Banking and Financial Intermediaries

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Overview of Banking and financial intermediaries

Financial intermediation is the process by which funds are channeled between the surplus and deficit agents. On the other hand, financial intermediary is a financial institution that enables this process to happen by bringing together these two agents. In essence, financial intermediaries channel funds from those people willing to save or have sufficient money to those who want to borrow or lack sufficient money to carry out a certain activity (Boot, 2000).

A bank is therefore an example of a financial intermediary that facilitates the transfer of funds between lenders and borrowers. Loans and mortgages form most of these funds. Banks, as a financial intermediary, is like the pillar in enhancing operation of all other intermediary because at, one point or the other, they will need banks so as to work efficiently. Therefore, because of their nature and the role it plays, the economic prosperity of a country highly depends upon the banks (Bhattacharya, 1993).

Financial intermediaries thus provide for the achievement of three major functions. One of them is maturity transformation, which deals with the conversion of short term liabilities to long-term assets. The other is risk transformation, which deals with conversion of risky investments into risk free investment by lending to a number of borrowers so as to spread the risk. The last on is convenience denomination, which deals with comparing small deposits with large loans and huge deposits with small loans (Goldsmith, 1969).

The costs of intermediation in the banking system

This is the differences between the total costs of loans and the total returns received by the saver. This is what is referred to as the financial intermediation. Normally, such cost are incurred in the process of uplifting the competitiveness and efficiency of financial systems since such system are important in ensuring that the banking system is stable for both private and public sector financing.

High cost of financial intermediation in a low interest rate economy shows the presence of oligopolistic trends in the market (Pilbeam, 2005). Thus, if such trends exist then cost of financial intermediation may be influenced in part by some banking variables given that the strategies of each bank may affect the price of loans (Siklos, 2001). In such a scenario, big banks will be able to take advantage of economies of scale, indicate relatively low interest margins and spread higher overhead cost to customers.

The costs that are associated with intermediation in the banking system vary depending on the function and scope of activities banks engage in as financial intermediary. Some of these costs include agency costs, cost of location, cost of communication technology and research, and transaction cost.

Agency cost

It is an economic term that relates to the cost incurred by a firm and is associated with problems emanating from an agency relationship. This type of cost is normally referred to in the context of two main sources. It is the costs that are involved due to the use of an agent and the cost of technique that will be used to reduce the problem that occurs as a result of using an agent.

Thus, agency cost, in reference to intermediation in the banking system, normally refers to the extent in which the bank – as the agent and custodian of the lenders asset – are in conflict as a result of possible decline of fiduciary duty to the principal (lenders). This means that, in the event that the bank give loans to individual or corporation from the savings of the principal and fails to recover this amount (as and when the principal requires this amount), then an agency problem arises between the bank and the principal. This leads to agency costs.

Three variables lead to agency cost. The first is the divergence of control. The others include the contracting costs and separation of ownership. When a bank has debt, conflict of interest arises between the bank and the lenders. This causes banks to adopt selfish activities. This may be by imposing agency cost on the company. These costs are thus inevitable within the banking sector as long as the principals are not completely in charge. This means that banks will always be there to place security transactions for clients. This also means that agency cost will always arise.

Banks – being one of the financial intermediaries – owes a fiduciary duty to the people who have entrusted them with their money. However, this does not prevent them from holding a stable portfolio of share but the disposal of a failing stock may as well be considered a cheaper and safe way of protecting the saver. This is better than embarking on a costly rescue attempt, which – by so doing – the agency cost may be reduced tremendously.

Cost of location

Cost of location is another fundamental concept of intermediation cost in the banking system. This comes in form of location barriers, which primarily are geographical and results from the spatial localization of bank branches. Certain studies have shown that location of banks is a key factor in enabling access to the banking system and significantly determining cost of location (Valdez, 2007).

Financial intermediation, being the fundamental service for efficient operation of an economy, ensures that the benefit from its growth spreads to all the segments of society. In achieving this, location costs are incurred. There is evidence of location of banking services in certain US cities that are known to attract huge location cost within the banking firms (Chang, 1997).

The localization factors for bank branches are linked to location strategies that are the sole determinants of the location cost. Banks recognize that the spatial distribution of their market in terms of customers, branches and competitor’ branches is not equal and will make strategic location in a city very advantageous but a lot of location cost will be incurred. Therefore, the motivating factor that enables banks to incur such costs is to be able to maximize three key factors. These include sales of banking services, access to potential customers and overall bank earnings.

Cost of communication technology

Information technology adoption in the banking sector is the primary reason why banks incur communication technology cost. However, this cost is not only associated with banks as a financial intermediary but it spans all round in banking services and functions. There are various approaches to studying the effect of information communication technologies on banks. These include technologies assessment and economies approach.

