The Role of Financial Intermediation in Banking

The Role of pecuniary intermediation in Banking mo gainary intermediaries exist to solve or narrow food market imperfections such as differences in preferences of lenders and borrowers, exertion represent, shocks in consumers consumption and lopsided teaching. Theories developed to explain how pecuniary intermediaries reduce market imperfection plus transformationTransaction cost reductionLiquidity insuranceInformational economies of master leaf and delegated monitoringAsset TransformationAsset transformation is a turn performed by financial intermediaries to transform particular types of assets into to opposites. This is to present the need of borrowers for longsighted term capital and the need of lender for high degree of liquidness in their asset. monetary intermediaries transform the primary securities issued by houses into indirect securities by lenders. They issue liabilities (deposit claims) which be short term, low risk and high runniness, and put on parts of these silver to find larger, high risk and illiquid claims.3 chief(prenominal) TransformationsMaturity TransformationAs the liabilities of financial intermediaries mature faster than their assets, financial intermediaries mismatch the maturity of the assets volition maturity of the liabilities by making semipermanent lends and fund them by issuing short-term deposit.Size TransformationThe feature along take ind by borrowers are much much than the amount prove avail commensurate by lenders. Financial intermediaries can then collect and intermingle the f at a dismount places from lenders as required by the borrowers.Liquidity TransformationFinancial intermediaries leave alone financial or secondary claims or bestows. Deposits which are held under liabilities of banks repose are low risk and high liquidity, while loans which are held under the assets of banks balance are riskier and illiquid. To hold liabilities and assets of different degree of liquidity, fi nancial intermediaries depart diversify their portfolios. More diversification will lower the default probability. peril TransformationFinancial intermediaries must be seen by the lenders as a safe place to hold deposits. However, the loans do by the intermediaries to the borrower bear any(prenominal) default risk. Therefore, financial intermediaries scram to transform risk to reconcile the preferences of borrowers and lenders.Firstly, banks affair credit scoring to select wide borrowers with sizable repaying loans history to play down the risk of loss of each loan.Second is to diversify risk by lending to different types of borrowers. Banks try to avoid heavy concentration on an economic activity or on a particular area. They likewise limit the amount that can be loan out.Example From 1985-1989, four hundred Texan banks failed which are resulted from heavy concentration on their loan portfolio in real estate dependent on the oil businesses.Third is by pooling risks. Varia bility of losses can be reduced by making loans to many borrowers. Although by making out many loans does non reduce the loss in the portfolio of loans overall, but it increase the bank accuracy of fortune telling and limits maximum loss for which the intermediaries has to stand.How financial intermediaries reduce transaction costs?Financial intermediaries reduce transaction costs by internalizing them. They unclutter network and randomness system available to lenders and borrowers. As such, lenders and borrowers do non have to take chances a suitable counterpart each time they want to make a transaction with the former(a) party. Financial intermediaries withal provide order products which help to reduce the learning cost related with scrutinizing unmarried financial instruments. They too use tested procedures and routines.Theory of transaction costsEconomies of scale refer to the transaction costs per dollar of output is reduced as the number of financial transactions i ncrease.Example When using loan rationalise for many loans, the unit cost of a contract per loan is lower than a loan contract drawn up individually when job direct lending.Economies of cost refer to the cost of producing at least 2 products together is lower that producing them individually. It is concerned with deposit and fee services, because deposits are profound financial claims which allow banks to collect funds to sustain their lending activities and satisfy the request of making payments.ExpertiseThey developed expertise to lower transaction cost. Financial intermediaries such as banks and mutual funds develop in knowledge technology such as ATM to provide liquidity service.Asymmetric InformationAdverse SelectionIt arises when borrowers who are likely to bring forth inapplicable results are the one who are actively seeking loans, because they go that they are unlikely to pay it back. Adverse selection increases the probability that the loan might become a problemat ical credit risk. Hence, lenders whitethorn reconcile not to loan out, even when in that respect is earnest credit risk. clean HazardIt is the risk that occurs after the transaction has been made. It is the risk that the borrower may take away in activities which is undesirable from the lenders point of view because there a likeliness that the loan will not be repaid. Therefore, lenders may decide not to make loan.How adverse selection influence financial structure? integrity MarketWhen borrower wanted to make investment funds funds and yet is unable to contend between good and bad familys, he is only ordain to pay the price the price that reflects the fair quality of debaucheds. However, the firms have more reading than the investors and will know the quality of the projects. Good firms will not be willing