Financial Intermediaries

FinancialIntermediaries

CriticallyExamine why Exist

Financialintermediaries are financial institutions that help in channelingfunds of individuals, firms and government organization into loans orinvestments. Their recent play in the financial market cannot gounnoticed due to their increased importance in funds trade. Some thefinancial intermediaries are insurance companies, mutual fundscompanies, non-banking finance companies, pension funds, investmentbanker and even normal banks. These institutions have been crucial inthe financial market even forcing the normal bank to change thetraditional way of doing business. You have noticed that many peopleinstead of using banks to keep their fund have resulted to eitherinvest their funds in bonds or shares or have chosen to use aninsurance cover as saving scheme (Allen and Satomero, 2001). Theelderly are joining pension schemes to provide themselves withsecurity in their old age after retirement.

Peopleare not sure which business to invest in or where to borrower funds,transaction cost involved, risk transformation, liquidity provision,and such problems have necessitated the rise of a new player thefinancial intermediary (Cetorelli, Mandel, B. H., &amp Mollineaux,2012).. It is these services that are being provided by the financialintermediaries that have made them successful even than banks in thefinancial market. That’s why you will continue to witness theworking of these intermediaries, now and in future as every tradewhether financial or not goes online as opposed to witnessing theinvolvement of individual or firms (Allen and Satomero, 2001). Thispaper is an essay on the roles that financial intermediaries play orrather satisfy in the financial market and change in the role of thetraditional bank as a result of financial intermediaries.

Rolesof financial intermediaries

Thereseveral roles that financial intermediaries play in the financialmarket, it would be worth noting that in any market there is alwaysan uneven distribution of funds. There are always individual or firmsthat have excess funds that they need to save on while borrowers whoare seeking funds. Financial intermediaries solve this problemexcellently by the minimizing risk associated, reducing cost,mitigating adverse selection, and moral hazard. Thus, throughoffering direct financial services (Adrian and Shin, 2010), they meetthe needs of surplus spending units and deficient spending units(Bebczuk, 2003). This is how financial intermediaries solve problemsalso with direct financing.

Tobegin with reducing financial cost, take for example if you wanted toinvest $2000. If you chose to invest this amount in the in thedifferent stock market, the fee you would pay for stock broker wouldbe high relatively to the investment you wish to make. Perhaps youchoose to turn into bond and purchase a treasury bill. You willnotice that the funds are little to be invested. Undaunted you willhave to avoid financial markets. On the other hand, assume that yourfriend new to borrow $2000 for his business and he wants you to loanhim that cash. You might choose to loan him or seek out otherborrowers. You will incur a lot of inconveniences trying to verifytheir plans. After that, you will draw a contract incurring lawyerand contact fees. Image the whole fee is approximate $1000 you willchoose not to invest even as it becomes costly.

Theillustration shows the transactional cost, the cost involved inselling and buying financial instruments and informational cost, thecost involved in determining whether you will lend your money tosomeone. It is expensive at a personal level to put up with this costassociated with direct dealing with finances. The financialintermediaries will solve this problem so easily they minimize thesecosts by exploiting the economies of scale. Accept deposits and lendto the individual. Their ability to accept many deposits from thesavers allows them to be able to have the cash to provide to lenders,thus, reducing the trouble of seeking a borrower or a lender (Adrian&ampShin, 2010).

Also,they sell their share to the individuals and invest those funds inthe bonds and shares business. Transaction cost per unit reduces asthe volume increases, for instance, the cost of purchasing a bond of$500000 is not so much compared to purchasing a bond of $10000. Also,these institutions can access cheap legal contract cost by utilizingthe economies of scale. Intermediaries are always located in knownplaces making them accessible, to both the lenders and borrower,saving the cost associated with search. Secondly it easier forintermediaries to verify the borrower as they can access informationabout the borrower easily compared to the lender. Also, due toeconomies of scale they can easily monitor and enforce contract termscheaply than the borrower (Pauly, 2007).

Secondly,financial intermediaries’ aid in maturity, liquid and risktransformation, financial intermediaries provide financial claims tosavers that always have high liquidity attributes compared toindividual borrowers. Their ability to provide contracts that arehighly liquid makes them attractive to the market. They achieve thisby diversifying some of the portfolio risks compared to individualsaver who are limited to holding relatively undiversified portfolios(Adrian&amp Shin, 2010). The more these financial intermediariesdiversify, the less the probable that they will default theirliability obligation and the lesser the risk, and much liquid itclaims. Also, financial intermediaries make funds be accessed bysavers who wish to access the funds within a short period. Also, theyprovide funds to borrowers who pay the funds in within a long period.