Technological assessment normally states objectively, both the positive and negative impacts of communication technology in the banking systems. It explores the possible risks and advantages that can be experienced by a bank in both the present and the near future. Banks are currently adopting the electronic payment system and an increase in efficiency is enhanced. However, there have been great concerns by policy makers, especially concerning the safety. These concerns and others that scrutinize the effectiveness of communication technologies are the major causes of the communication technology cost in the banking sector.

The use of information technology in the banking sector leads to the reduction of asymmetric information which causes adverse selection problem. This takes place before a transaction occurs and is related to the lack of information about lenders. In addition, the moral problems take place after a transaction has occurred and is related to lenders incentive to be opportunistic. Basically, financial intermediaries exist so as to overcome problem associated with informational asymmetries in markets. Therefore, the cost of communication technology is inevitable if informational asymmetries have to be dealt with.

The rapid advancement of information technology has enhanced the various banking and financial services to be much faster, cheaper and efficient. However, these technological resources consume a large part of bank resources and form a sizeable amount of the banks budget.

Research and transaction cost

Financial intermediation comes with the existence of research and transaction cost. A certain study shows that different writers interpret the transaction cost as the cost of transportation, administration, evaluation, research, search and monitoring (Strahan, 1999). These costs are associated with the fact that banks enjoy certain economies of scale and scope as they engage in the different tasks. This includes engaging in the trade-off between maintaining cash and financial assets of shoe leather cost, which have been hugely ignored in the micro economic theory.

In the presence of transaction cost, banks align consumption duration with portfolio duration. This is because the long-term security fetches lower prices on intermediary dates. Transaction costs have been found to have a cyclical effect that are nonlinear and are subject to change over time, which suggests that these costs are also subject to political economic environment.

Banking activities normally have two types of transaction cost. They include interest expense that indicate the costs of funds for banking activities and noninterest expense (which indicate the cost associated with information and coordination). Therefore, the total transaction cost is the sum of the interest expense and the noninterest expense. Interest expense has shown an increasing trend over the years while the noninterest expense seems to have a diminishing trend.

The benefits of intermediation in the banking system

Financial intermediation benefits evolve from the national and international financial markets, which are determined by informing the users and by the involvement of the financial intermediaries through offering consultation services. This happens to both the investors and the users of the capital, gathering and valuing vital existing information in the financial markets. It is also involved in offering enticing incentives to the investors and capital users who make use of the financial intermediaries. In light of these aspects, financial intermediation has, over time, contributed and continues to do so through allocation of capital resources and avoiding risk whilst at the same time making profit (Thakor, 1993).

Reduce search and transaction costs

Financial intermediaries not only reduce transaction costs but also solve inefficiencies due to asymmetric information and align incentives through active monitoring. However, there is limited research on how intermediaries reduce transaction costs. Intermediaries reduce search costs by acting as matchmaker to investors and potential capital users hence saving both parties from the hustle of finding the perfect match (Campbell, 1980).

Analysis shows that, apart from the reduced number of transactions, there is an additional advantage of intermediated economies as opposed to exchange economies in the latter severe cyclical pattern, which cannot be escaped from in the case of small transaction costs.

Reduce risk

Lenders who invest their money through financial intermediaries reduce their risk by a great margin. Lending directly is extremely risky. It also lacks diversity. Financial intermediaries provide diversity through lending many loans and although some of these loans may be defaulted, the losses incurred can easily be offset from the cleared ones.

In the absence of financial intermediaries, an investor could directly make a few loans and should make some default. He or she would incur substantial losses. By employing the services of financial intermediaries, depositors are insured from incurring these huge losses (Klingebiel, 2000).

Through repeated lending of loans, financial intermediaries learn how to tell the individuals capable of repaying the loans apart from the ones most likely to default. With this knowledge, they can be able to further reduce the risks involved. In essence, financial intermediaries turn risky assets into virtually safer ones for the benefit of both investors and themselves as they gain profits from the returns of the investments made once the initial capital outlay has been set aside.


Financial intermediaries provide liquidity to savers. Although, in some cases, the intermediaries may use the funds to make illiquid loans, there is usually enough money left in the reserves in case savers wish to make withdrawals. There could be a hitch if the depositors want to withdraw substantial deposits. Should such a scenario occur, the financial intermediary could obtain help from the government or other institutions. If that does not pan out, it will be forced to suspend payments to depositors (Blum, 1999)

The primary function of banks is to lend money to individuals and groups. Apart from that, banks also borrow and levy funds among themselves in the federal-funds market. In addition, banks do buy and sell commercial debts and foreign exchange (Berger et al., 1999).

