This essay will examine in detail the benefits that banks may bring to those undertaking financial transactions and will look specifically at the role of banks as financial intermediaries. These intermediaries bring together borrowers and lenders, reducing the costs that would be incurred when dealing with each other directly. They also help them to overcome asymmetric information flows and allow borrowers easier access to funds for a long period of time, at acceptable rates of interest, while allowing lenders to gain a return on their excess of money at a lesser risk.
Financial intermediaries also utilise societies scarce resources to increase productive efficiency and to raise the standard of living by allowing borrowers to invest today. The essay will also look at the issues of Maturity transformation, Risk transformation, Reduction of transaction costs, and Collection and Parcelling as each of these create benefits to those undertaking financial transactions.
A very basic description of a financial system is a system which consists ‘of a set of markets, and individuals and organisations who trade in those markets. The end users of the system are people and firms whose desire is to lend and to borrow. ‘ (Howells, P & Bain, K 1994) Therefore a financial system is a form of intermediary bringing together potential borrowers and potential lenders. Potential borrowers and lenders have three options to choose from in order to get what they want, i. e.
assets for lenders, such as a bank deposit, and liabilities for borrowers, such as loans. The first option is to deal with one another directly, however this choice is very costly as it would be hard to find someone willing to lend money to a complete stranger, for example i?? 10,000, as this is very risky. The lender would have to put great trust in that person to repay the full amount to them, or charge such a high interest rate to cover any potential damage that it would probably be unacceptable to the borrower.
Also the fact that the lender has to promise to lend the money for a specific period of time and is unable to liquidate the asset, if the money is needed, creates a great risk. This option is the least likely of the three, as there is too much risk involved and is too expensive for both parties. The second option is that a lender is able to purchase an existing asset from another lender, in a way this is refinancing the loan, an example of this is the stock market.
The third option is to deal with one another through a financial intermediary such as a bank as this limits risk, and costs. Intermediaries do much more than just bring borrowers and lenders together, as merely matching the needs of the borrowers and of the lenders from lists, then charging them a fee for the introduction, is actually Brokerage. The job of financial intermediaries is ‘to create assets for savers and liabilities for borrowers which are more attractive to each than would be the case if the parties had to deal with each other directly.
‘ (Howells, P & Bain K 2000) Intermediaries such as banks are deposit-taking institutions, these deposits are liabilities to the bank and assets to the lenders (savers). This deposit can be withdrawn with little or no notice, and can be considered as part of the national money supply. The bank issues loans to potential borrowers, which creates an asset for the bank and a liability for the borrower. As they are a profit maximising institution, it can be assumed that it will charge a higher rate of interest on the loans than the rate of interest given on the savers asset.
Both the lenders asset and the borrowers liability will remain on the intermediary’s balance sheet until the debt is paid off, or the lender withdraws their money. Due to the work of financial intermediaries there are many more financial assets and liabilities in existence than would be possible if borrowers and lenders were left to deal directly with one another. This is due to many reasons as there are many benefits for both the borrower and the lender when using intermediaries such as banks.
There is less risk for the lender as their asset has liquidity; this is because financial intermediaries must enable the lender to access their money quicker than would be possible if they had deal directly with a borrower. Liquidity has three main aspects the first being the time it takes for the lender to retrieve their money. The second is the risk involved, financial intermediaries use Risk pooling, they hold the risk of the loan for the lender and only in extreme circumstances will their asset depreciate or not be returned.
Finally, the costs involved, if a sacrifice has to be made in order to retrieve the exchange of asset to money. The borrower also gains benefits from using an intermediary such as a bank, as it is much easier than dealing directly with the lender. They do not have to search for a compatible lender and then sit negotiating interest rates etc. It is also much more cost effective as interest rates are lower due to the lowered risk of the lenders.
However financial intermediaries must make loans available for extended amounts of time, for example twenty years, for borrowers while allowing lenders to withdraw their deposits with little, or no, notice. These contrasting needs would appear to cause a problem, as how could a bank pay off (lender) liabilities and still afford to maintain the assets (borrowers). The answer to this is that they create liquidity in four ways, through Maturity transformation, Risk transformation, Reduction of transaction costs, and through Collection and Parcelling.