Explain the functions performed by financial intermediaries and how and why these promote economic efficiency in financial markets.
Funds can move from lenders to borrowers by a second route, called indirect finance. It is called indirect financing because a financial intermediary stands between the lender-savers and the borrower-spenders. The financial intermediary helps to connect the borrowers and lenders, thus connecting both lenders and borrowers. This process of indirect financing is called financial intermediation.
Financial intermediation is the primary route for moving funds from lenders to borrowers. Financial intermediation is the greatest source of financing for corporations than securities markets. Financial intermediaries play an important role in the economy because they provide liquidity services, promote risk-sharing, and solve the information problem and thus encourage small savers and borrowers to benefit from the existence of financial markets. These roles include transaction costs, risk sharing, and information costs in financial markets. These roles are explained below.
- Transaction Costs – financial intermediaries improve economic efficiency by reducing the transaction costs to substantial levels through the enjoyment of economies of scale. These financial intermediaries have enough expertise and resources to reduce the cost that is involved in seeking the funds and in providing the funds by individuals and companies. Through the benefit of economies of scale financial intermediaries will be able to provide funds indirectly. In addition to this, financial intermediaries will provide liquidity services to the economy. Liquidity services arise from the fact that banks make it easier for customers to conduct transactions easily and thus improve economic efficiency.
- Risk-sharing – this is sometimes called asset transformation and occurs when risky assets are turned into safer assets for investors.
- Diversification – this is another way the financial intermediaries reduce risks in the financial markets. Diversification occurs through a pooling of funds from different individual savers, and then invest the funds in a single portfolio. Financial intermediaries are able to pool funds from many savers through the enjoyment of economies of scale.
- Reducing the effects and costs of asymmetric information – another problem in the financial markets is the presence of asymmetric information. Due to asymmetric information, two problems arise in the financial markets, namely adverse selection, and moral hazards. Asymmetric information in short means inequality in the amount of information the parties have before and after the transaction.
- Adverse selection – adverse selection is the asymmetric information problem that exists before the transaction takes place. Adverse selection occurs when borrowers who have the greatest risk of failing to make repayments are the most immediate individuals to actively seek out a loan. In economic terms, we say adverse selection exists when individuals or potential borrowers who are the most likely to produce an undesirable outcome (the bad credit risks) are the ones who most actively seek out a loan and are thus most likely to be selected. Due to the likelihood of giving loans to clients with bad credit risk, lenders may decide not to make any loans even though there are good credit risks in the marketplace.
- Moral hazard – in contrast to adverse selection moral hazard is created by asymmetric information after the transaction occurs. A moral hazard is a risk the borrower might engage in undesirable activities after the transaction has been processed. The moral hazard increases the probability that the loan might not be paid and as a result, the lender may decide not to make a loan. An example of a moral hazard is when the borrower who asked for a loan for farming, gets the loan and uses the funds for gambling instead of the intended action of farming investment.
Conclusion
In a nutshell one would say, the presents of financial intermediaries will reduce or try to eliminate the problems associated with asymmetric information. The problems created by asymmetric information, namely moral hazard, and adverse selection are an important impediment to the well-functioning financial markets. Due to the economies of scale in the financial intermediaries, these problems are mitigated and thus encourage a smooth and oiled financial market system that allows small and large participants to meet in the market, as well as screening good and bad credit risk. Also, economies of scale enjoyed by financial intermediaries allow them to monitor the activities of the borrower after the transaction and thus reduces the problem of moral hazard. Screening of bad and credit risk clients reduces the problem of adverse selection.