ROLE OF FINANCIAL INTERMEDIARIES:Pooling Savings

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Money & Banking MGT411

Lesson 21

ROLE OF FINANCIAL INTERMEDIARIES

Role of Financial Intermediaries:

Pool Savings

Safekeeping, accounting services and access to the payments system

Liquidity

Risk diversification

Information Services

Role of Financial Intermediaries

As a general rule, indirect finance through financial intermediaries is much more important than

direct finance through the stock and bond markets

In virtually every country for which we have comprehensive data, credit extended by financial

intermediaries is larger as a percentage of GDP than stocks and bonds combined

Around the world, firms and individuals draw their financing primarily from banks and other

financial intermediaries

The reason for this is information;

Financial intermediaries exist so that individual lenders don't have to worry about getting

answers to all of the important questions concerning a loan and a borrower

Lending and borrowing involve transactions costs and information costs, and financial

intermediaries exist to reduce these costs

Financial intermediaries perform five functions:

They pool the resources of small savers;

They provide safekeeping and accounting services as well as access to the payments system;

They supply liquidity;

They provide ways to diversify risk; and

They collect and process information in ways that reduce information costs

International banks handle transactions that cross borders, which may mean converting

currencies

Taking deposits from savers in one country and providing them to investors in another country

Converting currencies to facilitate transactions for customers who do business or travel

Pooling Savings

The most straightforward economic function of a financial intermediary is to pool the resources

of many small savers

To succeed in this endeavor the intermediary must attract substantial numbers of savers

This is the essence of indirect finance, and it means convincing potential depositors of the

soundness of the institution

Banks rely on their reputations and government guarantees like deposit insurance to make sure

customers feel that their funds will be safe

Safekeeping, Payments System Access, and Accounting

Goldsmiths were the original bankers;

People asked the goldsmiths to store gold in their vaults in return for a receipt to prove it was

there

People soon realized that trading the receipts was easier than trading the gold itself.

Eventually the goldsmiths noticed that there was gold left in the vaults at the end of the day, so

it could safely be lent to others

Today, banks are the places where we put things for safekeeping;

We deposit our paychecks and entrust our savings to a bank or other financial institution

because we believe it will keep our resources safe until we need them

Banks also provide other services, like ATMs, checkbooks, and monthly statements, giving

people access to the payments system

Money & Banking MGT411

Financial intermediaries also reduce the cost of transactions and so promote specialization and

trade, helping the economy to function more efficiently.

According to the principle of comparative advantage, people and companies concentrate on the

activities

At which they are the best and

For which their opportunity cost is lower

This leads to specialization in a particular activity

More specialization => more trading => more financial transaction => calls for low cost of

transaction

The bookkeeping and accounting services that financial intermediaries provide help us to

manage our finances

Pay-Cheques

House-rents

Utility bills

Loan payments

Food clothing and other expenses

Savings and retirement plans

Providing safekeeping and accounting services as well as access to the payments system forces

financial intermediaries to write legal contracts, which are standardized

Much of what financial intermediaries do takes advantage of economies of scale,

The average cost of producing a good or service falls as the quantity produced increases

Information is also subject to economies of scale

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