firms. To reconcile the conflicting requirements of lenders and borrowers financial intermediaries undertake four main transformations which are as follows:
Maturity Transformation: Liabilities generally mature more quickly than assets. Banks issue long term loans using short term deposits. They mismatch the maturities of assets with the maturity of the liabilities. Banks deal with a large number of lenders and borrowers and reconcile their conflicting needs.
Size Transformation: Amounts lenders lend are often smaller than borrowers require. Banks collect theses small amounts and parcel them into larger amounts required by borrowers.
Risk Transformation: By transforming risky loans(assets) into virtually riskless deposits(liabilities). Banks transform risk by minimizing the risk of loss on each individual loan, diversifying risk and pooling risks.
Liquidity Transformation: Banks provide bank accounts which offer high liquidity features. Loans however are illiquid and higher risk than financial deposits. Financial Intermediaries can hold liabilities and assets of different liquidity features in their balance sheet through diversification. The higher the diversification the lower the default probability. They diversify in 3 ways:
Minimizing the risk of loss on each individual loan. The use of credit scoring enables banks to select only good borrowers.
Diversifying risk: Banks try to avoid a heavy concentration in a branch of economic activity and restrict the size of any single loan.
Pooling risk: By having a large number of loans, as a consequence of the law of large numbers, it reduces the viability of losses.
Transaction costs reduction
The existence of financial intermediaries is justified by the presence of transaction costs: financial intermediaries reduce transaction costs by developing branch networks and information systems which enable lenders and borrowers to avoid the need to seek out a suitable counterpart on each occasion, by providing standardized products and by using tested procedures. Financial institutions are able to reduce transaction costs by taking advantage of the following:
Economies of scale refers to the reduction in costs as intermediaries are able to combine funds of many investors and use a standard loan contract for a wide range of loans. The unit cost of contract per loan is thus reduced.
Economies of Scope occur when there is an advantage in producing a product jointly rather than many products separately.
Expertise is important for lowering transaction costs. Expertise in IT provides low cost liquidity services.
Liquidity Insurance
A key role of financial intermediaries is to provide insurance against liquidity shocks that eliminates idiosyncratic liquidity risk and aggregate liquidity risk as postulated in the liquidity insurance theory also known as consumption smoothing theory (Diamond and Dybvig (1983)). This liquidity insurance will appear by the fact that financial intermediaries will propose to depositors checking accounts remunerated and the possibility of withdrawing their deposits on demand. Banks allow consumers to deposit funds that they can withdraw when they have liquidity needs. This liquidity provision allows banks to accumulate funds that they can use to lend to firms to fund long term investments. Banks must manage their liquidity so that they can meet the liquidity needs of their depositors. Liquidity functions of banks affect investment and growth at different stages of economic development.
Information economies of scale and delegated monitoring
In the presence of adverse selection there are scale economies in the lending-borrowing activity. Financial Intermediaries are thus seen as information sharing coalitions. Entrepreneurs signal the quality of their project by the amount of their wealth invested in their firm or level of financing. If they are risk adverse this signaling is costly as they have to retain a substantial amount of risk of their project. Quality of projects however can be obtained with an expenditure of resources. However, buyers may not be convinced that the information is true and then again, the free rider problem is still in existence. Both of these problems however can be solved if the information is from a financial intermediary. Ultimately borrowers of all type of risk will deal with intermediaries.
Asymmetric Information: Adverse Selection and Moral Hazard
Another reason justifying the existence of the intermediaries financial is the reduction of information and asymmetries of information costs. The new theory of financial intermediation is concentrated on ex-ante problems of asymmetry of information (adverse selection) and ex-post problems of asymmetry of information (moral hazard).The solution to adverse selection is to provide full information of the borrowers to the lenders. Financial intermediaries produce more accurate valuations of firms and are able to select good credit risks thanks to their expertise. Banks have an advantage is that they can have information on their borrowers from transactions of their bank accounts. Banks are able to avoid the free rider problem because their loans are private securities not traded in the open financial market. They further reduce the adverse selection problem by taking collateral against the loan. It reduces the loss of lender if the borrower defaults. The solution that Financial Intermediaries bring to Moral Hazard is that they are able to avoid the free rider problem. They use funds of their partners to help entrepreneurs start businesses and in exchange and they receive an equity share of the new business. The venture capital firms have people participating in the management of the firm and the equity of the firm is not marketable to anyone but the venture capital firm.
Conclusion:
Financial institutions (intermediaries) perform the vital role of bringing together those economic agents with surplus funds who want to lend with those with a shortage of funds who want to borrow. In doing this they offer the major benefits of maturity and risk transformation. It is possible for this to be done by direct contact between the ultimate borrowers but there are major cost disadvantages of direct finance. Indeed, one explanation of the existence of specialist financial intermediaries is that they have a related (cost) advantage in offering financial services which not only enables them to make profit but also raises the overall efficiency of the economy. The other main explanation draws on the analysis of information problems associated with financial markets.
Reflect on whether banking as a business has a future in Mauritius and around the globe? Support your answer with clear elucidation of what is happening around the globe.
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