Ifthis function of maturity transformation were left to individual,probably they would not manage to lend it within that length period.Thus, financial intermediaries due to their ability to have manyfunds at once can provide funds to their lenders on the agreed shortterm period as well as provide cash to long-term borrowers. Forexample, a company borrowing funds to inject into a nuclear powerplant will borrow long term funds about its projected expected cashflows in future to repay the loan. On the other hand, a lender mayinvest the funds in a short period. The capability to satisfy thesetwo requirements by financial intermediaries is referred as maturitytransformation (Adrian&amp Shin, 2010).

Thirdly,the financial intermediaries solve the problem associated withinformation asymmetric (Auronen, 2003). Individuals with surplushave problems evaluating and identifying the creditworthiness ofthose in deficit. The surplus units have to take note of theuncertainty in a future event, the risk involved. While, borrowerslike to be issued with long-term liabilities, keep their creditworthiness a secret and opt to venture in events that are more riskdue to high-profit return. Thus, this makes it difficult forindividual lending monies direct to borrowers as they do not want tobe involved in a situation that might result in loss of their money.This situation has led to the rise of intermediaries between lendersand borrowers. The intermediaries absorb all the worries of thelender and evaluate the creditworthiness of the borrower. Thesituation that results from a lack of information between the lenderand borrower is what is referred as information deficiency. Financialintermediaries can solve this problem of information asymmetry, moralhazard, and adverse selection (Pauly, 2003).

Moralhazard risk occurs when a borrower does not use the funds borrowed asdeclared. For instance when someone borrows money and uses the fundfor gambling. Thus, the funds that were borrowed under the pretext ofbusiness venture are not used as they were intended. An individuallender would face a lot of challenges in try to monitor a borrower,and it would be so costly compared to a financial intermediary(Pauly, 2007). Financial intermediaries have a resolution to thisproblem. They have professional and qualified techniques to curb suchcase. Financial intermediaries are capable of having in place debtrestrictive contracts this might limit the risk that the borrowerwill involve in. Another measure that the financial intermediariestake is the maintenance of minim level of net worth. For instancewhen you take a mortgage the financial intermediary might request youtake some life insurance to pay off the loan in the event of yourdeath before the loan is repaid. Another method used to control moralhazard is the requirement that the borrower maintains the value ofany collateral offered to the lender. For instance, if you have takena mortgage to buy a house you won’t be able to sell the housebefore repaying the loan. These are some of the restrictions thatfinancial intermediaries are to impose on the borrowers which mightbe difficult to be carried out by an individual lender thus callingfor the need of qualified third party (Bebczuck, 2003).

Theproblem of adverse selection is best dealt with about George Akerlofexample of cars on the market. He gives a scenario whereby wherethere are good cars and lemons. In the market, the information isavailable to the sellers more than to the buyers as sellers know thestate of their cars. If buyers knew the quality and state of thecars, they would pay a fair price for each car. But since there arealso lemon cars on sale they will pay an average price based on theknowledge that there is a good car and lemon car. Owners of the goodcar will feel that the price offered little for their car and thusopt out of the market while lemon cars will be sold at a higher valuethan the real value. This will lead to a situation of zero sales aswith time buyer will not be inclined to buy the lemon cars. Thus thesituation above creates the need for a third party who has betterskills and tool to operate efficiently. Thus the situation abovecreates the need for a third party who has better skills and tool tooperate efficiently. Thus, financial intermediaries collectinformation about it borrowers and lend it depending on theircreditworthiness as they can research on borrower relatively cheap(Auronen, 2003).

Itis probably easy to control moral hazard than adverse selection thisis because adverse selection is based on information you know aboutthe client. You might have insufficient information about thecreditworthiness of a borrower since because he/she has nevertransacted before with an organization that keeps a record. Thus,adverse selection is riskier compared to moral hazard control. Therestrictive contracts available in control of moral hazard give muchauthority to control how a borrower uses funds. No borrower wouldrisk to invests their funds where there is high risk and even if theyinvest they will be more caution, having a collateral against theborrower is also a good advantage as it keeps the borrowers action inline due to the probability of losing the collateral if the contractis broken.

