How Financial Intermediaries Reduce Transaction Costs

5 Key excerpts on "How Financial Intermediaries Reduce Transaction Costs"

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  eBook - PDF

  The Economics of Banking

  • Kent Matthews, John Thompson(Authors)
  • 2014(Publication Date)
  • Wiley

    (Publisher)

  This leads to the conclusion that, in a world with perfect knowledge, no transaction costs and no indivisibilities, financial intermediaries would be unnecessary. In fact, these conditions/assumptions are not present in the real world. For example, uncertainty exists regarding the success of any venture for which funds are borrowed. Both project finance and lending are not perfectly divisible, and transaction costs certainly exist. Hence, it is necessary to move on to consider the reasons why borrowers and lenders prefer to deal through financial intermediaries. One of the first reasons put forward for the dominance of financial intermediation over direct lending/borrowing centres on transaction costs – Benston and Smith (1976) argue that the ‘raison d’ _ ^ e tre for this industry is the existence of transaction costs’, and this view is examined in Section 3.3. Other reasons include liquidity insurance (Diamond and Dybvig, 1983), information-sharing coalitions (Leyland and Pyle, 1977) and delegated monitoring (Diamond, 1984, 1996). These are dealt with in Sections 3.4 and 3.5. 3.3 TRANSACTION COSTS As a first stage in the analysis of the role of costs in an explanation of financial intermediation, we need to examine the nature of costs involved in transferring funds from surplus to deficit units. 9 The following broad categories of cost can be discerned: 1. Search costs – these involve transactors searching out agents willing to take an opposite position, e.g. a borrower seeking out a lender(s) who is willing to provide the sums 7 ‘Collateral’ refers to the requirement that borrowers deposit claims to one or more of their assets with the bank. In the event of default, the bank can then liquidate the asset(s). 8 Risk is often measured by the variance (or standard deviation) of possible outcomes around their expected value. Using this terminology, the variance of outcomes for bank deposits is considerably less than that for bank loans.

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  Monetary Economics

  Theories, Evidence and Policy

  • David G. Pierce, Peter J. Tysome(Authors)
  • 2014(Publication Date)
  • Butterworth-Heinemann

    (Publisher)

  Why are financial intermediaries able to reconcile the conflicting portfolio requirements of lenders and borrowers? The reason is primarily that they enjoy The nature and functions of financial intermediaries 83 certain economies of scale. By dealing with large numbers of lenders and borrowers they are able to pool the risk involved. By having large numbers of depositors to whom they have sold indirect securities the intermediaries are able to predict far more accurately what total withdrawals will be, because as some depositors are making withdrawals others will be paying in, and the greater the number of individual transactions making up the total, the more likely are random variations in individual magnitudes likely to cancel one another out, leaving the total more stable per unit period of time. Similarly the intermediaries can more accurately predict the number of borrowers who are likely to default than could a small-scale lender lending to only a few borrowers. Financial intermediaries will also enjoy administrative economies and managerial economies, being able to employ specialist staff in a wide range of activities. Their size, too, plus in some cases the fact that they are subject to government regulation and supervision, may make them appear less risky investments to ultimate lenders, who, as a result, may be prepared to lend to them at lower rates of interest than they would be prepared to lend to ultimate borrowers. A rather different kind of intermediation with related benefits is provided by institutions like investment trusts, unit trusts, and in some respects pension funds. These institutions, along with others, 'alleviate the market imperfections caused by economies of scale in transactions in financial markets and also in information gathering and portfolio management' (Goodhart 1975a, p. 104).

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  The Influence of Uncertainty in a Changing Financial Environment

