Chapter 11: The Economics of Financial

Intermediation
In chapter 3 we were introduced to the importance of the
financial sector in the allocation of funding, and thus
resources, to their best uses in the economy. Recall that direct
finance refers to savers and borrowers meeting directly in
financial markets, while indirect finance involves the use of a
financial intermediary. While the stock and bonds markets
play a most important and indispensible role in this
allocation of funding, we find that, in the U.S. and many
other countries, indirect finance is much more important.
Table 11.1 (261) highlight how indirect finance accounts for a
much larger share of GDP that stock and bond markets
combined.
The Role of Financial Intermediaries
So why is indirect financing so much more important? The
reasons center around the power of information: how to get
quality information at a reasonable cost. In this context,
financial intermediaries perform 5 functions:
1. Pooling the resources of small savers
Many borrowers require large sums, while many savers
offers small sums. Without intermediaries, the borrower for
a $100,000 mortgage would have to find 100 people willing

to lend her $1000. That is hardly efficient. Banks, for

example, pool many small deposits and use this to make
large loans. Insurance companies collect and invest many
small premiums in order to pay fewer large claims. Mutual
funds accept small investment amounts and pool them to
buy large stock and bond portfolios. In each case, the
intermediary must attract many savers, so the soundness of
the institution must be widely believed. This is accomplished
through federal insurance or credit ratings.
2. Providing safekeeping, accounting, and payments
mechanisms for resources
Again, banks are an obvious example for the safekeeping of
money in accounts, the records of payments, deposits and
withdrawals and the use of debit/ATM cards and checks as
payment mechanisms. Financial intermediaries can do all of
this much more cheaply than you or I because the take
advantage of economies of scale. All of these services are
standardized and automated on a large scale, so per unit
transaction costs are minimized.
3. Providing liquidity
Recall that liquidity refers to how easily and cheaply an asset
can be converted to a means of payment. Financial
intermediaries make is easy to transform various assets into
a means of payment through ATMs, checking accounts, debit
cards, etc. In doing this, financial intermediaries must many
short term outflows and investments will long term outflows

and investments in order to meet their obligations while

profiting from the spread between long and short term
interest rates. Again, economies of scale allow intermediaries
to do this at minimum cost.
4. Diversifying risk
We have seen in chapter 5 how diversification is a powerful
tool in minimizing risk for a given leven of return. Financial
intermediaries help investors diversify in ways they would
be unable to do on their own. Mutual funds pool the funds
of many investors to purchase and manage a stock portfolio
so that investors achieve stock market diversification for as
little at $1000. If an investor were to purchase stocks directly,
such diversification would easily cost over $15,000. Insurance
companies geographically diversify in ways that a Gulf
Coast homeowner cannot. Banks spread depositor funds
over many types of loans, so the default of any one loan does
not put depositor funds in jeopardy.
5. Collecting and processing information
Financial intermediaries are experts at collecting and
processing information in order to accurately gauge the risk
of various investments and to price them accordingly.
Indviduals do not likely have to tools or know-how to do the
same, and certainly could not do so as cheaply as financial
intermediaries (once again, economies of scale are important
here). This need to collect/process information comes from a
fundamental asymmetric information problem inherent in

financial markets.
Financial Intermediaries and Asymmetric Information
Despite their importance, your textbook author refers to
financial markets as "among the worst functioning of all
markets." (268) This is due the fundamental fact the
borrowers and debt/stock issuers know much more about
their likelihood of success than potential lenders and
investors. This asymmetric information causes one group
with better information to use this advantage at the expense
of the less-informed group. If not controlled, asymmetric
infromation can cause markets to function very inefficiently
or even break down completely.
Asymmetric Information
The lack of information on one side creates problems
BEFORE the loan is made and AFTER the loan. To you or I,
these problems are huge, but financial intermediaries use
their size and expertise to minimize them.
Before a financial instrument is bought or sold, there is the
problem of adverse selection. Basically, what happens is that
the worst candidates (adverse) are more likely to be selected for
the transaction. People who are bad credit risks are more
likely to try and get a loan than those who are good credit
risks. Thus, odds are that you might end up lending to
someone with a bad credit risk. Knowing that, you just
decide not to lend. Again, this problem occurs because of

asymmetric information: You do not have good information

about a stranger's credit risk, although that stranger knows
his/her own creditworthiness quite well. Banks, however,
are experts at assessing credit risk and can distinguish the
good from the bad. So you lend to the bank, and the bank
lends to those who are good credit risks.
After a the loan is made, there is the problem of moral
hazard. Once you lend someone money, you risk (the hazard)
that he/she does something stupid to blow the money (immoral)
and would be unable to pay you back. Your brother in-law
claims to be investing in a restaurant franchise and will
repay you with the profits, but once you lend him $10,000 he
goes and blows it in Las Vegas. Knowing about this risk, you
tell your brother-in-law to get lost, even though the franchise
might be a good idea. Again, this is from asymmetric
information: Your brother-in-law knows what he will do
with the money but you can only guess. Banks are experts
in monitoring and enforcing lending contracts in order to
minimize the moral hazard problem.
Disclosure rules for public companies also mitigate the
problems of asymmetric information. The SEC requires
companies that sell securities to the public to publish
quarterly financial statements and disclosure any relevant
information in a timely manner. The requirement are not
foolproof. As your book notes, the scandals with Enron and
WorldCom, among others, demonstrate that financial
statements may be manipulated in ways to deceive investors.

