Transactions Costs and Asymmetric Information in Financial Intermediation Process - Essay Example

What Is The Role Of Transactions Costs And Asymmetric Information In The Financial Intermediation Process? INTRODUCTION In current economic environment within the global plethora, financial markets and the way it operate have attracted the attention of many researchers, analysts and theorists. It was not prior to the occurrence of the recent financial turmoil in 2008, that researches have become more inclined towards assessing the viability and potentials of the financial markets. Simultaneously, the criticality of financial intermediaries has also been subjected to continuous scrutiny that has leveraged the working pattern of the global financial market to a large extent. It is in this context that financial intermediation have also attracted global attention with the prime objective of getting re-invented and error-free to the highest possible extent, which would in turn assist in making the entire global financial system more stable and reliable. Often defined in a complex manner, financial intermediation simply refers to the process through which, banks and other financial institutions attempt to obtain profit by acting as intermediaries between the transacting parties, such as when offering loans and when accepting deposits (Cetorelli, Mandel and Mollineaux 2-3). The two most critical factors frequently and widely related with the phenomenon are transaction cost and concept of asymmetric information. While transaction cost indicated towards costs incurred while making transactions by the involved parties, asymmetric information indicates towards a more vibrant approach of the financial intermediaries in the modern era (Liu and Browne 2-5). To be noted, definitions of these two factors remain ambiguous until date and surround many debates in the global front. However, overlooking those disparities until necessary, this research paper will focus on answering the question that whether transaction costs and asymmetric information have their roles to play when successful intermediation is considered in the global financial sector. What have been its pros and cons? Also, what are its needs in demand within the current financial platform? DEFINING THE CONCEPT OF FINANCIAL INTERMEDIATION PROCESS In the critical review of Diamond and Dybvig’s Classical Theory of Financial Intermediation, Green and Lin (p. 3) state, “History is replete with instances in which a seemingly healthy economy has plunged into difficulty, investors have become suddenly insistent on exercising contractual options to mitigate their individual risks, and financial intermediaries have consequently become unable to honor all their commitments”. As observable from this simple but lucrative statement, financial intermediaries have a significant role to play when it comes to the prosperity of financial investors and overall economic well-being. Theoretical elaboration of the concept has correspondingly focused on the use of additional information obtained from the lenders by these financial institutions those are further used to control or levy benefits to the borrowers. Apparently, financial intermediation process correlates with the functions of financial intermediaries, referred to those entities that operate as the mediator to the providers of financial capital and its users (Greenbaum and Thakor 13-19). In the practical conduct of financial services, financial intermediation and banking, operations have often been considered synonymously owing to their high degree of similarity persistent in the functional procedures. The commonness in the operations of banks and other forms of financial intermediaries relates to the information gathered and way it is used for the purpose of solving contractual problems related to financial lending and borrowing transactions (Thakor and Boot 31-35). As often observed, these financial intermediaries serve a large pool of small investors who are also equipped with inadequate information. This signifies the existence of asymmetric information in the financial system. Besides utilizing the information gathered from the market, financial intermediaries also function to reduce informational asymmetries as argued by Scholtens and Wensveen (20-23). A better understanding can be developed with reference to the following diagrammatic presentation. Figure 1: Basic Financial Intermediation Process Source: Adrian and Shin (p. 603) To be elaborated in the simplest manner, financial intermediaries play a pivotal role in the economic system of a region. It acts as a vital link amid the lenders and borrowers wherein information asymmetries are used by the intermediaries to obtain profit by controlling transaction costs throughout the process. As Allen and Santomero (10-12) addressed, financial intermediaries are the one responsible to facilitate fiscal cycles within an economy and thereby determine its progress on monetary terms. In other words, effectiveness and performances of financial markets in the modern day phenomenon largely depend on the way these financial intermediaries function. For instance, financial intermediaries play a vital role in controlling liquidity and leverages that might in turn have a toll on the risks of financial crises. It is worth mentioning in this context that in order to manage their overall business