Economists usually worry that financial intermediaries can cause an interruption in the normal flow of economic life. This is because banks debts serve as money and because financial intermediaries are related by chains of assets and debts. Money in circulation can be affected if there is any form of interruption in the banks. The relation of intermediaries also extends to their failures. The failure of one intermediary can weaken the rest and inevitably increase their chances of failure. Failure of a key intermediary could lead to a domino effect and may crumble the financial sector. Financial intermediaries increase investors’ welfare and enhance economic growth. They are also suppliers of liquidity (Diamond, 1984).

Regulation in the banking industry and the ongoing financial crisis since 2007

The ongoing financial crisis since 2007 has been referred to as the Global Financial Crisis. It is considered one of the worst financial crises, which resulted in the fall of large financial firms and led to the collapse of stock market around the world. This affected many areas including the housing market, consumer wealth, key businesses and the general economic activity. This subsequently led to a global economic meltdown in 2008.

Financial analysts said that this crisis was caused at two levels. The first level was the global macro policies that affect liquidity. The other cause was the extremely weak regulatory framework. This led to rapid fall in interest rates among the stable economies of the world, with countries like the United States having one percent and Japan zero percent.

The crisis was triggered by problems in the United States. She had liquidity problems in her banking system and the housing sector, which got to a high in 2007. This affected financial institutions and investors all over the globe. The investor confidence was given a blow and as a result, their investments reduced. This automatically affected the stock market around the globe.

The global financial crisis has also led to the collapse of large financial institutions making the wealthiest nations to design rescue strategies to pull them out of the ongoing crisis (Bernanke, 1983).

The financial crisis has elicited different reactions worldwide. Some people strongly feel that the impact and incidences of this crisis are not the same for everyone. They feel that the people who are directly responsible for the crisis have been let off rather easily and innocent people have been left to suffer instead.

Money lending institutions also contributed to the crisis. They stopped relying on savers as their primary source of funds and instead, borrowed loans from other banks and sold the loans as securities. This made defaulted loans a problem to whoever bought the securities. On the other hand, investment banks, a good example being the Lehman Brothers, contributed to the crisis through the buying of mortgages with an aim of securitizing them and eventually selling them (Hellwig, 2009).

There was less money in circulation as a result of banks with large reserves running out and turning to the government for more money. This enabled them to lose more money without severe consequences but it was still not enough. Depletion of the government kitty by the banks led to the thinning of the economy. This also happened when banks became more careful when lending money. This move largely affected businesses that were heavily reliant on credit.

The real cause of the crisis was the fact that the money-lending institutions hedged funds and some of them became too cocky. They thought they had understood all aspects of risks involved in moneymaking. The higher the risks they took, the higher the returns. However, when they fell, they fell very hard (Simkovic, 2009).

Since the onset of the crisis, banks have started taking measures to curb it. They are involved in making sure that all the deposits to the banks are covered. By so doing, the discrepancies between the covered and non-covered institutions are avoided.

Banks have since separated good assets from the bad ones and have since disposed off the toxic assets. Governments nationalized banks, cleaned up the bad assets and then when they were in good shape, they sold them back to the private sector (Claessens et al., 2000).

Developing countries, which more often than not have been sidelined in the monetary policymaking, should be actively involved in the reforming of the international banking institutions such as the World Bank and the International Monetary Fund.

Increasing the bank reserves will enable banks have sufficient funds to issue loans and to be able to withstand huge withdrawals by its clients. It also avoided instances where banks had to turn to their governments for help to supplement their reserves.

Economists are of the view that certain aspects such as the introduction of a bankruptcy code will facilitate debt restricting and make credit hard to find even during stable financial periods.

Credit rating agencies that play a huge role in inflicting damage should be reined in because they gave a go ahead to the acquisition of toxic assets. Therefore, these agencies need to be highly regulated or better yet, to be done away with and replaced with an international public body.


Financial intermediation costs and benefits vary with the extent of wealth of the economy, pooling of resources as well as liquidity risks, which enable the financial intermediary’s economy to have a higher level of wealth. It also leads to the increase in the liquidity insurance. Therefore, financial intermediaries can be able to find balance between liquidity needs and the preference agents as well as the highest return of the technologies.

The presence of the ongoing crisis can be seen to have both benefits and threats for public policies on the foreign direct investment. The future problems associated with the crisis involves the risk of shifting the strategies away from attaining a pro-investment and pro-business environment.

It is advisable to go beyond the mere short-term measures that have been employed and set up more long lasting measures. For this to be achieved, international coordination is vital in order to achieve more control over banks and hedging institution.

For the building of financial multilateralism, strong transparency as well as full disclosure should be promoted. Funds should be set aside to aid developing countries with their debts and reinforce the importance of public policies and regulations.


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