Show How a Financial Intermediary Can Solve Problems That Ultimate Savers and Borrowers Cannot Easily Solve When Dealing Directly with Each Other
As Bain (1992; p.5) states, ‘Financial intermediaries are institutions which attempt to serve the needs of both lenders and borrowers and are often able to reconcile the divergent requirements of borrowers and savers.’ It is important to highlight that there are several different financial intermediaries; banks, building societies, insurance companies and pension scheme companies, but in this case the role of the bank as an intermediary will mostly be considered.
In everyday lending transactions the use of the direct method (ultimate savers and borrowers dealing directly with each other) is uncommon. It has now become widely accepted that the existence of financial intermediaries actually makes direct contact unnecessary. It is true that if savers and borrowers dealt directly with each other then it would remove costs associated with using an intermediary. However, the direct method is an expensive and inefficient method of lending as it gives rise to many problems relating to information costs, administration costs, portfolio preferences, risk, lender of last resort and contracts and enforcement. Problems associated with the direct route and the ways in which intermediaries can solve these problems will be identified:
Information costs
Search costs
Savers and borrowers have to find each other, obtain information about each other, meet each other and negotiate a contract. If dealing directly with each other, the individuals concerned would have to incur these costs. It is often difficult for savers and borrowers to locate each other. They could use a broker but this is an expensive method.
Verification costs
Before the loan is given, lenders must verify the accuracy of information being provided about the borrower. If this process is not carried out correctly this may lead to asymmetric information between the borrower and the lender and may result in adverse selection and moral hazard. Asymmetric information is where all parties in the
In everyday lending transactions the use of the direct method (ultimate savers and borrowers dealing directly with each other) is uncommon. It has now become widely accepted that the existence of financial intermediaries actually makes direct contact unnecessary. It is true that if savers and borrowers dealt directly with each other then it would remove costs associated with using an intermediary. However, the direct method is an expensive and inefficient method of lending as it gives rise to many problems relating to information costs, administration costs, portfolio preferences, risk, lender of last resort and contracts and enforcement. Problems associated with the direct route and the ways in which intermediaries can solve these problems will be identified:
Information costs
Search costs
Savers and borrowers have to find each other, obtain information about each other, meet each other and negotiate a contract. If dealing directly with each other, the individuals concerned would have to incur these costs. It is often difficult for savers and borrowers to locate each other. They could use a broker but this is an expensive method.
Verification costs
Before the loan is given, lenders must verify the accuracy of information being provided about the borrower. If this process is not carried out correctly this may lead to asymmetric information between the borrower and the lender and may result in adverse selection and moral hazard. Asymmetric information is where all parties in the
Bibliography: Bain, A. D. (1992) The economics of the financial system, Blackwell Carter, H. and Partington, I. (1989) Applied economics in banking and finance.4th edition, Oxford University Press Economist Online (2005) Economics A-Z, Adapted from Essential Economist, Profile Books. Available from: http://www.economist.com/research/Economics/alphabetic.cfm? Heffernan, Shelagh A. (1996) Modern banking in theory and practice, Wiley Lewis, M. K. (1987) Domestic and international banking, Philip Allan