The Concepts of Financial Intermediation - Essay Example

(Please fill-in information and also do not forget to edit the header with on it) The Concepts of Financial Intermediation Financial intermediations is a hot topic of debates nowadays; as the arguments arise whether there is really a need for financial intermediations or is it still important or the least active in today's modern financial system. In order to provide firm stand proving that financial intermediations are still active and by fact plays an important role in the financial system, first a need to review the principles of the theory of financial intermediation is necessary. Fundamentally, we may differentiate these principles according to three arguments on the existence of financial intermediaries: A. The argument on informational asymmetries - Market imperfections are generated because of the informational asymmetries like divergence from the neoclassical structure of financial system. A lot of these imperfections lead to particular types of transaction costs. These asymmetries can produce unfavourable selection, they can be temporary, generate moral exposure, and they can result a costly verification and enforcement. Based on studies, financial intermediaries emerge to at least partially overcome these costs. Leland and Pyle (32) interpreted financial intermediation as a coalition of sharing information. And intermediary coalitions according to Diamond (51) can achieve economies of scale. He also envisioned that financial intermediaries act on behalf of ultimate savers by effectively monitoring returns. According to Hart (1995), savers positively value the intermediations in terms of ultimate investments. On banker's behalf, according to Campbell and Kracaw (863-882) financial intermediations can create a constructive incentive result of short-term debt. The deposit finance can produce the right incentives for the management of the bank. A delicate financial structure needed to discipline the bank managers resulted illiquid assets (Diamond 393; Miller 21). In cases wherein the bank borrower preferred direct finance; financial intermediaries still act as a brokerage which was explained by Fama (39-58) as investment banks. In this, reputation is at stake and according to Campbell and Kracaw (885) in financing, the borrower's reputation as well as the financier is relevant. B. The transaction costs approach argument- This approach does not disagree with the statement of complete markets unlike the first approach mentioned. It is in accordance with a no convexities transaction process. The financial intermediaries in this approach work as alliances of borrowers who make use of economies of scale in the transaction process. According to many experts, the concept of transaction costs covers not only monetary transaction costs, but also searches, auditing and monitoring costs. In this instance, the function of the financial intermediaries is to convert particular financial claims into a so-called qualitative asset transformation. Ross (23-40) called it offering liquidity and diversified opportunities. The stipulation of liquidity is a key function for investors and savers and highly for corporate customers, in which the stipulation of diversification is being appreciated in institutional as well as personal financing. This liquidity should play a key role in asset pricing theory (Oldfield and Santomero WP #95). With transaction costs the basis for the existence of financial intermediation is exogenous. C. Approach based on the regulation of money production - Regulation influences liquidity and solvency within the financial organization or market. It is argued that the capital of the bank affects its refinancing ability, bank safety, and ability to extract repayment from the borrowers (Diamond 414). Regulation as viewed on the basis of legality convenes as a vital factor in financial economy. However, the actions of the intermediaries intrinsically need regulation. The reason is that the banks specifically, are intrinsically illiquid and insolvent. Regulation of financial intermediaries, banks in particular, is expensive. It is due to the direct costs of employing the supervisors and administration, and the indirect costs of the deformations caused by prudential and monetary supervision. Regulation though, may also produce rents for the regulated financial intermediaries, as it may hinder market entry and exit. Consequently, there is a factual active connection between financial production and regulation. Fohlin (WP1088) attempted to build up theories that give explanation to the existence of the very broad guideline of financial intermediaries when enter the dynamics of financial regulation. . Regulation offers the foundation for the intermediaries to ratify in the making of their financial services. As discussed, financial intermediation has below importance to the financial system in accordance to the different approaches of financial intermediaries: 1. Financial intermediaries, banks specifically, act as agents or mediators and as delegated monitors- information gaps between investors and ultimate savers. This is because financial intermediaries have a qualified informational edge over investors and ultimate savers. 2. Financial intermediaries monitor and screen financiers on behalf of savers. Those are their fundamental function, which explains the transaction costs they charge. This in view of financial side is agreeable in terms of the advantage these intermediations can produce. 3. Financial intermediaries also link or connect the maturity disagreement between investors and savers and assist on dealing with payments among two parties by offering a payment arrangement and clearing scheme. 4. Consequently, financial intermediaries work best in qualitative asset transformation. 5. Fascinatingly, and demonstrating the vital significance of regulation for financial intermediation, is that unregulated finance would be extremely enviable, as it would be inflation-free and stable according to most of studies done by experts on the field. In case of the performance of the intermediaries, market optimization is the key reference. The studies that emerge analyze conditions and situations in which intermediaries as well as banks are making a less imperfect market as well as the obstacles to their best functioning. Financial intermediaries preserve market imperfections but they do not totally get rid of informational asymmetries and even amplify market imperfections when their risk aversion builds credit crisis. Financial intermediaries have a critical and even growing role inside the real-world of economy. They are more and more linked up in all sorts of economic processes and transactions. Thus, to sum up, financial intermediaries are important and active because market imperfections prevent investors and savers from transacting directly with each other in a best way possible as stated on the modern theory of financial intermediation. Central Bank in Focus Many of us may have wonder what a central bank is and how does it function. The central bank is the body accountable for the financial policy of a country. Its chief responsibility is to preserve the stability of the money supply and national currency; however, its dynamic responsibilities comprise controlling the rates of loan interest, and playing the part of a bailout financier to the banking division in times of economic crisis as a last resort. It guarantees that banks or financial institutions do not exert reckless behaviours in accordance to Central Banks supervisory power. Some of the central banks are owned publicly, and others are, in premise, owned privately. In tradition, there is slight variation between private and public ownership, because in the former case approximately all profits of the bank are paid to the government moreover as a transfer to the government or a tax. A Central Bank in actuality is a peak organization in a financial system, and is placed with the accountability of controlling the financial system for a country or a group of countries. The functions of a Central Bank at large consist of execution of managing currency stability, monetary policy, full employment and low inflation. There are key functions of Central bank as discussed below. These functions are actually derived from the definitions and powers given to Central Banks. 