Question

Explain how banks are able to act as intermediaries by reconciling conflicting requirements of lenders and borrowers and reducing costs.

Answer 1

Banks play an extremely vital role in an economic system, since they are responsible in mobilizaion of financial resources, thus determining growth and development of an economy.

As indicated in the statement, banks bring together lenders and borrowers by acting as intermediaries. In a nutshell, banks collect money from depositors or their lenders for an interest rate and lend that money to borrowers at a higher rate. Needless to say, there are multiple regulations applicable in executing such seemingly simple transactions.

When a lender or a depositor has surplus money to save, they will approach banks to do that, since banks not only offer rates but also security of their funds. In absence of such an intermediary, it would be impractical for most of the people (especially individuals) to find borrowers. Banks are governed by regulations imposed by the country's central banks and also government. This provides confidence to individuals and market participants to execute such transactions.

While lending money, banks need to assess the creditworthiness of their borrowers using various criterias. Risk adjusted rates are charged to borrowers depending on their credit quality. As they are exposed to large number of borrowers across multiple segments, banks are well-equipped to take informed decisions as compared to individuals directly lending to such borrowers. Not to mention, post disbursal of loan, regular monitoring of accounts is imperative.

Furthermore, banks being governmed by Central bank regulations can enforce debt covenants and charge of security to ensure that amount lent is received back as per agreed terms. Commercials banks are exposed to huge portfolio of borrowers, as a result even if certain borrowers default, the losses will get absorbed by interest being paid by regular borrowers (although, rising default rates and non-performing assets are growing concerns in real life scenarios).

Banks have the resources to invest in technology, access vast geographical segments of its economy, execute huge number of transactions both manually and automatically and leverage its economies of scale. Hence, they not only act as necessary intermediaries but also contribute towards reducing cost.