value, financial intermediaries depend on the economic model of risks and capital structure as persistent within their functional external environment (Adrian and Shin 603-605). Illustration to this particular argument can be obtained by referring to the recent financial crunch of 2007-2008. Theorists have been of the view that financial intermediaries have abilities to steer a turnaround in the monetary sector of any economy, alongside its ability to steer it towards certain doom. Taking example of the recently occurred financial crunch in the US market, the root of such a crisis was found inherent to the strategies adopted by financial intermediaries of the economy to leverage lending at a vast magnitude. Studies conducted thus show that subprime mortgages during the 2006-07 fiscal year had largely been accelerated by the US financial intermediaries that in turn increased their exposure to risks and consequently, led to the amplification of balance-sheet contraction. Figure 2: Total exposure to losses from subprime mortgages Source: Adrian and Shin (p. 622) Therefore, based on the above elaboration, financial intermediation can be defined in two forms or from a dual perspective – one, from finances bench and the other, from an economic viewpoint. Considering the perspective of the finance sector, financial intermediaries are those responsible to utilize asymmetric information to yield profit from transaction costs serving both the lenders’ end and the borrowers’ dimension. Similarly, from the economic viewpoint, financial intermediaries can be termed as those economic players, which are responsible for the smooth conduct of lending and borrowing actions, ensuring a systematic stream of asymmetric information and therefore, attempt to control fiscal flow in return of their benefits through transaction costs. In both these instances, the role of transaction costs and asymmetric information can be noted to play a key role. ROLE OF TRANSACTION COSTS AND ASYMMETRIC INFORMATION Drawing from the above discussion, transaction costs and asymmetric information, persistent within the current domain of economic functionalities, have a significant role to play when considering financial intermediation processes. Often denoted as a financial term, transaction costs has attracted a wider realm of discussion, although, it is much relevant to the domain of economics and correspondingly, infers substantial significance in the financial applications (Geyskens, Steenkamp and Kumar 520-521). It is in this context that transaction cost theory defines the organizational boundary decisions. To be specific, the theory behind transaction costs implies that every exchange or transaction incurs a degree of costs owing to the variables existing in the market and mandates the use of specific and objective-oriented mechanisms to be reduced or controlled. The transaction costs are identifiably related to three phases indicating the cost to drafting, negotiating and preserving the transaction profit. Altogether, these variables or phases are described as the frictions identified in the transaction process in general (Hardt 30-31; Martins, Serra, Leite, Ferreira and Li 7-10). Figure 3: Transaction Cost Theory (TCT) Source: Developed for the purpose of this study When related to the common procedure of financial dealing or transaction between the lender and the borrower, i.e. the capital provider and the capital user, financial intermediaries are often argued to reduce transaction costs (Scholtens and Wensveen 25-29). As argued by Adrian and Shin (606-610), recent illustrations depict that financial intermediaries have a strong influence on the fiscal and monetary policy designed within an economy. Thus, financial intermediaries make use of information technology innovation, deregulating measures adopted by the government and informational asymmetries as well, indicating the boundary decisions of economy. To put it in another way, financial intermediaries attempt to control and take benefits from these frictions persistent within an economic framework in order to reduce transaction costs (Scholtens and Wensveen 25-29). This fact also provides a rationale as to why financial intermediaries persist within the current economic domain. When answering the same question, Hasman, Samartin and Bommel (p. 2) asserted that financial intermediaries currently persist and are very much of use in the modern world as they “(i) provide liquidity risk sharing, (ii) solve inefficiencies due to asymmetric information, and (iii) align incentives through active monitoring”. Hence, it can be argued that as financial intermediaries attempt to reduce frictions occurring during the exchange, i.e. reduce transaction costs substantially to the margin that transactions become smooth, ensuring profits for all the parties involved and diligently avoiding risks to conflicts. It can be further related to the intensive categorization of a “pure exchange economy” and the intent of financial intermediaries to function towards building the same (Hasman, Samartin and Bommel 5-6). However, this particular thought has been contradicted by many theorists including recent researches of Aoki, Proudman and Vlieghe (5-7), Keim and Madhavan (265-267), Mehra, Piguillem and Prescott (20-25) and others. In most of these contradictory researches, an idealistic view has been framed, examined and