Within a financial system, surplus and deficit units trade, which facilitates the movement of funds from deficit units to have access to those with the budgeted units. Hence, there is always the incentive to trade. The role of the financial system is also to allow the deferral of expenditure. The question is often asked, how can this exchange of funds take place, one may think of it as a do it yourself project, like selling your house, without a …show more content…
Financial intermediaries reduce these transaction costs for individual borrowers and lenders because they are large highly specialized organizations with substantial capital and are therefore able to take advantage of economies of scale and scope (basically they can cover a large base with their funds). For example an individual drafting a legal contract for the provision of funds to another will incur substantial costs which will only be spread over the one investment. By specializing in lending arrangements a depository institution may be able to spread these costs over numerous transactions reducing the unit costs of the legal fees. Moreover they will be able to create unique investment and lending products which the individual may not be able to.
3) Information Asymmetry
– Information asymmetry exists in a situation where one party in a transaction has more information than the other party. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation because one party can take advantage of the other party’s lack of knowledge. In a direct finance scenario a potential borrower may have poor credit or may not be able to repay borrowed funds. Disclosing this information may reduce his chance of acquiring a loan and he may choose not to do so, creating a high risk of default for