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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
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
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.