concluded asserting that financial intermediaries do not necessarily work towards reducing transaction costs. Depending on its boundaries as well as those of the economy, it rather attempts to control transaction costs to retain higher or lower margins of profits. Taking the example of 2001 credit crunch experienced within the UK housing market, the inference can be better established. It was during the first decade of the 20th century that policy implementations dictated considerable rise in the housing prices within the UK economy. This augmentation in the real estate value led to the rise in housing equity prices within the market. Therefore, consumers were able to obtain higher borrowings from the banks (financial intermediaries) with their real estate properties as mortgages. Correspondingly, as the transaction costs of such borrowings reduced, the financial intermediaries augmented their lending volume steeply that further led to a sudden increase in the market consumption pattern of the economy. However, with greater elasticity in the housing market and increased liquidity, risks also grew in manifold to assure loan repayment that in turn increased transaction costs for the financial intermediaries and therefore, again to control their profit margin a sudden shock waved through the market leading to a credit crunch. The same was observed as the prime reason for housing bubble in the US market during the 2007-2008 credit crunch (CBRE 10-11; Maillet and Michel 10-14). A comprehensive inference that can be drawn from the above illustration of the UK credit crunch is the existence of asymmetric information within the market. As the theory asserts, consumers lack access to uniform information and it is thus that informational asymmetries persist in the money market. Subsequently, an individual borrower is able to forecast the needs of their individual projects having negligible idea regarding the total production of the market (Gorton and Winton 20-23). As apparent, transaction costs, under the influence of persistent asymmetric information, dictate equity prices and other forms of investment instruments offered by financial intermediaries. Undoubtedly, the influence of monetary and fiscal policies implemented plays a significant role in determining the strictness or the flexibility of the financial intermediation process. Figure 4: Financial Intermediation Process and Its Different Drivers From a critical point of view, the roles played by transaction costs and informational asymmetries can be referred to those acting as competition drivers and financial accelerators in the market. As argued by Stucke (162-163), financial intermediaries, in order to gain competitive advantages, often attempt to control transaction costs and make use of informational asymmetries. To be mentioned in this context, transaction costs act as the determinants of rate of return enjoyed by the financial intermediaries and that is correspondingly channelized to the borrowers and lenders within an economy. Therefore, to maintain the equilibrium position and obtain competitive advantages financial intermediation process intends to reduce transactional costs that would leverage profits in terms of the rate of Returns on Investment (ROI). On the similar context, informational asymmetries encourage diversity in the market wherein information obtained by consumers and their differing needs and preferences are also used by financial intermediaries throughout the intermediation process to obtain profits or make the transaction smoother. These drivers of market competition, as asserted by Biggar and Heimler (13-14), create a strong influence on the economic dimensions of a region and the way financial intermediation process functions. According to Biggar and Heimler (14-15), these factors underlying the financial intermediation process give rise to microeconomic concerns those are in turn necessary to ensure that the lending side is in accordance with the borrowing end. Contextually, banking policies, interest rates and line-of-business restrictions also have their unique role to play in the financial intermediation process. Stating precisely, interest rate policies and prices of the commodity market tend to have strong influences on the needs and preferences of consumers, especially when considering long term and short-term investment sectors, such as the equity market, insurance market, housing sector and others. These influences are further observed to differ substantially within the different groups of consumers in the market owing to persistent informational asymmetries. In accordance, these factors also act as frictions to the intermediation process, giving rise to transaction costs. It is in this context that to reduce transaction costs, financial intermediates further tend to bring changes in their policy measures and price control features (Williamson 485-486). This proves that financial intermediation is actually a cyclical process wherein the roles played by transaction cost variables and informational asymmetries are crucial and inherent. Nevertheless, it is worth mentioning in this context that informational asymmetries present moral hazards to the financial intermediation process as well. Financial intermediaries are thus responsible to omit these moral hazards in order to ensure smooth functioning of the intermediation process and assure