Discuss the Major Outcomes of Financial Intermediation Essay

Financial Intermediation is referred to as an institution that acts as a ‘middleman’ per say between investors and firms raising funds (also known as financial institutions). These are firms such as chartered banks, insurance companies, investment dealers and pension funds. Matthews and Thompson (2008) pp.35–36 show that financial intermediaries can be established by four qualities: †¢ Their main category of liabilities (deposits) are specified for a fixed sum which is not related to the performance of a portfolio †¢ The deposits are typically short-term and of a much shorter term than their assets †¢ A high proportion of their liabilities are chequeable (can be withdrawn on demand) †¢ Their liabilities and assets are largely not transferable. There are exceptions such as certificates of deposit and securitisation (see Chapter 6 of this subject guide). Financial Intermediaries have a huge effect on the economy. Without such institutions firms may be unable to fund their day-to-day business activities which will put a lot of pressure on these said activities and may reduce production as a whole. If this happens it will have negative effects on the economy and may lead to a recession (depending on how big the firm is). An example of this can be taken from the beginning of the recession we have recently experienced which began in roughly 2007 ‘Credit Crunch’. The financial intermediaries in this case banks, were accepting most mortgage applications without thoroughly checking that the consumer could re-pay the funds. This act led to a huge negative outcome. It is important to distinguish between banks as financial intermediaries (who accept deposits and make loans directly to borrowers) and non-bank financial intermediaries who lend via the purchase of securities. The latter category includes insurance companies, pension funds and investment trusts who purchase securities, thus providing capital indirectly rather than making loans The passing of bad loans to individuals that are unable to pay will lead to damaging outcomes for the economy. If there is a substantial loan an individual has to pay off and their interest rate is ridiculously high, it will cause them to stop spending, leading to falls in other aspects of the market. On the other hand, financial intermediaries provide loans more freely than any other direct finance and they also provide a means to fund large operations of which a potential upcoming firm cannot fund from its personal capital. The dominance over direct finance is due to transaction costs (Benston and Smith, 1976), liquidity insurance (Diamond and Dybvig, 1983)and information sharing. As the transaction costs are likely to be less via such intermediaries they are a preffered financing method. Actions of financial intermediaries can have both positive and negative outcomes on the economy as they play a major role in the funding of all businesses. Without such intermediations the GDP of, say, the United Kingdom would decrease significantly as production would be reduced due to the lack of finances. References Financial Intermediation: NewYorkFed (Unknown) Hedge Funds, Financial Intermediation, and Systemic Ris, [Online] newyorkfed Available http://www.newyorkfed.org/research/epr/07v13n3/0712kamb.pdf Bhattacharya, S. and A.V. Thakor ‘Contemporary banking theory’, Journal of Financial Intermediation, 3(1) 1993, pp.2–50; Sections 1, 2, and 7 Diamond, D.W. ‘Financial intermediation as delegated monitoring: A simple example’, Federal Reserve Bank of Richmond Economic Quarterly, 82(3) 1996, pp.51–66 Saunders and Cornett (2006) Chapter 1, pp.2–10, 15–21 Matthews and Thompson (2008) Chapter 3