1.

THE NATURE OF FINANCIAL INTERMEDIATION

- A financial claim: is a claim to the payment of a future sum of money and/or a periodic payment of mon

- Direct finance: The situation where borrowers obtain funds directly from lenders in financial markets.
For example, borrowing money directly from investors by selling stocks or bonds; in this financ

- Indirect finance: The situation where borrowers obtain funds indirectly from lenders through financial i
For example, borrowing money from a bank. The bank lends out depositors money to borrowers

2. THE ROLE OF BANKS

Banks bridge the gap between the needs of lenders and borrowers by performing a transformation function:

- Size transformation: refers to joining several small deposits by different surplus units to issue loans of
For example, 1000 surplus units deposit €1000 each with the bank, which in theory is able to iss

+ Savers/Depositors are willing to lend smaller amounts of money than the amounts required b

+ Banks collect funds from savers in the form of small-size deposits and repackage them into la

+ Banks perform this function exploiting economies of scale associated with the lending/borrow

• Economies of scale: Cost savings arising from decreasing unit cost of production as

- Maturity transformation: refers to the short-term nature of continuously incoming client deposits being
For example, demand deposits such as savings and current accounts can be converted in Home

+ Banks transform funds lent for a short period of time into medium-term and long-term loans

+ Banks’ liabilities are mainly repayable on demand or at relatively short notice

+ Banks’ assets are normally repayable in the medium to long term

+ ‘borrowing short and lending long’ may lead to ‘mismatch’ between banks’ assets and liabili
 - Risk transformation: means minimising credit risk: the risk of the funds deposited by savers and lent to

+ Individual borrowers carry a risk of default (credit risk) - the risk that they might not be able

+ Screening: The action undertaken by the less informed party to determine the information po
For example the action taken by a bank before giving a loan to gather information ab

3. INFORMATION ECONOMIES

- Transactions costs: relate to the costs of searching for a counterparty to a financial transaction:

- Economies of scale: Cost savings arising from decreasing unit cost of production as output increases.
Thanks to economies of scale, financial intermediaries reduce transaction, information and searc

- Economies of scope: Cost savings arising from joint production.

For example, the costs of a financial institution offering banking and insurance products are low
C(Q1,Q2) < C(Q1) + C(Q2)

not everyone has the same information

- Asymmetric information:
everyone has less than perfect information

some parties to a transaction have 'inside' information which is

- Adverse selection: occurs before transaction takes place, refers to the selection of borrowers who are mo

- Moral hazard: occurs after transaction takes place, refers to the incentives of borrowers to act 'immorall

- Principal-agent problem:

+ The agent can choose his or her behavior after the contract has been established

+ Managers in control (the agents) may act in their own interest rather than in the interest of sh
 - Free-rider problem: occurs when people who do not pay for information take advantage of the informa
For example: you purchase information that tells you which firms are good and which are bad.

4. THEORIES OF FINANCIAL INTERMEDIATION

- Delegated monitoring: Surplus units delegate the task of monitoring to specialised agents (i.e. banks) d

+ Delegated monitor: is a financial intermediary because it borrows from small investors (dep

- Information production: Banks have economies of scale and other expertise in processing information
For instance, surplus units could incur substantial search costs if they were to seek out borrower

+ As banks build up this information (e.g., the knowledge of credit risk associated with differen

+ As such they have an information advantage and depositors are willing to place funds with a
 d/or a periodic payment of money. More generally, a financial claim carries an obligation on the issuer to pay interest periodical

m lenders in financial markets.

g stocks or bonds; in this financing method a company or entity didn't pay interest rate.

rom lenders through financial intermediaries

depositors money to borrowers at a profit.

nsformation function:

surplus units to issue loans of large amounts to deficit units.

nk, which in theory is able to issue a loan of €1000000 to a company to finance the purchase of machinery equipment.

ey than the amounts required by borrowers.

osits and repackage them into larger size loans.

ociated with the lending/borrowing function

asing unit cost of production as output increases

y incoming client deposits being converted to longer-period loans to deficit units.

unts can be converted in Home Loans for 25 years.

ium-term and long-term loans

vely short notice

etween banks’ assets and liabilities, hence create problems in terms of liquidity risk
 deposited by savers and lent to borrowers. Banks do this by diversifying their investment funds, pooling risks, screening and mo

isk that they might not be able to repay the amount of money they borrowed. Savers wish to minimize risk and prefer their mone

o determine the information possessed by the informed party.

a loan to gather information about the creditworthiness of a potential borrower.

Obtaining information

Negotiating the contract

a financial transaction:
Monitoring the borrowers

The eventual enforcements costs should the borrower not fulfill its commitments

oduction as output increases.

ansaction, information and search costs mainly by exploting economies of scale.

and insurance products are lower than the costs of separate firms providing only banking and insurance services

ve 'inside' information which is not made available to both sides of the transaction.

ection of borrowers who are more likely to produce an adverse outcome for lender => Getting worse with higher interest rates

es of borrowers to act 'immorally' once loan is approved.

s been established

rather than in the interest of shareholders (the principals) because the managers have less incentive to maximize profits than shar
n take advantage of the information that other people have paid for.
ms are good and which are bad. You believe the purchase is worthwhile because you can buy securities of good firms that are und

pecialised agents (i.e. banks) due to the cost of doing by their own

rows from small investors (depositors), using unmonitored debt (deposits) to lend to borrowers (whose loans it monitors).

rtise in processing information relating to deficit units – this information may be obtained upon first contact with borrowers but i
they were to seek out borrowers directly. If there were no banks, then there would be duplication of information production cost

dit risk associated with different types of borrowers – ‘customer relationships’) they become experts in processing this informati

e willing to place funds with a bank knowing that these will be directed to the appropriate borrowers without the former having t
issuer to pay interest periodically and to redeem the claim at a stated value in one of three ways:

achinery equipment.
pooling risks, screening and monitoring borrowers, and holding capital and reserves to be able to make up for unexpected losses

mize risk and prefer their money to be safe

not fulfill its commitments

urance services

rse with higher interest rates

ve to maximize profits than shareholders

 rities of good firms that are undervalued so you will gain extra profits. But free-rider investors see that you are buying certain sec

whose loans it monitors).

rst contact with borrowers but in reality is more likely to be learned over time through repeated dealings with the borrower.
of information production costs as surplus units would individually incur considerable expense in seeking out the relevant inform

erts in processing this information.

wers without the former having to incur information costs.

make up for unexpected losses without affecting the savers badly.
e that you are buying certain securities and will want to buy the same.

ealings with the borrower.

n seeking out the relevant information before they committed funds to a borrower. An alternative is to have a smaller number of s
s to have a smaller number of specialist agents (banks) that choose to produce the same information.