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MGT411 - Money & Banking - Lecture Handout 21

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ROLE OF FINANCIAL INTERMEDIARIES

Role of Financial Intermediaries:

  • Pool Savings
  • Safekeeping, accounting services and access to the payments system
  • Liquidity
  • Risk diversification
  • Information Services

Role of Financial Intermediaries

  • As a general rule, indirect finance through financial intermediaries is much more important than direct finance through the stock and bond markets
  • In virtually every country for which we have comprehensive data, credit extended by financial intermediaries is larger as a percentage of GDP than stocks and bonds combined
  • Around the world, firms and individuals draw their financing primarily from banks and other financial intermediaries
  • The reason for this is information;
  • Financial intermediaries exist so that individual lenders don’t have to worry about getting answers to all of the important questions concerning a loan and a borrower
  • Lending and borrowing involve transactions costs and information costs, and financial intermediaries exist to reduce these costs
  • Financial intermediaries perform five functions:
  • They pool the resources of small savers;
  • They provide safekeeping and accounting services as well as access to the payments system;
  • They supply liquidity;
  • They provide ways to diversify risk; and
  • They collect and process information in ways that reduce information costs
  • International banks handle transactions that cross borders, which may mean converting currencies
  • Taking deposits from savers in one country and providing them to investors in another country
  • Converting currencies to facilitate transactions for customers who do business or travel

Pooling Savings

  • The most straightforward economic function of a financial intermediary is to pool the resources of many small savers
  • To succeed in this endeavor the intermediary must attract substantial numbers of savers
  • This is the essence of indirect finance, and it means convincing potential depositors of the soundness of the institution
  • Banks rely on their reputations and government guarantees like deposit insurance to make sure customers feel that their funds will be safe

Safekeeping, Payments System Access, and Accounting

  • Goldsmiths were the original bankers;
  • People asked the goldsmiths to store gold in their vaults in return for a receipt to prove it was there
  • People soon realized that trading the receipts was easier than trading the gold itself.
  • Eventually the goldsmiths noticed that there was gold left in the vaults at the end of the day, so it could safely be lent to others
  • Today, banks are the places where we put things for safekeeping;
  • We deposit our paychecks and entrust our savings to a bank or other financial institution because we believe it will keep our resources safe until we need them
  • Banks also provide other services, like ATMs, checkbooks, and monthly statements, giving people access to the payments system
  • Financial intermediaries also reduce the cost of transactions and so promote specialization and trade, helping the economy to function more efficiently.
  • According to the principle of comparative advantage, people and companies concentrate on the activities
  • At which they are the best and
  • For which their opportunity cost is lower
  • This leads to specialization in a particular activity
  • More specialization => more trading => more financial transaction => calls for low cost of transaction
  • The bookkeeping and accounting services that financial intermediaries provide help us to manage our finances
  • Pay-Cheques
  • House-rents
  • Utility bills
  • Loan payments
  • Food clothing and other expenses
  • Savings and retirement plans
  • Providing safekeeping and accounting services as well as access to the payments system forces financial intermediaries to write legal contracts, which are standardized
  • Much of what financial intermediaries do takes advantage of economies of scale,
  • The average cost of producing a good or service falls as the quantity produced increases
  • Information is also subject to economies of scale

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