Changein Traditional Role of Banks

Thetraditional role of banks of receiving deposits and giving loans hasdeclined due to switch from holding assets directly to mutual fundsand pension funds. However, the banks have tried to maintain theirplace about the gross domestic product through innovating andswitching from the traditional way of doing business to fee producingactivities (Allen and Satomero, 2001). The declining trend in thetraditional way of doing business by the banks and the financialinnovation assimilated by banks can be interpreted as a reaction tothe effect of other players in the financial market (Cetorelli etal., 2012). For instance taking the USA as an example, thedepository financial institutions have declining trend in the shareof financial assets of intermediaries. Single purpose providers offinancial services have managed to compete for some profitabletraditional bank services that were originally offered by banks alone(Allen and Satomero, 2001).

Also,with securitization techniques, the emergence of new financialintermediaries has changed how many kinds of transactions especiallycredit transactions that were previously conventional bank loansstructured. In demonstration how the traditional role of banks haschanged, let’s take for instance a mortgage. Traditionally a bankwould come up with the mortgage, finance it and service the mortgageuntil it was completely repaid. Currently a firm comes up with amortgage, another funds it, servicing of the mortgage might be givento another firm who has data processing expertise. The result wouldbe that the mortgage will be funded at a cheap cost than if theintermediary were obliged to cling onto the mortgages to maturity(Allen and Satomero, 2001). The mortgage that was once an illiquidasset of a bank has been transformed into a highly marketablesecurity.

Thetechnique has been successfully used to other transactions such ascredit card receivables, small business loans and auto loans. Thistrend can be seen in the standard commercial loan with the rise anddevelopment of collateralized loan obligation market (Allen andSatomero, 1996). Banks are dropping their ground on the liabilityside of balance sheet. The consumer demand is moving from creditservices to saving service, the reason for the boom in mutual funds,pension’s schemes and insurance companies. The asset accumulationby the people towards retirement has been paramount in making thesefinancial intermediaries grow (Cetorelli et al., 2012). This has ledto a drop in bank function in providing time and consumer deposits asthese intermediaries have convenient and lenient cost structures thathave high returns (Allen and Satomero, 2001).

Theemergence of new technologies, introduced by the non-banksinstitution is threatening the fundamental duties of banking inassisting payments. The mutual funds and most brokerages areproviding management accounts that allow individuals to have theirincome automatically deposited in their accounts. In addition tothat, the individuals can make routine automatic and irregularpayments by phone or checks 24 hours a day. In addition to drawingpersonal checks routinely on the money market account, these accountscan be linked to a credit card that serves the purpose of debit cardused at Automated teller machine when in need of cash (Allen andSatomero, 2001). It is these factors that are making theintermediaries be preferred than traditional banks.

Thoughthe role of banks in intermediation has fallen, banks have continuedto prosper nevertheless, by moving from the traditional way of doingto fee producing services (Allen and Satomero, 2001). You havenoticed that banks are currently offering advisory service to theirsavers when they wish to invest and can act as brokers for theirclient in financial markets. Banks nowadays are involved in buyingand selling share and securities of private companies and as well asgovernment securities for their customer. Banks have also resulted ingiving advice to their customers on matters of tax and sometimesprepare income tax returns for their clients for a fee. To keepthemselves attractive in the market they have chosen to act ascustomer correspondent, they obtain passports, secure air, and seapassages and obtain travelers tickets on behave of their customer.Banks have also adopted to act as trustee and executor of wills theypreserve the final wills of their clients and execute them aftertheir death at a fee. In addition to that banks are also offeringinsurance cover to their client, annuities, and mutual funds. Todaytime and saving deposit are not the primary source consumer andbusiness finance neither are they the main repository of liquidsavings. Banks have managed to restructure their deals so that theydo not much dependent on traditional intermediation income. Thesechanges have been necessitated by the need to react to thecompetition imposed by the entry of other intermediaries in thefinancial market.

Conclusion

Theproblem associated with the transfer of fund from surplus units todeficit units has necessitated the existence of a middle party thatcan provide financial assistance at the same time solving the problemof direct finance. Costs associated with personal investment withoutthe involvement of middle party are adverse and discourage theindividuals from participating in the investment. A problem relatedto asymmetric information especially adverse selection and moralhazards have far discouraged the individual saver. It these problemsthat have made the market need the services of the qualified partywho’s can utilize the economies of scale and provide lenders andborrower with their needs through utilization of cheap contractualcost, search cost, monitoring cost, and informational cost ascompared to individual (Cetorelli et al., 2012).

Also,the financial intermediaries have greatly influenced how thetraditional functions, by providing some of the services that wereoriginally provided by banks. To curb the competition, the banks haveresulted in providing service for a fee, such as insurance, brokerservices, mutual funds, correspondent services and trustee servicesto stay relevant in the market (Allen and Satomero, 2001).. Thefuture holds much for the financial intermediaries as we expect moreinnovation to come up.

References

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