November 24, 2012

MA0044 [Institutional Banking] Set1 Q1

Q1. What/who are financial intermediaries? Explain their role in the growth of the economy?


Financial intermediaries are those entities with "low-cost" money (banks, credit unions, savings & loan associations, mutual and pension funds and insurance companies) that act as providers of money (as loans or investments) to those needing funding. They have developed a sophisticated network to allow them to have these funds available and deliver them as quickly and efficiently as electronically possible.

Financial intermediaries perform as provider of funds to those who need money. From banks, credit unions, savings & loans, mutual funds, insurance companies and pension funds, financial intermediaries provide funds for all manner of borrowers and investors. Whether it's a bank providing a personal loan, a mortgage lender or financial entities creating investment markets, financial intermediaries keep the flow of funds moving.

Individuals and businesses often need funds for working capital, asset purchases (homes, cars, equipment, buildings and computer systems) and the financial intermediary network serves as the source of this money. Borrowing from savers (depositors in banks and credit unions), financial intermediaries provide monies at a reasonable cost to those who need them. Their network, a finely tuned money machine, eliminates most difficulties for those needing funds.

Financial intermediaries exercise great power and control over the country's economy. In theory, their network allows the country's financial transactions and money movement to keep funds flowing. At most times, this theory is the reality. However, they can also enhance the effects of a negative economy by refusing to become players in the global financial game. When regional, national or global economic problems occur, financial intermediaries sometimes choose to tighten their requirements or even to suspend money offerings. This action often makes a bad situation worse.

While always necessary components to the economy, the sophistication of computers and the Internet has allowed financial intermediaries to become even more efficient and important. Those needing funds can often be anywhere in the world and receive the money they need electronically. The risk of transferring funds, the time delay and the need for "hard cash" have all been effectively eliminated. This has allowed financial intermediaries to serve just as professionally as banking institutions. For example, mutual and pension funds effectively offer financial intermediary services to individuals and businesses at reasonable rates.

It is important to understand both what financial intermediaries are able to do and what they are willing to do for you. Having large amounts of money for loan or investment without the desire to provide these monies to others serves little purpose to those individuals and companies needing funding. Carefully consider your need for funds and those financial intermediaries most interested in providing the money.

Transformation of the risk characteristics of assets
The second main service financial intermediaries and markets provide is the transformation of the risk characteristics of assets. Financial systems perform this function in at least two ways. First, they can enhance risk diversification and second, they resolve an information asymmetry problem that may otherwise prevent the exchange of goods and services, in this case the provision of capital (Akerlof 1970).

Financial systems facilitate risk-sharing by reducing information and transactions costs. If there are costs associated with the channelling of funds between borrowers and lenders, financial systems can reduce the costs of holding a diversified portfolio of assets. Intermediaries perform this role by taking advantage of economies of scale, markets do so by facilitating the broad offer and trade of assets comprising investors’ portfolios.

Financial systems can reduce information and transaction costs that arise from an information asymmetry between borrowers and lenders.[3] In credit markets an information asymmetry arises because borrowers generally know more about their investment projects than lenders. A borrower may have an entrepreneurial “gut feeling” that can not be communicated to lenders, or more simply, may have information about a looming financial risk to their firm that they may not wish to share with past or potential lenders. An information asymmetry can occur ex ante or ex post. An ex ante information asymmetry arises when lenders can not differentiate between borrowers with different credit risks before providing a loan and leads to an adverse selection problem. Adverse selection problems arise when lenders are more likely to make a loan to high-risk borrowers, because those who are willing to pay high interest rates will, on average, be worse risks. The information asymmetry problem occurs ex post when only borrowers, but not lenders, can observe actual returns after project completion. This leads to a moral hazard problem. Moral hazard problems arise when borrowers engage in activities that reduce the likelihood of their loan being repaid. They also arise when borrowers take excessive risk because the costs may fall more on lenders compared to the benefits, which can be captured by borrowers.

The problem with imperfect information is that information is a “public good”. If costly privately-produced information can subsequently be used at less cost by other agents, there will be inadequate motivation to invest in the publicly optimal quantity of information (Hirshleifer and Riley 1979). The implication for financial intermediaries is as follows. Once financial intermediaries obtain information they must be able to obtain a market return on that information before any signalling of that information advantage results in it being bid away. If they can not prevent information from being revealed prior to obtaining that return, they will not commit the resources necessary to obtain it. One reason financial intermediaries can obtain information at a lower cost than individual lenders is that financial intermediation avoids duplication of the production of information faced by multiple individual lenders. Moreover, financial intermediaries develop special skills in evaluating prospective borrowers and investment projects. They can also exploit cross- customer information and re-use information over time. Financial intermediaries thus improve the screening of potential borrowers and investment projects before finance is committed and enforce monitoring and corporate control after investment projects have been funded. Financial intermediation thus leads to a more efficient allocation of capital. The information acquisition cost may be lowered further as financial intermediaries and borrowers develop long-run relationships (Petersen and Rajan 1994 and Faulkender and Petersen 2003).

Financial markets create their own incentives to acquire and process information for listed firms. The larger and more liquid financial markets become the more incentive market participants have to collect information about these firms. However, because information is quickly revealed in financial markets through posted prices, there may be less of an incentive to use private resources to acquire information. In financial markets information is aggregated and disseminated through published prices, which means that agents who do not undertake the costly process of ex ante screening and ex post monitoring, can freely observe the information obtained by other investors as reflected in financial prices. Rules and regulation, such as continuous disclosure requirements, can help encourage the production of information.

Financial intermediaries and financial markets resolve ex post information asymmetries and the resulting moral hazard problem by improving the ability of investors to directly evaluate the returns to projects by monitoring, by increasing the ability of investors to influence management decisions and by facilitating the takeover of poorly managed firms. When these issues are not well managed, investors will not be willing to delegate control of their savings to borrowers. Diamond (1984), for example, develops a model in which the returns from firms’ investment projects are not known ex post to external investors, unless information is gathered to assess the outcome, i.e. there is “costly state verification” (Townsend 1979). This leads to a moral hazard problem. Moral hazard arises when a borrower engages in activities that reduce the likelihood of a loan being repaid. For example, when firms’ owners “siphon off” funds (legally or illegally) to themselves or their associates through loss-making contracts signed with associated firms.

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