Whydo Financial Intermediaries Exist?
Significant changes in the workings of financial intermediaries have been witnessed in recent years. Emerging markets for financing options and futures have required input from financial intermediaries, as opposed to individuals or firms (Allen and Satomero, 1996).
This paper will discuss the role of financial intermediaries today.
Financial intermediaries offer direct financial services (Adrian and Shin, 2010). Direct financing involves developing an exact match between the claims of Deficit Spending Units (borrowers) and Surplus Spending Units (savers) (Shay, n.d.). Thus, financial intermediaries resort to reshaping direct claims sold by DSUs to make them more appealing to SSUs. (University of South Carolina, n.d.).
Financial institutions also solve the problem of information assymerrics. Financial institutions overcome such problems by estimating the capacity of a borrower to repay the outstanding sum or adjusting the interest rate accordingly (Auronen, 2003).
Financial intermediaries can apply one of two approaches to risk minimization: adverse selection or moral hazard. In adverse selection, lenders (due to lack of information) cannot make a distinction between projects that pose low risk and those that pose a high risk. On the other hand, borrowers may elect to allocate the funds that have been advanced to them for other purposes, other than those that have been agreed upon: moral hazard (Bebczuk, 2003).
Of the two approaches, adverse selection is more efficient (Pauly, 2007).
Recent decades have witnessed a significant reduction in asymmetric information and transaction costs: the traditional role of banks has declined (Crawford, 2014).
In essence, financial intermediaries act as middlemen between the net savers and net borrowers of the economy (Genberg, n.d.: 100). Over the years, however, the role of financial intermediaries become more involved (Cetorelli et al., 2012: 4).
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