Question

Write a thousand words on theories of financial intermediation -Economics

This isn't an essay

Answer 1

FINANCIAL INTERMEDIATION

The financial intermediation is defined as a productive activity in which an institutional unit (generally referred to private sector intermediaries: banks, private equity, venture capital funds, leasing companies, insurance and pension funds and micro-credit providers)incurs liabilities on its own account for the purpose of acquiring financial assets by engaging in financial transactions on the market; basically, the role of financial intermediaries is to channel funds from leaders to borrowers by intermediating between them. Usually, this process is performed by the banks, taking in funds from a depositor and then leading them out to a borrower. The banking business thrives on the financial intermediation abilities of financial institutions that allow them to lead out money at relatively high rates of interest while receiving money on deposit at relatively low rates of interest. Financial intermediaries offer a number of benefits to the average consumer, including safety, liquidity and economy of scales involved in baking and asset management, for instance, financial intermediaries access to economies of scale to expertly evaluate the credit profile of potential borrowers and keep records and profiles cost-effectively. When financial intermediaries move funds from parties with excess of capital to parties needing funds, this process creates efficient markets and lowers the cost of conducting business. For example, a financial advisor connects with clients through purchasing insurance, stocks, bonds, real estate and other assets.

Why are financial intermediaries important? One reason is that the overwhelming proportion of every dollar financed externally comes from banks. In the United States for example, 24.4% of firm investment was financed with bank loans during the 1970 - 1985 period. Bank loans are the predominant source of external funding in all the countries. In none of the countries are capital markets a significant source of financing. Equity markets are insignificant. In other words, if finance department staffing reflected how firms actually finance themselves, roughly 25 percent of the faculty would be researchers in financial intermediation and the rest would study internal capital markets.

In the last fifteen years, researchers have made significant progress in understanding the roles of financial intermediaries. These advances are not only theoretical. Despite a lack of data as rich as stock market prices, significant empirical work on intermediaries has been done. All of this work has contributed to a deeper appreciation of the role of banks in the savings-investment process and corporate finance, of the issues in crises associated with financial intermediation, and of the functioning of government regulation of intermediation. The terms “borrow” and “lend” mean that the contracts involved are debt contracts. So, to be more specific, financial intermediaries lend to large numbers of consumers and firms using debt contracts and they borrow from large numbers of agents using debt contracts as well. A significant portion of the borrowing on the liability side is in the form of demand deposits, securities that have the important property of being a medium of exchange. The goal of intermediation theory is to explain why these financial intermediaries exist, that is, why there are firms with the above characteristics.

There are a number of issues in studying intermediation that are perhaps unique, compared to other areas of finance. First, there are issues of data. While governments often collect an enormous amount of data about banks, for example, in the U.S. there are the Call Reports that provide a massive amount of accounting information about commercial banks, there is a lack of price data. Thus, unlike other areas of finance, there is an almost embarrassing lack of essential information, prices of loans, of secondary loan sales, and so on. Researchers have been creative in finding data, however, as we discuss below. Other periods of history have also been intensively studied. Apparently, more so than other areas of finance, research in financial intermediation is intimately linked with economic history. In addition, other countries offer rich laboratories as banking systems vary across countries to a significant degree. Second, in the study of financial intermediation, institutions, regulations, and laws are important. Banking systems have been influenced by laws and regulations for hundreds of years and it is difficult to make progress on many issues without understanding the enormous variation in banking system structures across countries and time, which is due to these laws and regulations. This is most apparent in the variety of industrial organization of banking systems around the world and through history. This variation is just beginning to be exploited by researchers and seems a likely area for further work.

The most basic question with regard to financial intermediaries is: why do they exist? This question is related to the theory of the firm because a financial intermediary is a firm, perhaps a special kind of firm, but nevertheless a firm. Organization of economic activity within a firm occurs when that organizational form dominates trade in a market. In the case of the savings-investment process, households with resources to invest could go to capital markets and buy securities issued directly by firms, in which case there is no intermediation. To say the same thing a different way, nonfinancial firms need not borrow from banks; they can approach investors directly in capital markets. Nevertheless, most new external finance to firms does not occur this way. Instead, it occurs through bank-like intermediation, in which households buy securities issued by intermediaries who in turn invest the money by lending it to borrowers.

In summary, the financial intermediaries are meant to bring together those economics agents with surplus funds who want to lead (invest) to those with a shortage of funds who wants to borrow. In doing this, they offer the benefits of maturity and risk transformation. Specialist financial intermediaries are ostensibly enjoying a related (cost) advantage in offering financial services, which not only enables them to make profit, but also raises the overall efficiency of the economy. Their existence and services are explained by the "information problems" associated with financial markets. Nowadays, in certain areas, such as investing, advances in technology threat in other areas of finance, including banking and insurance.