FUNCTION OF FINANCIAL

INTERMEDIARIES: INDIRECT
FINANCE
Christopher B. Tagnipis
 Funds also can move from lenders to borrowers by a
second route called indirect finance because it
involves a financial intermediary that stands between
the lender-savers and the borrower-spenders and
helps transfer funds from one to the other.
How does this work?
 A financial intermediary does this by borrowing
funds from the lender-savers and then using these
funds to make loans to borrower-spenders.

 The process of indirect finance using financial

intermediaries, called financial intermediation, is the
primary route for moving funds from lenders to
borrowers.
Why are financial intermediaries
and indirect finance so important
in financial markets?
To answer this question, we need to
understand the role of transaction costs,
risk sharing, and information costs in
financial markets.
1. Transaction Costs
 Financial intermediaries can substantially reduce
transaction costs because they have developed
expertise in lowering them and because their large
size allows them to take advantage of economies of
scale.
 Financial intermediary’s low transaction costs mean
that it can provide its customers with liquidity
services, services that make it easier for customers
to conduct transactions.
2. Risk Sharing
 low transaction costs of financial institutions is that
they can help reduce the exposure of investors to
risk—that is, uncertainty about the returns investors
will earn on assets.

 Financial intermediaries do this through the process

known as risk sharing.
asset  They create and sell assets
transformation with risk characteristics that
people are comfortable with,
and the intermediaries then
use the funds they acquire by
selling these assets to
purchase other assets that
may have far more risk.
Diversification

 entails investing in a collection

(portfolio) of assets whose returns do
not always move together, with the
result that overall risk is lower than for
individual assets
3. Information costs
 one party often does not know enough about
the other party to make accurate decisions.
This inequality is called asymmetric
information.

Which results into two problems…

Adverse selection
 Created before the transaction occurs.
 It occurs when the potential borrowers
who are the most likely to produce an
undesirable (adverse) outcome—the
bad credit risks—are the ones who most
actively seek out a loan and are thus
most likely to be selected.
Moral hazard
 Created after the transaction occurs.
 the risk (hazard) that the borrower
might engage in activities that are
undesirable (immoral) from the lender’s
point of view because they make it less
likely that the loan will be paid back.
Economies of Scope and Conflicts of
Interest
 Economies of scope, they can lower the cost of
information production for each service by applying
one information resource to many different services.

 Conflicts of interest are a type of moral hazard

problem that arises when a person or institution has
multiple objectives (interests) and, as a result, has
conflicts between those objectives.
Types of Financial Intermediaries
Depository Institutions: we refer to these as banks;
financial intermediaries that accept deposits from
individuals and institutions and make loans.

a. Commercial Banks raise funds primarily by issuing

checkable deposits, savings deposits and time deposits.
They then use these funds to make commercial,
consumer, and mortgage loans and to buy
government securities and municipal bonds.
b. Savings and Loan Associations (S&Ls) and Mutual
Savings Banks These depository institutions, of which
there are approximately 900, obtain funds primarily
through savings deposits (often called shares) and time
and checkable deposits.

c. Credit Unions are typically very small cooperative

lending institutions organized around a particular group:
union members, employees of a particular firm, etc. They
acquire funds from deposits called shares and primarily
make consumer loans.
Contractual Savings Institutions: acquire funds at
periodic intervals on a contractual basis. Because they
can predict with reasonable accuracy how much they
will have to pay out in benefits in the coming years.

a. Life Insurance Companies insure people against

financial hazards following a death and sell annuities
(annual income payments upon retirement).
b. Fire and Casualty Insurance Companies insure
their policyholders against loss from theft, fire, and
accidents. They are very much like life insurance
companies, receiving funds through premiums for
their policies, but they have a greater possibility of
loss of funds if major disasters occur.

c. Pension Funds and Government Retirement Funds

provide retirement income in the form of annuities to
employees who are covered by a pension plan.
Investment Intermediaries: This category of financial
intermediaries includes finance companies, mutual
funds, money market mutual funds, and investment
banks.

a. Finance companies raise funds by selling

commercial paper (a short-term debt instrument)
and by issuing stocks and bonds.
c. Mutual Funds acquire funds by selling shares to
many individuals and use the proceeds to purchase
diversified portfolios of stocks and bonds.

d. Money market and mutual funds- have the

characteristics of a mutual fund but also function to
some extent as a depository institution because they
offer deposit-type accounts.
e. Hedge funds are a type of mutual fund with
special characteristics. Hedge funds are organized
as limited partnerships with minimum investments
ranging from $100,000 to, more typically, $1
million or more.

f. Investment Banks does not take in deposits and

then lend them out. Instead, an investment bank is a
different type of intermediary that helps a
corporation issue securities.
Regulation of the Financial System
The government regulates financial
markets for two main reasons:

 to increase the information available to investors

 to ensure the soundness of the financial system.

Increasing Information Available to
Investors
 Asymmetric information in financial markets means
that investors may be subject to adverse selection
and moral hazard problems that may hinder the
efficient operation of financial markets.

 As a result of the stock market crash in 1929 and

revelations of widespread fraud in the aftermath,
political demands for regulation culminated in the
Securities Act of 1933 and the establishment of the
Securities and Exchange Commission (SEC).
 SEC requires corporations issuing securities to
disclose certain information about their sales, assets,
and earnings to the public and restricts trading by
the largest stockholders (known as insiders) in the
corporation.
Ensuring the Soundness of Financial
Intermediaries
 Asymmetric information can lead to the widespread
collapse of financial intermediaries, referred to as
a financial panic.

To protect the public and the economy from financial

panics, the government has implemented six types
of regulations.
1. Restrictions on Entry- tight regulations governing
who is allowed to set up a financial intermediary.
Only if they appear to be upstanding citizens with
impeccable credentials and a large amount of initial
funds will they be given a charter.

2. Disclosure- Reporting requirements for financial

intermediaries are stringent. Their bookkeeping must
follow certain strict principles, their books are subject
to periodic inspection, and they must make certain
information available to the public.
3. Restrictions on Assets and Activities- Financial
intermediaries are restricted in what they are
allowed to do and what assets they can hold. This
is to restrict the financial intermediary from
engaging in certain risky activities.

4. Deposit Insurance- insure people’s deposits so

that they do not suffer great financial loss if the
financial intermediary that holds these deposits
should fail.
5. Limits on Competition- Politicians have often
declared that unbridled competition among
financial intermediaries promotes failures that will
harm the public.

6. Restrictions on Interest Rates- Competition has

also been inhibited by regulations that impose
restrictions on interest rates that can be paid on
deposits.