Assignment 3 - Function of Financial Intermediaries
Assignment 3 - Function of Financial Intermediaries
Assignment 3 - Function of Financial Intermediaries
BSA -2
Transaction costs, the time and money spent in carrying out financial
transactions, are a major problem for people who have excess funds to lend.
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, the reduction in
transaction costs per dollar of transactions as the size (scale) of transactions
increases. Because financial intermediaries are able to reduce transaction
costs substantially, they make it possible for you to provide funds indirectly to
people like Carl with productive investment opportunities. In addition, a
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.
Another reason why financial intermediaries play such an important role in the
economy is that by providing multiple financial services to their customers, such as
offering them bank loans or selling their bonds for them, they can also achieve
economies of scope; that is, they can lower the cost of information production for
each service by applying one information resource to many different services. An
investment bank, for example, can evaluate how good a credit risk a corporation is
when making a loan to the firm, which then helps the bank decide whether it would be
easy to sell the bonds of this corporation to the public. Although the presence of
economies of scope may substantially benefit financial institutions, it also creates
potential costs in terms of conflicts of interest. 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. Conflicts of
interest are especially likely to occur when a financial institution provides multiple
services. The potentially competing interests of those services may lead an individual
or firm to conceal information or disseminate misleading information. We care about
conflicts of interest because a substantial reduction in the quality of information in
financial markets increases asymmetric information problems and prevents financial
markets from channeling funds into the most productive investment opportunities.
Consequently, the financial markets and the economy become less efficient.
2. Credit Unions
These financial institutions, numbering about 7,000, are typically very small
cooperative lending institutions organized around a particular group: union members,
employees of a particular firm, and so forth. They acquire funds from deposits called
shares and primarily make consumer loans.
3. Savings and loan associations
4. Finance companies
5. Pension funds
Private pension funds and state and local retirement funds provide retirement
income in the form of annuities to employees who are covered by a pension plan.
Funds are acquired by contributions from employers and from employees, who either
have a contribution automatically deducted from their paychecks or contribute
voluntarily. The largest asset holdings of pension funds are corporate bonds and
stocks. The establishment of pension funds has been actively encouraged by the
federal government, both through legislation requiring pension plans and through tax
incentives to encourage contributions.