Role of Transaction Cost in Intermediation Process - Assignment Example

? Finance and Accounting Assignment Table of Contents Role of Transaction Cost in Intermediation Process 3 Role of Asymmetric Information in Intermediation Process 4 Adverse Selection 6 Moral Hazard 7 References 9 Role of Transaction Cost in Intermediation Process A financial intermediary is a financial institution that brings together an entity with surplus funds with an entity with deficit funds. Such intermediary serves the purpose of proper channelling of funds in the economy. Transaction costs are the main issues related to financial intermediary. This is because transaction cost reduces the profit margin. The transaction cost increases whenever an individual or corporate raises funds from the financial intermediaries (Chandra, 2011, p.32). For instance, when the bank acts as intermediary it connects individuals with different needs, financial inputs at different point of time. It allows people to save money into various accounts like savings account, time deposits, salary account, pension funds, and so on. After the bank accepts deposits from an individual it invests that sum into projects which have returns greater than or equal to the cost of investment which is also the bank’s liability. Now, if any corporate or individual approaches the bank for loan, the bank will charge interest on that loan. This interest will increase the transaction cost of the individual or corporate. The interest charged on loans by the bank on the borrower will obviously higher than what the bank has to pay to the depositors. This is because in order to operate in the market and serve the community it has to maintain a profit margin for all transaction which otherwise would lead to collapse of business. The advantage that an individual or a corporate will get from an intermediation process is that the credit risk is transferred from individual borrower to the bank. This is because when a corporate raises funds from market directly without any intermediation, the credit risk of parties to transaction has to be evaluated personally. This is true in case of over-the-counter markets where the contracts are much customised according to individual requirements and parties to contract enter into agreement with each other without any intermediary. This reduces their transaction cost but also increases the credit risk. When an intermediary is introduced in the same model as in case of exchange traded funds, the transaction cost increases due to brokerage charges, maintenance fee, printing and advertising charges, commissions, and so on. The various costs are passed on to the fund raiser and hence decreasing the transaction cost of the individual from intermediation process (Buckle and Thompson, 2004, p.37). From the above discussion, the role of transaction cost in the intermediation can be summarised as follows. The intermediation process aims to connect the individuals with surplus funds with individuals with deficit funds in order to channel funds properly in the economic system. In the process of intermediation the individuals and corporate is able to reduce search cost of raising funds, verification cost, monitoring cost, and credit worthiness of the parties involved in transaction. Since the intermediary provides these services, it charges a fee or commission for providing these services which increases the cost of transaction from intermediation process but such cost is much less compared to the benefit from intermediations (Mishkin and Eakins, 1998, p.369). For instance, the banks offer standardised services and products that reduce cost of transaction and the risk of investment. The OTC market mainly operates without intermediation and is hence a much more risky option. Role of Asymmetric Information in Intermediation Process In order to understand the role of asymmetric information in the intermediation process, it is important to understand the concept of asymmetric information. Asymmetric information arises from a situation when one party to transaction has more information compared to the other. This is generally true in case when the seller knows more than the buyer although the reverse can also happen (Buckle and Thompson, 1998, p.32). For instance, the seller generally sells after keeping sufficient margin of profit. When the buyer is absolutely unaware of the true cost of items, the seller would be in a position to make super profits by charging more than the true worth of product. This means that asymmetric information can become a harmful situation since one party can take advantage of the other’s unawareness. The role of asymmetric information in the intermediation process is concerned with credit worthiness in the market. Consider a situation when the lenders’ offers credit to the borrowers. The lenders may be banks, financial institutions, individuals, corporate, etc. They face uncertainty about the credit worthiness of borrower in the sense as to how much the borrower will be able to pay back the outstanding loan amount along with the interest. The biggest issue which can rise from asymmetric information is the moral hazard and adverse selection. In order to reduce the impact of asymmetric information, lenders gather proprietary information about the borrowers’ creditworthiness. This process helps them to get an idea about their clients that can help them to formulate interest rates which are unjustified and above market rates. Thus, it can be said that asymmetric information can be very harmful for individuals lacking proper knowledge. The asymmetric or private information in the hands of intermediaries causes the group of participants to claim higher interest rates. These rates will be received by the lead banker that leverages asymmetric information to obtain excess premium. The information asymmetry was one of the reason to cause the current financial crisis as many investors took risk aggressively which they actually do not understand. The innovative derivative products attracted the individuals who have limited knowledge about the creditworthiness of the borrowers (Bebczuk, 2003, pp.3-7). In a classic syndicate lending the lead banker is