The presence of transaction costs makes it very difficult for a potential lender to find an appropriate borrower. There are four main types of transaction costs: Search costs: both lender and borrower will incur costs of searching for, and finding information about, a suitable counterparty. Verification costs: lenders must verify the accuracy of the information […]
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This is an important concept in finance and needs to be fully understood. Asymmetric information refers to the situation where one party to a transaction has more information than the other party. This is a problem with most types of transactions, not just financial, and a classic example is provided by the sale/purchase of a […]
A financial intermediary is able to hold the long-term, high-risk, claims issued by borrowers and finance this by issuing deposit claims with the characteristics of low-risk and short-term (often repayable on demand). The financial intermediary therefore transforms the characteristics of the funds that pass through it. A financial intermediary is said to mismatch the maturity […]
If lenders incur lower transaction costs by lending to an intermediary, such as a bank, compared to lending directly to a borrower then lenders will choose to lend to (deposit money with) a bank. Similarly, borrowers will prefer to borrow from a bank if the information costs (mainly search costs) are lower than direct borrowing. […]
The problem of adverse selection can be solved by the production of more information on the circumstances of the borrower. This can be done through private companies collecting and publishing information on firms’ balance sheet positions and financial statements. In the US, firms such as Moody’s and Standard and Poor’s do this. The information helps […]
The Hirschleifer model This model allows us to consider the effects of the creation of a financial system that allows lending and borrowing to take place. The precise mechanism for the lending and borrowing are not important and could come either from the development of capital markets or financial intermediaries. What is important is that […]
There is evidence that traditional banking (i.e. financial intermediation) has declined in recent years in countries such as the US, Germany and the UK. The main reasons for this decline are: Low cost deposits from the public are not as readily available as a source of funds. Alternative liquid investments offering higher returns have taken […]
The effects of financial intermediation on economic development A reduction in transaction costs and other frictions, such as asymmetric information, which result from the presence of financial intermediaries. The demand for credit is represented by the line D–D, with the normal downward slope. The supply of credit is considered to respond positively to increases in […]
Retail banks have traditionally provided intermediation and payments services to individuals and small businesses with all the components of those services supplied by the bank. However it is becoming increasingly difficult to identify the nature of a retail bank. Firstly because many banks now combine both retail and wholesale activities. Secondly because technological developments have […]
It is becoming more and more difficult to define a retail bank. Traditionally, retail banks provided banking services to individuals and small businesses dealing in large volumes of low value transactions. This is in contrast to wholesale banking which deals with large value transactions, generally in small volumes. In practice it is difficult to identify […]
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