to sell the securities because they know that their securities are undervalued. Only bad firms are willing to sell their securities at the average price because the pr ice is high than the value of bad firms securities. However, investors may not want to deal securities from bad firms and end up decides not to defile any.Bond MarketA potential investor will only be willing to buy a bond if the sake rate is high enough to compensate him the average default risk between the good and bad firms. Good firms will not want to borrow funds because they know that they are little risk adverse and should not pay an interest that is high than what they in the first place should pay for. Only bad firms are willing to pay for such interest rate. However, investor does not wish to buy bond from bad firms. Subsequently, there will be fewer bonds sold in the markets.Tool utilise which helps to reduce or solve adverse selection problemsPrivate payoff and sales of info disposal regulation to increase informationFinancial intermediariesPrivate companies such as Standard and Poors, Moodys and Value Line fulfil firms financial position and investment activitie s, and sell them to potential investor. much(prenominal) information will help investors in making more accurate investment decisions. However, this does not completely solve the asymmetric problem because of the free-rider problem. The free-rider problem occurs when individual who do not pay for the information take advantage of the information of which others has paid for. An investor who has paid for the information knows which the are good firms. He decides to buy securities of good firms that are undervalued. The free-riding investors observe which securities is the investor who paid for information is buying, will buy the same securities. This leads to increase in demand of the securities and soon the price of that security measure will increase to reflect the true value. As a result, because of these free-riders, the investors who bought the information will not benefit. As such, he will realize that he should not buy the information in the first place. If other investors withal realize this, private companies may not be able to make enough earnings from producing the information, and slight information is produced in the market and so adverse selection will interfere with the efficient function of securities markets.Government regulation to increase informationGovernment could regulate financial markets to fasten that firms disclose all information so that investors could distinguish between good firms and bad firms. In United States, the Securities and Exchange Commission (SEC) is the government style that requires firm selling securities to be certified in adhering to standard news report principles and disclose honest information about their sales, assets and earnings. But, government intervention on disclosing information does not solve adverse selection completely because story principles can be manipulated. Also bad firms can slant information which is required to transmit public to make them look like good firms. By doing so, they can g et higher price for their securities. Thus, investors will have problem again to identify which firms are the good ones.Financial intermediariesFinancial intermediaries such as banks have developed expertise in the ware of information so that they can evaluate the quality of firms better. Banks produce information through the transactions on the borrowers bank accounts. From the transactions, banks will be able to determine the suitability of credit and ability to repay the loan. Banks then acquire funds from depositors and lend them to good firms. By lending the money to good firms, banks will be able to earn a higher depict than they pay to depositors. Banks will then earn meshwork and can wrap up in producing information. Also, banks can make improvement because it can avoid free-rider problem. They make private loans which are not traded in open markets. As such, other investors cannot follow what the bank did and bid the price of loan where the bank does not get any gain f or the information it produces.Fact Banks are strategic to developing countries. When banks produce information, the problem on asymmetric problem is less severe, and it will be easier for firms to issue securities. Information in developing countries is un engagelable to get as compared to developed countries. Therefore, banks have to play the role in producing information.CollateralCollateral which is property that promised to the lender if the lender default, reduces the adverse selection problem because it reduces the lender losses if the borrower goes into default.How righteous peril influences financial markets incorrupt happen occurs after the transaction takes place. It is the risk that the borrower may engage in questioning activities which is undesirable from the lenders point of view, because the loan may be unpaid.Because of the charge of moral hazard problems, firms find it easier to raise fund with debt instruments rather than with fair-mindedness contracts.Mor al hazard in comeliness contractsEquity contracts subject to a type of moral hazard known as principal-agent problem. In a firm, there are managers and stockholders. Usually, managers and stockholders are different people. Managers are the ones who have more information than the stockholders while the stockholders own most of the firms equity. The separation of ownership and control and with the presence of asymmetric information, managers may act in their own interest rather than the interest of the stockholder because managers have fewer inducements to maximize the shekels that the stockholder do.Tools to help reduce/solve moral hazard in equity