Question

Financial intermediaries play a major role in the financial markets . without financial intermediaries being in place, some financial market transactions may not occur smoothly. Required:

a) Explain and discuss the functions of financial intermediaries in the economy

b) Identify and discuss the relative advantage and disadvantages of financial intermediations and disintermediation

Answer 1

A)Financial intermediaries perform two major economic functions in almost all economies. First, they create money and administer the payments mechanism. In most economies today, a central bank or monetary authority issues currency and depository institutions supply deposit money. Therefore, rather than look for individuals to borrow a sum, it is more efficient to go to a bank, a financial intermediary to borrow money. The bank raises funds from people looking to deposit money, and so can afford to lend out to those individuals who need it. At the same time, financial intermediaries pool risk by spreading funds across a diverse range of investments and loans. Loans benefit households and countries by enabling them to spend more money than they have at the current time.

The main function of financial intermediaries is a financial institution that connects surplus and deficit agents. The classic example is a bank that consolidates deposits and uses the funds to transform them into loans. The job of the financial intermediaries is to connect borrowers to savers.

B) The two essential advantages of using financial intermediaries are 1. Cost advantage over direct lending/borrowing

  2. Market failure protection: The conflicting needs of lenders and borrowers are reconciled, preventing market failure.

And others cost advantages of using financial intermediaries include :

1) Risk aversion intermediaries help spread out and decrease the risk

2) Reconciling conflicting preferences of lenders and borrowers and also reduces the cost of lending and borrowing.

3) Intermediaries concentrate on the demands of the lenders and borrowers and are able to enhance their products and services

However, in the context of climate finance and development finance institutions, various disadvantages have also been noted. These include a lack of transparency, inadequate attention to social and environmental concerns and a failure to link directly to proven developmental impacts. And another disadvantage is that they may impose fees or charge commissions for their services, which would reduce the amount of money they can actually invest and reduced return from lending.

Advantages of DIsintermediation: The main advantages of disintermediaries is that it keeps price increases and predatory pricing under control in the economy. For a manufacturer, selling directly to consumers cuts out the expense of paying sales representatives, allowing the manufacturer to gather consumer information directly and established relationships with buyers of its products particularly appealing in the case of large volume buyers such as businesses.

Disadvantages of Disintermediation: It does eliminate jobs as small local retailers go out of business because they can't compete with the prices offered by discounters and wholesalers. Another disadvantage for the consumer is the lack of personal help in making purchasing decisions. There could be even a lack of transparency in markets, lessening of competition as brokers and retailers are eliminated and a return to predatory pricing.