Question

Briefly explain why markets and intermediaries are fundamental for a well-functioning economy?

(answer must be at least 300 words)

Answer 1

A financial intermediary is a firm or an institution that acts an intermediary between a provider of service and the consumer. It is the institution or individual that is in between two or more parties in a financial context. In theoretical terms, a financial intermediary channels savings into investments. Financial intermediaries exist for profit in the financial system and sometimes there is a need to regulate the activities of the same. Also, recent trends suggest that financial intermediaries role in savings and investment functions can be used for an efficient market system or like the sub-prime crisis shows, they can be a cause for concern as well.

Financial Intermediation

Financial intermediaries work in the savings/investment cycle of an economy by serving as conduits to finance between the borrowers and the lenders. In the financial system, intermediaries like banks and insurance companies have a huge role to play given that it has been estimated that a major proportion of every dollar financed externally has been done by the banks. Financial intermediaries are an important source of external funding for corporates. Unlike the capital markets where investors contract directly with the corporates creating marketable securities, financial intermediaries borrow from lenders or consumers and lend to the companies that need investment.

Role of the Financial Intermediaries

The reason for the all-pervasive nature of the financial intermediaries like banks and insurance companies lies in their uniqueness. As outlined above, Banks often serve as the “intermediaries” between those who have the resources and those who want resources. Financial intermediaries like banks are asset based or fee based on the kind of service they provide along with the nature of the clientele they handle. Asset based financial intermediaries are institutions like banks and insurance companies whereas fee based financial intermediaries provide portfolio management and syndication services.

There are dozens of reasons why financial intermediaries exist, but a major one is the fact that people demand liquidity. Various types of liquidity exist, such as market liquidity versus funding liquidity. Fundamentally though, liquidity refers to the ability to exchange goods or services immediately, no questions asked. For example, cash is considered the most liquid asset because people accept cash as payment without doing any due diligence about the value or risks associated with cash as an asset. In contrast, houses are not liquid assets because you generally can’t sell a house immediately. It’s hard to find a buyer, and when you do find a buyer, they often go through a costly process of verifying the value of your home.

Financial intermediaries thus exist to provide liquidity to people who need it. Crucially, intermediaries enable populations of self-interested individuals to pool risks and satisfy liquidity needs. A classic paper on liquidity demand is the Diamond-Dybvig model. In this paper, for whatever reason, people don’t know when they’ll need liquidity, but with some probability, they need consumption now. In econ jargon, these are called liquidity shocks. Potential examples are when a family member suddenly becomes sick. You’ll need money now in order to care for them, and you couldn’t have known beforehand that this would happen. In a competitive equilibrium with no intermediaries, no one trades, so everyone is fully exposed to liquidity risk. People are generally risk-averse, so this is not a good outcome.

Financial intermediaries, however, enable people to mitigate their risk from liquidity shocks. By pooling people’s money together (as banks do), the single entity can deliver the efficient/socially optimal outcome. Unlike individuals, who are fully exposed to liquidity shocks, financial intermediaries are only partially affected by liquidity shocks precisely because they accept deposits from many people, a fraction of whom will need liquidity now. In a sense, financial intermediaries insure people who need liquidity right now, and consumers accept this insurance contract because they don’t know when they’ll need liquidity.

How Capital Markets Facilitate Economic Development

The capital markets are a network of specialized financial institutions, series of mechanism, processes and infrastructure that in various ways facilitate the bringing together of suppliers and users of medium to long-term capital. Capital markets connect the monetary sector with the real sector, which is the sector of the economy concerned with the production of goods and services. Considering this role in the economy, the capital markets play an important role in economic development as they facilitate growth in the real sector by giving producers of goods and services, and entities tasked with infrastructure development. access to long-term financing.

The fundamental channels through which capital markets are connected to the economy, economic growth and development can be outlined as follows:

1. Creating a Bridge Between Suppliers of Capital and Users: The contact between agents with a monetary deficit and the ones with monetary surplus can take place directly through direct financing, but also through a financial intermediary in form of indirect financing, which is a situation whereby specific operators facilitate the connection between the real economy and the financial market. In this case, the financial intermediaries could be banks, investment funds, pension funds, insurance companies, or other non-bank financial institutions,
2. Promoting Saving and Investments: The capital markets increase the proportion of long-term savings (pensions, life covers, etc.) that is channeled to long-term investment. Capital markets enable the contractual savings industry (pension and provident funds, insurance companies, medical aid schemes, collective investment schemes, etc.) to mobilize long-term savings from small individual household and channel them into long-term investments. It fulfills the transfer function of current purchasing power, in monetary form, from surplus sectors to deficit sectors, in exchange for reimbursing a greater purchasing power in future. In this way, the capital markets enable corporations to raise funds to finance their investment in real assets.
3. he implication will be an increase in productivity within the economy leading to more employment, increase in aggregate consumption and hence growth and development. It also helps in diffusing stress on the banking system by matching long-term investments with long-term capital. It encourages broader ownership of productive assets by small savers. It enables them to benefit from economic growth and wealth distribution, and provides avenues for investment opportunities that encourage a thrift culture critical in increasing domestic savings and investments that translate to economic growth,
4. Facilitating Efficient Allocation of Scarce Financial Resources: The capital markets facilitate the efficient allocation of scarce financial resources by offering a large variety of financial instruments with different risk and return characteristics. This competitive pricing of securities and large range of financial instruments allows investors to better allocate their funds according to their respective risk and return appetites, thereby supporting economic growth,
5. Financing Utility and Infrastructure Development: The capital markets also provide equity capital, debt capital and infrastructure development capital that have strong socio-economic benefits through development of essential utilities such as roads, water and sewer systems, housing, energy, telecommunications, public transport, etc. These projects are ideal for financing through the capital markets via long dated bonds and asset backed securities. Infrastructure development is a necessary condition for long-term sustainable growth and development. In addition, capital markets increase the efficiency of capital allocation by ensuring that only projects that are deemed profitable can successfully attract funds. This will, in turn, improve competitiveness of domestic industries and enhance ability of domestic industries to compete globally, given the current momentum towards global integration. The result will be an increase in domestic productivity which may spill over into an increase in exports and, therefore, economic growth and development,
6. Financing Private Public Partnerships, “PPPs”: Capital markets promote PPPs, thereby encouraging participation of private sector in productive investments. The need to shift economic development from public to private sector to enhance economic productivity has become inevitable as resources continue to diminish. It assists the public sector to close the resource gap, and complement its effort in financing essential socio-economic development, through raising long-term project-based capital. It also attracts foreign portfolio investors who are critical in supplementing the domestic savings levels and who facilitate inflows of foreign financial resources into the domestic economy, thereby supporting economic growth.