Introduction. A financial intermediary is one of the participants in the financial market, and it was put in the center in the year 2007 when the financial crisis took place. Financial intermediaries are essential because they stand between buyers and sellers, facilitating the exchange of assets, capital, and risks. Their services allow for greater efficiency and are vital to a well-functioning economy.
This essay considers what roles financial intermediaries have played within society and financial systems and discusses the impact on the financial market if no financial intermediaries exist. It will mainly analyze impacts on five factors: transaction costs, total risks, liquidity management, asymmetric information, and economic growth. By assuming financial activities without financial intermediaries, the essay will clarify how important it is to have financial intermediaries in the financial system and economy.
Prices start at $12
Prices start at $11
Prices start at $14
Prices start at $12
What do financial intermediaries do? Many investors will not usually choose to enter the financial markets by themselves; they are willing to seek financial intermediaries. In daily financial activities, commercial banks are one of the most common financial intermediaries. Besides, there are also mutual and pension funds, insurance companies, which are regarded as financial intermediaries as well.
Investors deposit the excess money to a financial intermediate; the financial intermediate lends the money to deficit units as mortgages, students who need the money to pay for education, or firms to finance its inventories. An individual investor could find borrowers independently and pass the financial intermediary (Bencivenga, V and B Smith, 1991). By doing so, the investor could get a higher return. Why do financial intermediaries exist if investors can search counterparty themselves? The essay will discuss the reasons below.
Impact on transaction costs. The transaction costs have been reduced significantly in recent years, mainly due to the rapid growth of financial intermediaries (Diamond, D, 1984). Financial intermediaries generally take deposits and create loans. Lenders with excess money will deposit the money to financial intermediaries, and then the money will be lent by the financial intermediaries to fund deficit units. The money generated from these securities is finally used by firms to reinvest.
If there are no financial intermediaries, the investors themselves must do this. However, it could be difficult for an individual investor to find an appropriate borrower because of the informational asymmetry between the investors and the firms. In addition, when investors have to do research and collect information and data themselves, there will be a significant transaction cost. Therefore, with financial intermediaries, transaction costs and asymmetric information can be reduced.
The impact on risks. Lending through a financial intermediary is usually less risky than lending by an individual investor directly. The reason why financial intermediaries can reduce risks is mainly that they can diversify. Financial intermediaries always make great outstanding loans; in this case, when part of these investments suffer losses, these losses may usually be compensated by those investments which make profits. By comparison, an individual investor can only make a few loans, and any losses may have a significant effect on his wealth.
With financial intermediaries, “eggs” are put in many different “baskets,” which insure their depositors from substantial losses (Adrian, Tobias and Hyun Song Shin, 2009). There is a second reason why financial intermediaries can reduce risks is that they can make better predictions on a borrower’s credit than an individual investor. Therefore, with financial intermediaries, the investor’s total risk is reduced.
The impact on liquidity management. Liquidity is usually defined as the speed and ability to change an asset into cash. When an individual investor lends his excess money to a deficit unit that he found himself, the loan is usually defined as illiquid. Because the investor suffers an emergency and needs cash at once, he can only try to ask the deficit unit to give his money back as soon as possible or borrow from others. Although financial intermediaries often lend their money into illiquid assets, their larger size allows them to keep some money to ensure the liquidity of their investors (Holmstr¨om Bengt and Jean Tirole, 1997).
Once again, some long-term projects usually have higher returns than show-term ones; however, an individual investor can hardly get into these projects because they are short-term preferred. Financial intermediaries make this possible. A most individual investors cannot make long-term investments. They prefer the short-term because they may suddenly need money. However, this gap can be broken by financial intermediaries. Therefore, with financial intermediaries, investors will have higher liquidity on their investments.
The impact on asymmetric information. Only in theory, there is no conflict of interest between the investors and borrowers (usually the firms). However, additional problems arise when firms have incentives not to reveal all information or delay the declaration of information. Firms are suffered from different kinds of risks, which are hard for an individual investor to distinguish.
Therefore, there may be a high possibility that a firm will have adverse selection and moral hazards. What’s more, it is also costly to monitor the activities of the firm. In this case, financial intermediaries can help; they can do it on behalf of small investors. Therefore, with financial intermediaries, investors will have a lower asymmetric information problem.
The impact on economic growth. Holmstr¨om Bengt and Jean Tirole (1997) describe a very intimate relationship between financial intermediaries and economic growth in modern growth theory. According to the theory, financial intermediaries play a role in increasing the efficiency of investment. Because they can easily identify and reallocate resources to some projects which have a high return. Besides, they can also discipline corporations.
With the development of financial innovation and knowledge creation, which are the power of capital accumulation and economic growth, financial intermediaries can enhance growth while at the same time make themselves perform their functions far more efficiently. As it is known to all, that countries’ economic growth performance usually changes with the level of financial efficiency. Then financial efficiency in turn usually depends importantly on how well the economy of scale and economy of scope is realized and how much has the financial sector developed (Allen, F., Gale, D., 1997).
Also, it can be seen that government interventions can sometimes severely affect the efficiency of financial intermediaries and economic growth. If there are no financial intermediaries, the financial market and society will be run inefficiently, investors can hardly allocate their excess money with higher returns and lower risks, which will finally lead to the inefficiency of the whole financial market as well as the whole economic growth. Therefore, with financial intermediaries, the whole financial market and society can be more efficient and reach higher economic growth.
Conclusion. Economists are recently worried that financial intermediaries may bring economic shocks to the financial system and society; they create bumps that have a bad effect on the normal flow of economic life. However, if some major financial intermediaries break down; this shock will have a domino effect on the whole financial system and society. As the essay has discussed above, without financial intermediaries, there will be higher transaction costs, higher risks, lower liquidity and lower economic growth. Then these results will cause unpredictable troubles to the financial markets, which may then break down the other parts of the economy.
- Adrian, Tobias and Hyun Song Shin (2009), The Changing Nature of Financial Intermediation and the Financial Crisis of 2007 – 2009, Forthcoming in the Annual Review of Economics.
- Allen, F., Gale, D.,(1997), Financial markets, intermediaries and intertemporal smoothing. Journal of Political Economy 105, 523-546.
- Bencivenga, V and B Smith (1991), Financial Intermediation and Economic Growth, Review of Economic Studies, 58:195-209.
- Diamond, D, (1984), Financial Intermediation and Delegated Monitoring, Review of Economic Studies 51:393-414.
- Holmstr¨om Bengt and Jean Tirole (1997), Financial Intermediation, Loanable Funds, and the Real Sector, Quarterly Journal of Economics, 112, 663-692.
- Rajan, Raghuram and Zingales, Luigi. (1998), Financial Dependence and Growth. American Economic Review, 88, 1998, 559-586.
- Saunders, A. and M. M. Cornett (2006), Financial Institutions Management: A Risk Management Approach. London, McGraw-Hill.