1. The Central Bank manages issuance of currency and the monetary policy. As a component of its accountability of supervising the financial system of the state, the Central Bank is provided with the sole power of issuing currency annotations. In several nations, the governments release currency notes of smaller values and coins that act as the vital legal care, whereas the Central Bank provides the larger currency values. 2. The Central Bank act as a banker to the state as well as Banker to the banks- It carries out all significant role of being the banker to the government. The Central Bank does all monetary transactions for the nation and also accumulates money for the nation through instruments such as T-Bills and bonds. The latter function is also strongly connected to the financial management of the state economy, wherein releases or recovery of T-Bills impact the supply of money in the nation. Another function of Central Bank is to act as banker to various commercial banks of the nation. It refinances commercial banks' debts at the existing discount rates. The Central Banks act as a clearing quarters for the commercial banking system too. Aside from this, Central Bank can act as a lender to some commercial banks when necessary. This is with the implementation of existing interest rates. This becomes significant when commercial banks experience an unexpected monetary crisis or become bankrupt. The Central Bank can re-establish confidence in the system through planning a range of bailout packages for the commercial bank or banks. Below tables are proofs that CB controls accounts of many countries. The table was taken on the Committee on Payment and Settlement Systems (2003). 3. 4. 5. Central Bank sets various rates and manages inflation: Constituting vital financial policy instruments, a Central Bank is typically vested with the right of setting various rates. These rates embrace cash reserve ratio and the interest rate in the midst of other instruments. The interest rate is governed by varying the discount rate at which the commercial banks are being refinances by the Central Bank. The cash reserve ratio is the ratio of all deposits that commercial banks are authorized to preserve with the Central Bank. By altering cash reserve ratio, the Central Bank can readily alter the money supply of the nation. The Central Bank can also employ its prise of interest rates to persuade or discourage investment and influence employment levels in the financial system. Central Banks can also use open market operations as a monetary policy instrument. This is an important function of a Central Bank, in which it preserves the stability of the exchange rate. The Central Bank moves in to buy or sell foreign exchange so as enormous fluctuations of the local currency can be avoided. More often than not, in established markets like the Europe Japan and US, it is unusual for a Central Bank to carry out this operation as the currency is typically steady. The Central Banks in addition can use open market operations as a financial policy tool. They can put up for sale some foreign exchange to lessen money supply in the financial system and vice versa. The most important function of Central Bank is to manage inflations. A Central Bank uses its power to twist interest rates to control the inflation rate in the financial system. The changes in bank rates affect a lot of things in the financial system of the country as it affects the market value of securities, such as equities and bonds. The worth of bonds is inversely proportional to the long-term interest rate, thus a rise in long-term interest rates depreciates bond prices, and vice versa for a drop in long rates. If other factors are equal particularly inflation expectations, a higher interest rates also diminishes the value of other securities prices, like equities. This is because the expected future returns are discounted by a larger factor, consequently the current worth of any given future income stream declines. Other factors may not be equal. For instance, changing the policy may have indirect effects on confidence or expectations; however, these are considered independently below. A change in the official rate is instantaneously conveyed to other short-term authentic comprehensive money-market rates, both to money-market instruments of different maturity and to other short-term rates, like inter bank deposits. But these rates may not constantly go by the precise amount of the official rate change. Almost immediately after the official rate change, the banks correct their standard base rates, typically by the correct amount of the policy change. This promptly affects the interest rates that banks charge their customers for variable-rate loans, which include overdrafts. Charges on standard variable-rate mortgages may also be altered, although this is not readily established and may be postponed (taken on the speech of Bernanke np). References Bernanke, Ben S. Central Bank Talk and Monetary Policy. Remarks at the Japan Society Corporate Luncheon: New York, NY, October 7. Federal Reserve Board of Governors. 2004. Campbell, T.S., and Kracaw, W.A, Information production, market signaling, and the theory of financial intermediation. Journal of Finance. 1980. Committee on Payment and Settlement Systems, The role of Central Bank Money in Payment Systems, August 2003. Diamond, D. Financial intermediation and delegated monitoring. Review of Economic Studies.1984 Fama, E.. Banking in the theory of finance. Journal of Monetary Economics. 1980. Fohlin, C. IPO Underpricing in Two Universes: Berlin 1882-1892, and New York, 1998 2000. Social Science Working Paper 1088, California Institute of Technology. 2000. Leland, H.E. and D.H. Pyle. Informational asymmetries, financial structure, and financial intermediation. Journal of Finance. 1977. Miller, M. H., , Financial innovation: the last twenty years and the next, Journal of Financial and Quantitative Analysis. 1986. Oldfield, G. and A. Santomero. The place of risk management in financial institutions, Working Paper, #95-05 .Wharton Financial Institutions Center. 1995. Ross, S. The determination of financial structure: the incentive-signaling Approach. Bell Journal of Economics. 1977. Read More