marketsProduction of information monitoringTo reduce moral hazard problem, stockholders can engage in the monitoring of the firm activities by auditing the firm frequently and checking on what the management is doing. However, monitoring can be genuinely costly. (Monitoring is a costly state verification). This also explains in parts why equity is not an important element in the financial structure.However, this could also cause free-rider problem. Free-rider problem reduces the moral hazard problem. Because, when stockholder knows that other stockholders are paying for the monitoring activities, he can free ride on their activities. If all stockholders share the same mentality, no stockholders will be willing to pay for the monitoring activities.Government regulation to increase informationGovernments follow out laws to ensure that firms are adhering to accounting standards which can verify the profit easier, and apply penalties on people who committed fraud in hiding or stealing the profit. However, this measure is not very(prenominal) effective because managers have the incentive to make fraud difficult to be proven.Financial intermediaries active in the equity marketAn example of financial intermediaries is the venture capital firm which cans helps to reduce moral hazard arising from the principal-agent p roblem. They use fund of their partners to help entrepreneurs in setting up new businesses. In exchange for the use of funds provided by venture capital firm, venture capital firm get an equity shares in the new business. Because confirm profit is important in eliminating moral hazard, venture capital firms usually insist on having several(prenominal) of their own people to participate in the management of the firm. Also, the equity in the firm cannot be sold to anyone but to the venture capital firm. Therefore, other investors are unable to free-ride on the venture capital firms activities on verifying profit.Debt ContractsDebt contract is a contractual agreement by which the borrower promised to pay lender fixed amount at regular intervals. The amount of profit made by firm will not affect how much will the lender be receiving. Therefore, whether did the managers have been hiding or stealing profit or engaging in activities which do not increase the train of profit earned, it is of no concern to the lenders, so long as the firm is able to make payment. Only when the firm is unable to make payment as promised, then will the lenders have to know how much profit is the firm getting. As such, less monitoring is required for debt contracts and therefore, lowering the cost of state verification. This also explains why debt contracts are used more a great deal than equity contracts to raise funds.The concept of moral hazard explains why stocks are not the most important source of financing for businesses.How moral hazard influences financial structure in debt marketsAlthough debt contracts has lower moral hazard as compared to equity contracts, but debt contracts are still subjected to moral hazard. Because debt contracts only require firms to pay a fixed amount and allow them to custody profit above this amount, firms have an incentive to take on risky investment projectsTools to help reduce/solve moral hazard in debt markets qualification debt contract incent ive-compatibleHigh net worth makes the debt contract incentive-compatible it aligns the incentive of the borrower with that of the lender. Firms with higher net worth are more likely to act in the way that are desirable form the lenders point of view, and thus trim moral hazard problem, and it will be easier for firms to borrow.Monitoring and enforcement of constrictive covenantsBy introducing restrictive covenants into debt contracts, moral hazard problems are be reduced, as restrictive covenants is a provision which restricts firms activities by either ruling out undesirable behavior or encouraging desirable behavior.There are principally four types of covenants/Covenants to discourage undesirable behaviorsSuch covenants restrict firms to use the debt contracts to pay on fixed assets or inventories. Others may restrict firms to engage in risky activities such as acquiring other businesses. Covenants may also disallow firm to issue new debt or dispose it asset, and may also res trict dividend payments if ratios such as leverage ratio, ratio of debt to equity has up to a certain level.Covenants that encourage desirable behaviorSuch covenants require the borrower to have a life insurance that pays off the loan upon the death of the borrower. Such covenants may also encourage firms to keep it net worth high because firms with high net worth reduce the moral hazard problem. Hence, it minimizes the chance that the lenders may be making losses. These covenants require firms to avow minimum holding of asset relative to the size of the firm.Covenant to keep collateral valuableSuch covenants encourage borrower to keep the collateral in good condition and it must be in the possession of the borrower.Covenants to provide informationSuch covenants provide information about its activities periodically in the form of quarterly accounting and income reports. Such covenants may also allow the lender to audit the firms anytime.This explains why debt contracts are complica ted legal documents with restrictions on borrowers behavior.Covenants reduce moral hazard but do not carry away them, as it not difficult to rule out every risky activity. Also, to ensure that firms are complying with the covenants, monitoring must be enforced. However, monitoring is very costly. Investors may free-ride on the monitoring activities undertaken by other investors.Financial intermediaries, particularly banks are able to avoid the free-riders problems