Discuss the role of financial intermediaries in a developed economy. What are the advantages of using a financial intermediary rather than having a direct transaction between borrowers and lenders?
Financial intermediaries are organisation that “connects” borrowers and lenders by accepting funds from lenders and loaning funds to borrowers, they have numerous roles in the economy. This will be discussed in more detail throughout the question. Financial intermediaries are considered more important than having a direct transaction between borrowers and lenders which will also be explained in detail.
“Financial intermediaries are firms whose primary business is to provide customers with financial products and service that cannot be obtained more efficiently by transacting directly in securities markets. The financial intermediaries include the banks, investment companies, insurance companies and credit unions” (Zvi, Bodie et al., 2000: page number 50). Their main products include checking accounts, loans, mortgages, mutual funds and a wide range of insurance contracts. Financial intermediaries issue their own securities to raise funds and to purchase the securities of other businesses. The main importance of financial system is “bringing together people who have accumulated an excess of money with those who have a requirement to borrow in order to finance investment, the financial system helps to utilise the economy’s resources, increase efficiency, promote growth and ultimately lead to a better standard of living”: (Peter :lecture 13)
There are three main reasons why financial intermediaries are used:
Different requirements of lenders and borrowers
A business that borrows funds to investment will tend to want to reply the borrowing over the expected life of the investment. In addition the claims issued by business will be relatively high default risk reflecting the nature of business investment and lenders will generally be looking to hold assets which are relatively liquid and low stock.
A transaction cost makes it difficult for a potential lender to find an appropriate borrower. These are the four main transaction costs
Search costs – this is when lender and borrower will experience cost of searching and finding information about the suitable counterparty.
Verification costs – lender will have to verify the accuracy of the information provided by the borrowers.
Monitoring costs – once the loan has been conformed, the lender should monitor the borrower.
Enforcement costs – “the lender will need to make sure that enforcement of the terms of the contract or recovery of the debt in the event of default”.
Problems arising out of information asymmetries
This is one of the main concept that relates to financial intermediaries and “Asymmetric information refers to the situation where one party to a transaction has more information than the other party”.
Overall I believe that financial intermediaries are able to reduce transaction costs substantially because they have developed expertise and because their large size enables them to take advantage of economies of scale.
What are financial assets and what is their role in the economy.
Secondarily I will be explaining about financial assets and what their role are in the economy. Financial assets are any form of holding that has value. However, most common financial assets are bonds and equity securities.
“Real assets create wealth and financial assets represent claims to all parts or all of that wealth. Financial assets determine how the ownership of real assets is distributed among investors. Financial assets can be categorized as fixed income, equity or derivative instruments”( Zvi, Bodie, Robert G, Martin (2000). Finance. USA: Prentice Hall International,Inc. 50-51).
“Bonds are often sold by firms or governments to investors in order to help fund short-term projects. They are a type of allowed