Note: adverse selection and moral hazard are important

concepts that explain the structure and regulation of the
financial sector as well as the major crises that have
plagued the financial sector in the past 30 years, so take the
time to understand these concepts.
Role of Financial Intermediaries in Reducing Information
Costs
How do intermediaries reduce adverse selection and moral
hazard? There are several ways.

Screening. Prior to a loan being given, a bank investigates a

firm's or individual's credit history and financial status. Such
information is fed into sophisticated computer programs
that compute a "credit score" (known as a FICO score). The
higher the score, the better the borrower. Also, banks
specialize in lending to certain industries, especially local
industries. This makes the screening process cheaper and
more accurate, although the lack of diversification does
increase the risk of the bank's asset portfolio
Monitoring. Once the loan is made, the bank must ensure
that the borrower does not engage in risky activities that
could lead to default. One way to prevent this is for banks to
place "restrictive convenants" into the loan contract to
prohibit certain activities, and then to check compliance and
enforce the agreement when necessary.
Creating long-term customer relationships. Repeat
customers will not require the same effort for screening and
monitoring that new customers. Also, customers have an

incentive to establish a good repayment record in order to

get loans from the same bank in the future.
Collateral. Requiring a potential borrower to pledge assets to
be turned over in case of default reduces credit risk in
several ways. Obviously, it protects the bank from total
financial loss in the event of a default. But it also screens out
questionable borrowers (who will not have sufficient
collateral) and reduces moral hazard problems since the
borrower risks losing his/her property if a default occurs.
Credit rationing. Riskier borrowers will be expected to pay
higher interest rates to compensate for this risk. However,
ONLY the riskiest borrowers are willing to pay the highest
rates. This is an extreme case of adverse selection. In this
case, banks may be unwilling to assume the high risk levels
and simply refuse to lend to these types of borrowers.
Alternatives, banks would lend out only small amounts,
giving the borrower the incentive to establish a good
payment record to obtain additional loans.
Disclosure. Disclosure rules for public companies also
mitigate the problems of asymmetric information. The SEC
requires companies that sell securities to the public to
publish quarterly financial statements and disclosure any
relevant information in a timely manner. The requirement
are not foolproof. As your book notes, the scandals with
Enron and WorldCom, among others, demonstrate that
financial statements may be manipulated in ways to deceive
investors.
FYI: Related Links

Mulitple Choice Quiz, Chapter 11 Test your understanding

with a quiz from the textbook website.

Functions and Examples of Financial

Intermediaries
Definition of financial intermediaries
A financial intermediary is a financial institution such as
bank, building society, insurance company, investment bank
or pension fund.A financial intermediary offers a service to
help an individual/ firm to save or borrow money. A
financial intermediary helps to facilitate the different needs
of lenders and borrowers.
For example, if you need to borrow 1,000 you could try to
find an individual who wants to lend 1,000. But, this would
be very time consuming and you would find it difficult to
know how reliable the lender was.
Therefore, rather than look for individuals to borrow a sum,
it is more efficient to go to a bank (a financial intermediary)
to borrow money. The bank raises funds from people looking
to deposit money, and so can afford to lend out to those
individuals who need it.

Examples of Financial Intermediaries

1. Insurance Companies
If you have a risky investment. You might wish to insure,
against the risk of default. Rather than trying to find a
particular individual to insure you, it is easier to go to an
insurance company who can offer insurance and help spread
the risk of default.
2. Financial Advisers
A financial adviser doesnt directly lend or borrow for you.
They can offer specialist advice on your behalf. It saves you
understanding all the intricacies of the financial markets and
spending time looking for best investment.
3. Credit Union.
Credit unions are informal types of banks which provide
facilities for lending and depositing within a particular
community.
4. Mutual funds/ Investment trusts
These are mutual investment schemes. These pool the small
savings of individual investors and enable a bigger
investment fund. Therefore, small investors can benefit from
being part of a larger investment trust. This enables small
investors to benefit from smaller commission rates available
to big purchases.

Benefits of Financial Intermediaries

Lower search costs. You dont have to find the right lenders,
you leave that to a specialist.
Spreading risk. Rather than lending to just one individual,
you can deposit money with a financial intermediary who
lends to a variety of borrowers if one fails, you wont lose
all your funds.
Economies of scale. A bank can become efficient in collecting
deposits, and lending. This enables economies of scale
lower average costs. If you had to sought out your own
saving, you might have to spend a lot of time and effort to
investigate best ways to save and borrow.
Convenience of Amounts. If you want to borrow 10,000 it
would be difficult to find someone who wanted to lend
exactly 10,000. But, a bank may have 1,000 people
depositing 10 each. Therefore, the bank can lend you the
aggregate deposits from the bank and save you finding
someone with the exact right sum.

Potential Problems of Financial Intermediaries

There is no guarantee they will spread the risk. Due to poor

management, they may risk depositors money on ill-judged
investment schemes.
Poor information. A financial intermediary may become
complacent about spreading the risk and invest in schemes
which lose their depositors money (for example, banks
buying US mortgage debt bundles, which proved to be
nearly worthless precipitating the global credit crunch.)

They rely on liquidity and confidence. To be profitable, they

may only keep reserves of 1% of their total deposits. If
people lose confidence in the banking system, there may be a
run on the bank as depositors ask for their money bank. But
the bank wont have sufficient liquidity because they cant
recall all their long-term loans. (This can be overcome to
some extent by a lender of last resort, such as the Central
Bank and / or government)