Role Of Financial Intermediaries

The Role of Financial Intermediaries

So why is indirect financing so much more important? The reasons center around the power of information: how to get quality information at a reasonable cost. In this context, financial intermediaries perform 5 functions:

1. Pooling the resources of small savers

Many borrowers require large sums, while many savers offers small sums. Without intermediaries, the borrower for a $100,000 mortgage would have to find 100 people willing to lend her $1000. That is hardly efficient. Banks, for example, pool many small deposits and use this to make large loans. Insurance companies collect and invest many small premiums in order to pay fewer large claims. Mutual funds accept small investment amounts and pool them to

Financial intermediaries make is easy to transform various assets into a means of payment through ATM's, checking accounts, debit cards, etc. In doing this, financial intermediaries must many short term outflows and investments will long term outflows and investments in order to meet their obligations while profiting from the spread between long and short term interest rates. Again, economies of scale allow intermediaries to do this at minimum cost.

4. Diversifying risk

Financial intermediaries help investors diversify in ways they would be unable to do on their own. Mutual funds pool the funds of many investors to purchase and manage a stock portfolio so that investors achieve stock market diversification for as little at $1000. If an investor were to purchase stocks directly, such diversification would easily cost over $15,000. Insurance companies geographically diversify in ways that a Gulf Coast homeowner cannot. Banks spread depositor funds over many types of loans, so the default of any one loan does not put depositor funds in jeopardy.

5. Collecting and processing

Do stock markets perform the same functions as banks, so that banks and stock markets are substitute institutions? These questions are implicitly posed by studies of Germany, for example, where the economy appears to be very successful, but where historically the economy has been organized around banks.Dow and Gorton (1997) present a model of the stock market in which stock prices serve two roles. First, informative stock prices can lead to efficient executive compensation. But stock prices are only informative if some traders are willing to trade on their information about projects that the firm is considering undertaking. Thus, informative stock prices have a second role: the firm can use information from stock prices in making capital budgeting decisions. In this way, the stock market performs both a screening role for projects and a monitoring role in the sense of performance-sensitive compensation. The distinction between bank-based systems and stock market-based systems is not as stark as it is usually presented. In the case of Germany, for example, Dow and Gorton show that a bank can also perform these roles, suggesting that banks and stock markets are alternative institutions in the savings/investment process. By contrast, Allen (1993) and Allen and Gale (1999) argue that banks and stock markets are fundamentally different in the way that they process and act on information.