Explain the role of financial intermediaries by referring to the problem of high transaction costs in financial transactions and the role of financial expertise.
Transaction costs are a major problem in financial markets, and the presence of financial intermediaries in the financial markets improves efficiency through the reduction in these costs. Transaction costs restrict smaller investors with small amounts of funds from engaging in stock and equity markets. The transaction costs arise from high breakage fees associated with investing. High legal costs in drafting the legal agreements. Due to high transaction costs, investors with a small number of funds are restricted to a smaller number of investment opportunities.
Financial intermediaries play an important role in the financial markets, by reducing the transaction costs, and enabling small savers and borrowers to benefit from the existence of financial markets. Availability of expertise and enjoyment of economies of scale by financial intermediaries allows them to reduce the transaction costs, that benefit small and big investors.
Economies of scale through bundling the funds of many investors together, help the financial intermediaries in reducing the transaction costs. As the funds of investors are bundled together and invested together, the transaction costs for each investor fall as the transaction costs are spread among many investors. Economics of scale exists because the total cost of carrying out a transaction increases only a little as the size of the transaction grows. The mutual fund is the best example that can be used in explaining the presence of economies of scale. We explain this example below.
A mutual fund is a financial institution that invests funds on behalf of other investors. It sells shares to individuals and invests the proceeds in large blocks of bonds or stocks. Purchase of large blocks of shares or bonds allows the mutual fund to enjoy economies of scale, and thus reduce the transaction costs. These cost-cut savings through block purchases are passed to individual investors. Using funds from different individual investors, the mutual fund will purchase diversified portfolios, which benefits the individual investors from reduced risk which could have not otherwise been enjoyed when a single investor invested their own funds individually.
The benefits of economies of scale will have spillover effects, of reducing the costs of things like computer technology that are used by financial intermediaries. Upon setting a successful mutual fund, the cost will go down as the number of investors served by the mutual fund increases. Another advantage of economies of scale is that financial intermediaries can provide their client’s liquidity services. For instance, money market mutual funds provide their clients with provision to write cheques for convenient bill-paying.
Expertise – financial intermediaries have better technology and expertise which they use to lower the transaction costs. Examples of this expertise include the use of toll-free numbers.