situated at the core of syndication that helps other bankers to make deals by financially assisting them. The lead bankers are like the guarantors who would pay off bad loans in case the core participant bankers fail to repay loans. The arranger or the lead directs the participants since the later lacks proper experience and knowledge to handle large transactions. Other reason may be that the participants do not have required net worth to finance critical loans immediately. Thus, in this type of intermediation, the participants rely greatly on the arranger. The participants also depend on the arranger to evaluate the credit of the borrowing firm. After issuing loans, the process of customer relation and monitoring is delegated to the arranger. This means that the arranger will actually have more information about the borrower compared to the participant bankers. This information asymmetry will give a chance to the arranger to charge higher interest rates to the participants due to cost attached from monitoring loan accounts and services rendered to customers. In this case if the participants are not aware of the true creditworthiness of the borrower, the asymmetric information will affect the cost of loan and intermediation process by increasing the total cost of transaction from intermediation process which will be passed on to the borrower. In case the borrower defaults, the participant as well as the arranger banks will suffer in terms of non-performing assets or bad loans. With improved advancements in technology and availability of information to public globally through the internet, asymmetric information in the market is declining. The internet has given access to more and more people about all types of information and as well as compare it with the industry benchmarks. Adverse Selection Adverse selection results from asymmetric information between the buyers and sellers in markets. It is an ironical situation where the buyer actually wants the good product or services but ends up selecting the bad ones due to information asymmetry. Consider an example where a bank sets differential prices for rendering services to customers on the basis of profitability, balance and creditworthiness of the customers. Thus, in this situation the customers who are more active in term of profitability and credit will obviously enjoy much more benefits and less transaction costs compared to individuals with lower credit ratings. The term adverse selection is primarily used in the insurance sector and refers to situation when either the seller or buyer of product has more knowledge about the product’s quality. The party to transaction having more knowledge about the product will be in better position to estimate the true worth of the product. In case of insurance sector, adverse selection simply means that the products will be much more costly than they actually ought to be. This also means that insurance is supposed to be more costly for healthy individuals where as they are less costly for unhealthy individuals requiring medical attention. But, the insurance companies cannot determine the every individual’s health profile and then price their products. This is the reason as to why insurance products are underpriced for bad products and overprices for good products. If the products are not managed properly, adverse selection might occur for the buyer leading to selection on bad policies that might cause the company substantial loss of money (Nachane and Chatterjee, 2006, p.74). Moral Hazard Moral hazard is a situation when one individual takes risks while the cost of risk will be felt by another party. Such tendency of taking more risk after knowing that the potential cost of taking risk will be taken by others lead to 2008 Mortgage crisis in US. People generally take risk when they are paid incentives to do so (Taylor and Weerapana, 2009, p.484). The concept of moral hazard states that a trade off between risk and return balances the consequences (Arnold, 2008, p.666). Consider an example that if people get unlimited car insurance they will bother less about their car. This is a moral hazard since the individual will misuse the benefits of insurance. Moral hazard states that if people feel that they are insulated from taking risk in terms of financial cost of transactions, then their risk taking appetite will increase. In the year 2008, the impact of moral hazard was felt globally when the regulators pumped money into the system while home owners walked away for mortgages. Ultimately the government had to bail out the distressed firms from financial crisis. But ironically, such bailouts by central banks or other financial institutions can increase the risk taking tendency in the markets leading to increased burden of potential losses on the lending institutions and government. From the above discussion it can be said that the mortgage securitization contributes to moral hazard by passing the risk to third party who are not original parties to contract. Moral hazard also occurs with the borrowers who spends money carelessly ultimately leading to default and losses. For instance, the credit card companies limit the borrowing limit of individual because without such limits the individual might spend money irresponsibly and ultimately default. References Buckle, M. J. and Thompson, J. L., 2004. The UK Financial System. 4. United Kingdom: Manchester University Press. Buckle, M. J. and Thompson, J. L., 1998. The United Kingdom Financial System: Theory and Practice. 3. United Kingdom: Manchester University Press. Chandra, P., 2011. Financial Management. 8. New Delhi: Tata McGraw-Hill Education. Mishkin, F. and Eakins, S. G., 1998. Financial Markets and Institutions. 6. New Delhi: Pearson Education India. Bebczuk, R. N., 2003. Asymmetric Information in Financial Markets: Introduction and Applications. United Kingdom: Cambridge University Press. Nachane, D. M. and Chatterjee, B., 2006. The Economics of Asymmetric Information. New Delhi: Deep and Deep Publications. Arnold, R. A., 2008. Economics. United States: Cengage Learning. Taylor, J. B. and Weerapana, A., 2009. Principles of Microeconomics. United States: Cengage Learning. Read More