profits for both the lenders and the borrowers (Hansen and Keiding 189-190). CONCLUSION The objective of this study was to examine the role played by transaction costs and informational asymmetries in giving shape to financial intermediation process in the current era. In accordance, the results obtained through this study elaborated that transaction costs are the results of frictions persistent in an intermediation process wherein a financial institution (either a bank or an insurance company among others) tends to act as the mediator between the capital provider and the capital user in the market. Correspondingly, the persistence of informational asymmetries was identified as such a friction that tends to have an influence on the transaction costs incurred by these financial intermediates. In most instances, it is observed that informational asymmetries impose a positive influence on the transaction costs and thereby, offer a competitive advantage to the financial intermediaries. However, it is worth mentioning that the entire cycle of financial intermediation replicate a complex procedure involving various determinants, drivers and elements, those either impose or are influenced by the policies adopted by these intermediaries. In order to obtain better understanding of this cyclical process, further research is mandatory wherein focus may be drawn upon a particular investment instrument, such as housing equities, which would assist in interpreting the entire procedure in a more comprehensive manner. Conclusively, it can be asserted that the issue considered for this essay represents an intriguing but complex phenomenon of the modern world, which demands further exploration in a comprehensive manner. Works Cited Adrian, Tobias and Hyun Song Shin. “The Changing Nature of Financial Intermediation and the Financial Crisis of 2007–2009.” Annual Review of Economics 2 (2010): 603–618. Print. Allen, Franklin and Anthony M. Santomero. “What Do Financial Intermediaries Do?” The Warton School (1999): 1-41. Print. Aoki, Kosuke, James Proudman and Gertjan Vlieghe. “House Prices, Consumption, and Monetary Policy: A Financial Accelerator Approach.” Federal Reserve Bank of New York Economic Policy Review (2002): 5-39. Print. Biggar, Darryl and Alberto Heimler. “An Increasing Role for Competition in the Regulation of Banks.” International Competition Network Antitrust Enforcement in Regulated Sectors Subgroup 1 (2005): 1-30. Print. CBRE. “Credit Crunch and the Property Market.” Greater London Authority (2008): 1-79. Print. Cetorelli, Nicola, Benjamin H. Mandel, and Lindsay Mollineaux. “The Evolution of Banks and Financial Intermediation: Framing the Analysis.” FRBNY Economic Policy Review 18.2 (2012): 1-12. Print. Geyskens, Inge, Jan-Benedict E. M. Steenkamp and Nirmalya Kumar. “Make, Buy, or Ally: A Transaction Cost Theory Meta-Analysis.” Academy of Management Journal 49.3 (2006): 519–543. Print. Gorton, Gary and Andrew Winton. “Financial Intermediation.” NBER Working Paper Series (2002): 1-140. Print. Green, Edward J. and Ping Lin. “Diamond and Dybvig’s Classic Theory of Financial Intermediation: What’s Missing?” Federal Reserve Bank of Minneapolis Quarterly Review 24.1 (2000): 3-13. Print. Greenbaum, Stuart I. and Anjan V. Thakor. Contemporary Financial Intermediation. UK: Academic Press, 2007. Print. Hansen, Badil O. and Hans Keiding. “Financial Intermediation, Moral Hazard, and Pareto Inferior Trade.” Revista EconomiA 5.2 (2004): 189-219. Print. Hardt, Lukasv. “The History of Transaction Cost Economics and Its Recent Developments.” Erasmus Journal for Philosophy and Economics 2.1 (2009): 29-51. Print. Hasman, Augusto, Margarita Samartin and Jos van Bommel. “Financial Intermediaries and Transaction Costs.” OFCE (2010): 2-27. Print. Keim, Donald B. and Ananth Madhavan. “Transactions Costs and Investment Style: An Inter-Exchange Analysis of Institutional Equity Trades.” Journal of Financial Economics 46 (1997): 265-292. Print. Liu, Jerry W. and Mark J. Browne. “Asymmetric Information, Transaction Cost, and Externalities in Competitive Insurance Markets.” Journal of Economic Literature (2002): 1-51. Print. Maillet, Bertrand and Thierry Michel. “How Deep was the September 2001 Stock Market Crisis? Putting Recent Events on the American and French Markets into Perspective with an Index of Market Shocks.” London Stock Exchange (2002): 1-14. Print. Martins, Rodrigo, Fernando Ribeiro Serra, Andre da Silva Leite, Manuel Portugal Ferreira and Dan Li. “Transactions Cost Theory Influence in Strategy Research: A Review Through A Bibliometric Study In Leading Journals.” Working paper no 61 (2010): 1-29. Print. Mehra, Rajnish, Facundo Piguillem and Edward C. Prescott. “Costly Financial Intermediation in Neoclassical Growth Theory.” Working Paper 685 (2011): 1-36. Print. Scholtens, Bert and Dick Van Wensveen. “The Theory of Financial Intermediation: An Essay on What It Does (Not) Explain.” SUERF – The European Money and Finance Forum (2003): 1-59. Print. Stucke, Maurice E. “Is Competition Always Good?” Journal of Antitrust Enforcement 1.1 (2013): 162–197. Print. Thakor, Anjan V. and Arnoud Boot. Handbook of Financial Intermediation and Banking. UK: Elsevier, 2008. Print. Williamson, Stephen. “Transactions Costs, Inflation, and the Variety of Intermediation Services.” Journal of Money, Credit and banking 19.4 (1987): 484-498. Print. Read More