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Financial intermediaries Free essay! Download now

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Financial intermediaries

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Downloads to date: N/A | Words: 1922 | Submitted: 16-Apr-2011
Spelling accuracy: 97.7% | Number of pages: 3 | Filetype: Word .doc


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Description

Financial intermediaries perform the essential function of channelling funds from those with surplus funds to those with shortage of funds. However without financial intermediates, the level of funds flow between household savers and corporation sectors is likely to be low.

Preview

Financial intermediaries perform the essential function of channelling funds from those with surplus funds to those with shortage of funds. However without financial intermediates, the level of funds flow between household savers and corporation sectors is likely to be low. This is due to several reasons like monitoring costs, liquidity costs and price risk. With the introduction of financial intermediaries, savings are channelled via them as savers prefer to hold financial claims issued by financial intermediates then those issued by corporations. Financial intermediaries function as brokers as they act as an agent for investors. They reduce transaction and information cost. This is through economies of scale, which is the concept of cost reduction in trading and other transaction services results from increased efficiency when financial intermediaries perform these services. Then, when small savers placed their funds with a single financial intermediate, this financial intermediate will group the funds together and invest in corporations directly or through primary financial claims. Financial intermediaries will then have a greater incentive to collect information and monitor actions of the firms as they have more at stake than the individuals. Therefore, in a way, financial intermediaries are appointed by individuals as a delegated monitor to act on their behalf to monitor their investments.

Transaction costs and delegated monitoring will be critically analysed to show why financial intermediaries are preferred over direct financing as followed. Firstly, analysing how transaction costs are reduced by financial intermediaries which made them preferred over direct financing. Next, delegated monitoring by financial intermediaries will be analysed to show how information costs, information asymmetry and agency cost will be reduced by financial intermediaries, which will make investing safer and more profitable. Hence, proving why financial intermediaries more preferable than direct financing.

Transaction costs will be analysed and discussed first.

Transaction costs are incurred because of the time and money spent in performing financial transactions (Coase, 1960). The presence of transaction costs causes difficulties for a potential lender in finding an appropriate borrower. Transaction costs consist of search, verification, monitoring and enforcement costs. Search costs are costs for searching out, and finding information about, a suitable counterpart. Verification costs are lenders incur costs to verify the accuracy of the information provided by the borrowers. Monitoring and auditing costs occurred when lenders incur costs to monitor the activities of the borrowers after giving them a loan, and their adherence to the conditions of the contract. Lastly, enforcement costs are costs incurred when borrower is unable to meet the conditions of the contract, the lender will need to ensure their enforcement.

Financial intermediaries reduce transaction costs by internalising them. First, they develop branch networks and information systems, which enable lenders and borrowers to ...

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