Theories of Financial Intermediation - Essay Example

(Please fill-in information and also do not forget to edit the header with on it) The Theories of Financial Intermediation leading to its importance One of the hot topics of debates nowadays is financial intermediations; since disagreements occur on the issue of financial intermediations as a significant role to consider in our modern financial system. To provide firm stand arguing that financial intermediations are still active and has proven to still play a significant role in the financial system; initially it is necessary to review the principles of the theory of financial intermediation. Basically, we may distinguish these principles in accordance to three arguments on the subsistence of financial intermediaries: First Principle: Theories of informational asymmetries Market imperfections are produced because of the informational asymmetries like deviation from the neoclassical organization of financial system. A lot of these imperfections direct towards specific kinds 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. As proven on different studies, financial intermediaries come out to at least partially surmount these costs. Based on the interpretation of Leland and Pyle (32); financial intermediation act as an alliance of information-sharing, and intermediary coalitions as argued by Diamond (51) can attain economies of scale. He also projected that financial intermediaries can effectively monitor returns by acting on behalf of ultimate savers. Hart (1995) explained that savers optimistically value the intermediations in terms of ultimate investments. According to Campbell and Kracaw (863-882) financial intermediations can create a useful incentive result of short-term debt on banker's behalf. The deposit funding can turn out the right incentives in managing the bank. A subtle financial organization necessary to control the bank managers produced illiquid assets (Diamond 393; Miller 21). In instances where the borrower in the bank chose direct finance; the role of a brokerage is in acted by financial intermediaries as explained by Fama (39-58) as investment banks. On this situation, reputation is at risk and according to Campbell and Kracaw (885) in financing, the financier's reputation as well as the borrower's is relevant. Second Principle: The Transaction Costs Approach This approach agrees with the concept of complete markets unlike the initial approach specified. It agrees that transaction process is of no convexities. In this approach, the financial intermediaries using economies of scale in the transaction process work in coalitions with borrowers. Many experts explained that the concept of transaction costs comprises not only monetary transaction costs, but at the same time covers auditing, searches and monitoring costs. Therefore, the function of the financial intermediaries is to transform specific financial claims into a so-called qualitative asset in this example. It is called offering diversified opportunities through liquidity as Ross (23-40) stated. The provision of liquidity is a main function for investors and savers and highly for corporate customers, in which the provision of diversification is welcomed in institutional as well as personal financing. Oldfield and Santomero (WP #95) in their submitted work paper stipulated that this liquidity plays a key role in asset pricing theory. Financial intermediation then becomes exogenous with transaction costs. Third Principle: Principle in accordance to the regulation of money production Regulation affects solvency and liquidity inside the financial market or organization. Diamond (414) argued that the capital of the bank affects its refinancing ability, bank safety, and ability to extract repayment from the borrowers. 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. Importance of financial intermediation based on the Principles discussed is summarized below. 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. 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. 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. Consequently, financial intermediaries work best in qualitative asset transformation. 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: Bank of England in Focus (Information derived from the Bank of England Website: www.bankofengland.co.uk) 'The Bank of England is the central bank of the United Kingdom. Sometimes known as the 'Old Lady' of Thread needle Street' stated at the online site of the Bank of England (homepage) taken at www.bankofengland.co.uk. Like any other Central Banks 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. The Bank of England in actuality is a peak organization in a financial system of the entire United Kingdom, and is placed with the accountability of controlling the financial system for a group of countries. The functions of the Bank of England at large consist of execution of managing currency stability, monetary policy, full employment and low inflation. There are key functions of the Bank of England and are herby discussed below. These functions are actually derived from the definitions and powers given to Central Banks, specifically The Bank of England and are shown in a diagram below. Diagram of the Functions of the Central Bank of England Manages issuance of currency and the monetary policy - As a factor of its responsibility of supervising the financial system of the state, the Bank of England 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 Bank of England provides the larger currency values. 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 Bank of England does all monetary transactions for group of nations and also accumulates money for the nation through instruments such as T-Bills and bonds and gold reserves. 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 Bank of England is to act as banker to various commercial banks of the nation. It refinances commercial banks' debts at the existing discount rates. The Bank of England act as a clearing quarters for the commercial banking system too. Aside from this, it 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 Bank of England can re-establish confidence in the system through planning a range of bailout packages for the commercial bank or banks. Sets various rates and manages inflation: Constituting vital financial policy instruments, the Bank of England 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 Bank of England. 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 Bank of England can readily alter the money supply of the nation. It can also employ its price of interest rates to persuade or discourage investment and influence employment levels in the financial system. Bank of England 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 Bank of England moves in to buy or sell foreign exchange so as enormous fluctuations of the local currency can be avoided. The Bank of England 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 Bank of England is to manage inflations. A Central Bank uses its power to twist interest rates to control the inflation rate in the financial system just like the Bank of England. Effects on the reduction of Base Rates in mortgages and Bonds 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 Bank of England Copyright. Bank of England: About the Bank. 1 May 2008. < http://www.bankofengland.co.uk > 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