Financial intermediary is one of the participants in the financial market and it has been put in the center in year 2007 when the financial crisis took place. Financial intermediaries are important because they stand between buyers and sellers, facilitating the exchange of assets, capitals, and risks. Their services allow for greater efficiency and are vital to a well-functioning economy. This essay is to consider what roles have financial intermediaries played within the society and financial systems and discuss the impact on the financial market if there are no financial intermediaries exit.
It will mainly analyze impacts on five different factors, namely transaction costs, total risks, liquidity management, asymmetric information and economic growth. By assuming financial activities without financial intermediaries, the essay will make it clear that how important it is to have financial intermediaries in the financial system and economy. What do financial intermediaries do? Many investors will not choose to enter the financial markets by themselves, usually; they are willing to seek for financial intermediaries.
In daily financial activities, commercial banks are one of the most common financial intermediaries. Besides, there are also mutual and pension funds, insurance companies, which are regarded as financial intermediaries as well. Investors deposit the excess money to a financial intermediate; the financial intermediate lends the money to deficit units as mortgages, or to students who need the money to pay for education, or to firms in order to finance its inventories. An individual investor could find borrowers on his own and pass the financial intermediary (Bencivenga, V and B Smith, 1991).
By doing so, the investor could get a higher return. Why do financial intermediaries exit if investors can search counterparty himself? The essay will discuss the reasons below. Impact on transaction costs The transaction costs have been reduced significantly in recent years, which mainly due to the rapid growth of financial intermediaries (Diamond, D, 1984). Financial intermediaries generally take deposits and create loans. Lenders with excess money will deposit the money financial intermediaries, and then the money will be lent by the financial intermediaries to fund deficit units.
The money generated from these securities are finally used by firms to reinvest. If there are no financial intermediaries, the investors themselves must do this. However, it could be really difficult for an individual investor to find an appropriate borrower because of the informational asymmetry between the investors and the firms. When investors have to do a research, collect information and data themselves, there will be a significant amount of transaction cost.
Therefore, with financial intermediaries, transaction cost and asymmetric information can be reduced. The impact on risks Lending through a financial intermediary is usually less risky than lending by an individual investor directly. The reason why financial intermediaries can reduce risks is mainly because they can diversify. Financial intermediaries always make great outstanding loans, in this case, when part of these investments suffer losses, these losses may usually be compensated by those investments which make profits.
By comparison, an individual investor can only make a few loans, and any losses may have a significant effect on his wealth. With financial intermediaries, “eggs” are put in many different “baskets,” which insure their depositors from substantial losses (Adrian, Tobias and Hyun Song Shin, 2009). There is a second reason why financial intermediaries can reduce risks is because they can make better prediction on the credit of a borrower than an individual investor. Therefore, with financial intermediaries, investor’s total risk is reduced.
Liquidity is usually defined as the speed and ability to change an asset into cash. When an individual investor lends his excess money to a deficit unit that he found himself, the loan is usually defined as illiquid. Because if the investor suffer an emergency and needs cash at once, he can only try to ask the deficit unit to give his money back as soon as possible, or he can only borrow form others. Although financial intermediaries often lend their money into illiquid assets, their larger size allows them to keep some money to ensure the liquidity of their investors (Holmstr?
om Bengt and Jean Tirole, 1997). Once again, some long-term projects usually have higher return than show term ones, however, an individual investor can hardly get into these projects, because they are short-term preferred. Financial intermediaries make this possible. Most individual investor cannot make long-term investments. They prefer short-term because they may suddenly need money. However, this gap can be broken by financial intermediaries. Therefore, with financial intermediaries, investors will have higher liquidity on their investments.