Question

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

(b) Explain the Diamond theory of delegated monitoring and discuss its contribution to our understanding of financial intermediation.

Answer 1

(a) A bank is a financial intermediary which accepts deposits from customers and lend money to borrowers. There are different requirements of lenders and borrowers:

Requirement of lender:

• Minimizing the risk of getting default.
• reducing the cost
• They prefer to hold assets that are easily convertible into cash

Requirements of borrowers:

• Low cost fund
• Long-term funding

Banks used to reconcile the conflicting requirements of lenders and borrowers by holding the long-term asset which possess high risk of default and illiquid in nature and use the deposits to finance these loans as deposits are meant to possess low-risk of getting default and are highly liquid.

Reduction of cost: Banks as an intermediary aims to reduce the cost by benefiting from the economies of scale and diversifying the risk by investing in various type of secondary securities which are highly liquid. Banks reduce the transaction cost by exploiting the economies of scale and earn profits because of the difference in cost of lending and borrowing and extra profits from buying and selling of securities in the secondary market. This activity also help intermediary to lend at low cost.

(b) Diamond theory of delegated monitoring:

This theory says that financial intermediaries must be delegated with monitoring activity as they are competent enough in monitoring in comparison to the individual investors. The main requirements of the theory are:

• as financial intermediaries are a main source of funding to various investment projects, therefore they perform at economies of scale
• the funding to investment projects are a pool of funds of various investors.
• the cost of monitoring is lower than gain from operating at economies of scale.

Debt contracts are important to intermediaries. The cost of monitoring and enforcing debt contracts is a main reason that raising fund through intermediaries are superior.