Question

In the absence of information and transactions costs, financial intermediaries would not exist. Is this statement true, false or uncertain? Explain your choice with a suitable analytical framework. Can you think of two or three concepts that can help explain this further?

Answer 1

Financial intermediaries helping channelising the funds of savers to investors. In this sense they represent an important link between the Savers and investors. The existence of financial intermediaries is reasoned for the information asymmetries that exist in the market. Some Investors maybe demanding funds for various projects including risky once while some savers may not be willing to lend to risky projects. Savers have insufficient information about the intention of the investors and this calls for asymmetry in the information. This leads to the problem of adverse selection and moral hazard where without the intermediation by Financial Institutions, no lending will be transacted.

Financial Institutions also help in sharing the risk of individuals which helps in creating a diversified portfolio for individual investors. The transaction cost is also shared by the financial intermediary which further helps in encouraging the investor to participate in the capital market. This risk sharing and the reduction of cost of transaction helps in channelising more funds in the financial market. Therefore the statement is true.