Question

How do monetary financial institutions create liquidity, pool risk, lower the cost of borrowing, and lower the cost of monitoring borrowers?

Answer 1

Monetary Financial institutions provide important functions like creating liquidity, pooling risk, lowering the cost of borrowing, and lowering the cost of monitoring borrowers.

Liquidity means having the property of being redaily converted into cash and at the same time there is no loss of value. Depository institutions offer deposits. These deposits can be withdrawn and converted into cash at a short notice and also these deposits can be used to make long term loans. So it creates liquidity by borrowing short and lending long, taking deposits and standing ready to repay them on short notice or demand and making loan commitments that run for terms or many years.

Depository institutions use funds obtained from from diiferent depositors to provide as losns to the borrowers. This means that if a single borrower defaults in returning the loan amount then the loss will not be borne by single depositor rather it will spread among all depositors. Thus, there will be pooling of risk.

Depository institutions lower the cost of borrowing because they specialize in borrowing. A firm is able to get large loans from the bank.The institution offers a single loan but spreads the cost of this activity over many borrowers For instance, a firm that wants to borrow a large sum of money need only visit one depository institution to arrange such a loan.

Depository institutions lower the cost of monitoring borrowers.By monitoring borrowers, a lender can encourage good decisions that prevent defaults. This activity is costly but depository institutions can perform this activity at a much lower price.