  An Inquiry into the Root Causes of the Great Recession of 2007-2008

  • Ricardo A. Halperin(Author)
  • 2017(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  THE THEORY OF FINANCIAL INTERMEDIATION Neoclassical economists were aware that the decisions to save and to invest were largely taken by different economic actors. They argued that finan- cial intermediaries (at that time this reference was almost synonymous with commercial banks) brought them together and posited that interest rates were the variable that enabled savings and investment to come into equilibrium. Later an alternative consideration became common in the financial lit- erature: different economic actors have different appetites for risk, and the role of financial intermediaries is to allocate these risks in an optimizing manner. The development of forward markets, and later of derivatives, serves to highlight this important role. Finally, a third consequence of financial intermediation needs to be highlighted. Financial intermediaries do not just shift risks within the R.A. HALPERIN 79 economy, they also create liquidity and rely on leverage for their profits, and in the process they create new risks. These three perspectives on financial intermediation are not mutually exclusive, each one illustrates one of the roles of the financial sector, but it is the third one, sometimes overlooked, which deserves special attention as we try to understand how the economy works and what drives economic fluctuations. When the role of financial intermediaries creating, or absorbing, liquid- ity is taken into account, it becomes clear that intermediaries do not play a neutral role as sometimes assumed. Indeed, the word “intermediary” becomes misleading, as by creating additional risks they affect the evolu- tion of the economy. In addition, while liquidity is obviously necessary for the smooth functioning of the economy, it is far from evident that the more liquidity the better. On the contrary, at some point the negative consequences of additional liquidity start to exceed its benefits.

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  Demystifying Global Macroeconomics

  • John E. Marthinsen(Author)
  • 2020(Publication Date)
  • De Gruyter

    (Publisher)

  Chapter 7 Financial Intermediation For most businesses, having sufficient access to lines of credit at banks or other financial institutions is as essential to their health and survival as adequate access to water is for families. In the course of providing liquidity to businesses and individuals, financial intermediaries do more than just channel funds from lenders and savers to borrowers. They also act as independent money creators for the nation as a whole. The speed at which a nation ’ s money supply changes is important because it affects the rate and sustainability of real economic growth and development, as well as inflation. A central bank ’ s job is to ensure that the money supply is not growing so slowly that it causes a recession or too rapidly that it causes unwanted inflation. Central banks control financial intermediaries by regulating and supervis-ing both the structure and size of their balance sheets. This chapter discusses the bank assets and liabilities that are important to the money creation process, as well as the vital role that a nation ’ s check-clearing process plays in our financial system. The Rest of the Story section of this chapter discusses how companies use check clearing in their cash management systems, the process of international check clearing, financial dis intermediation, and ten major causes of bank failures. The Basics Financial Intermediaries What role do financial intermediaries play in an economy? Why do people place funds in financial intermediaries, such as banks and thrift institutions 1 when they could lend directly to borrowers and earn higher returns? Direct Versus Indirect Financing To frame our discussion, let ’ s divide the economy into two segments, with ulti-mate lenders and savers (lenders/savers) on one side and ultimate borrowers on the other side (see Figure 7.1).

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  Handbook of Monetary Economics 3A

  • (Author)
  • 2010(Publication Date)
  • North Holland

    (Publisher)

  In conventional models of monetary economics commonly used in central banks, the banking sector has not played a prominent role. The primary friction in such models is the price stickiness of goods and services. Financial intermediaries do not play a role, except as a passive player that the central bank uses as a channel to implement monetary policy.

  However, financial intermediaries have been at the center of the global financial crisis that erupted in 2007. They have borne a large share of the credit losses from securitized sub-prime mortgages, even though securitization was intended to parcel out and disperse credit risk to investors who were better able to absorb losses. Credit losses and the associated financial distress have figured prominently in the commentary on the downturn in real economic activity that followed. These recent events suggest that financial intermediaries may be worthy of separate study to ascertain their role in economic fluctuations.

  The purpose of this chapter is to reconsider the role of financial intermediaries in monetary economics. In addressing the issue of financial factors in macroeconomics, we join a spate of recent research that has attempted to incorporate a financial sector in a New Keynesian DSGE model. Curdia and Woodford (2009) and Gertler and Karadi (2009) are recent examples. However, rather than phrasing the question of how financial “frictions” affect the real economy, we focus on the financial intermediary sector. We explore the hypothesis that the financial intermediary sector, far from being passive, is instead the engine that drives the boom-bust cycle. To explore this hypothesis, we propose a framework for study to address the following pair of questions. What are the channels through which financial intermediaries exert an influence on the real economy (if at all)? What are the implications for monetary policy?

  Banks and other financial intermediaries borrow in order to lend. Since the loans offered by banks tend to be of longer maturity than the liabilities that fund those loans, the term spread is indicative of the marginal profitability of an extra dollar of loans on intermediaries’ balance sheets. The net interest margin (NIM) of the bank is the difference between the total interest income on the asset side of its balance sheet and the interest expense on the liabilities side of its balance sheet. Whereas the term spread indicates the profitability of the marginal loan that is added to the balance sheet, the NIM is an average concept that applies to the stock of all loans and liabilities on the balance sheet.

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