The efficiency of an economy is much determined by not only how developed the financial system is but also by the effectives of its financial intermediation. A health economy requires a well run intermediation process.
A financial intermediary is a firm whose assets and liabilities are mainly financial instruments. The goal of financial intermediation is to pool resources from savers and lend them to people and firms who need to borrow. These institutions also play a pivotal economic function of gathering and relaying information about the financial conditions of firms and individuals which helps in allocation of resources to their most valued use. The failure of intermediation process implies the fall of financial sector and this can cripple the whole economy for instance the failure of the banking sector in the 1930s helped to bring about the Great Depression. Similar arguments exist for the Asian crisis of the late 1990s.
The Role of Financial Intermediaries
Financial intermediaries perform five basic functions which are crucial in the economy
These functions are listed below:
1. Pooling of resources from small savers
2. Providing safekeeping and services and access to the payments system
3. Supplying liquidity
4. Providing methods and avenues of diversification to reduce risk
5. Collecting and processing information to reduce information costs
A keen observation reveals that the first four functions focus on reducing transactions costs while the fifth function deals with reducing information costs. An in-depth analysis of the three functions is given below:
The most obvious function of a financial intermediary is to pool resources of a large number of small savers. By pooling these resources the banks can then make large loans to other people or firms. It is very unlikely that one person could finance a $200,000 mortgage or a multi-million dollar investment. However, a bank will pool
together the asset of several individuals to accomplish this goal. To be effective, financial intermediaries need to attract a large number of savers. This is generally accomplished by banks who make savers feel secure in the fact that their assets are safe.
Safekeeping, Payments System Access, and Accounting
Banks used to construct large, heavy safes which looked imposing. This safekeeping of valuables and assets is just one of several services provided by intermediaries. Banks provide services that give savers quick access to their assets through things like ATMs, credit and debt card, checks, and monthly statements. Bank are extreme efficient at
financial transactions greatly reducing their costs. Many banks also provide bookkeeping and accounting services. They help customers maintain their finances and plan for the future.
Financial intermediaries also provide liquidity to their customers. Liquidity is simply the ease at which assets can be turned into a means of payments and thus consumption. Banks allow their depositors to quickly and easily turn their deposits into money quickly and easily whenever needed. Borrowers also benefit from easier liquidity. They can
make loans which require repayment in a extended fashion. Intermediaries specialize their balance sheet so that they can make sizeable quick withdraws for customers.
Banks mitigate several types of risk. First, they take deposits from many people and make thousands of loans with these deposits. Thus, each depositor faces only a small amount of the risk associated with loans that would go default. No one depositor losses all their assets when a bank loan goes unpaid. Banks also provide a low-cost way for depositors to diversify their investments. Mutual fund companies offer small investors a way to purchase a diversified portfolio of several different stocks.
Collecting and Processing Information
One of the biggest problems that savers face is whom to lend their assets too. The fact is that the borrowers could lie about their true state and the lender has little ability to verify the truth. Finding out the truth can be a costly venture. The problem of information asymmetry sets in i.e the borrowers have information that the lenders do not. By collecting and processing information, financial intermediaries reduce the problems associated with asymmetric information. Loan applicants are carefully screened. They monitor loans for timely payments hence reducing this information problems.
These information problems have huge implications on the financial systems.