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2.4. Economic functions of financial intermediaries

2.4.1. Introduction

As noted, the financial intermediaries essentially metamorphose the unacceptable claims on borrowers into acceptable claims on themselves. From this a number of benefits for the economy arise:

• Facilitation of flow of funds.

• Efficient allocation of funds.

• Assistance in price discovery.

• Money creation.

• Enhanced liquidity for lender.

• Price risk lessened for the ultimate lender.

• Improved diversification for lender.

• Economies of scale.

• Payments system.

• Risk alleviation.

• Monetary policy function.

These benefits are discussed in some detail below. Figure 2 is presented at the outset of this discussion because it may assist in this discussion.

facilitation of flow of funds

Figure 2: facilitation of flow of funds

2.4.2. Facilitation of flow of funds

In essence, financial intermediaries facilitate the flow of funds from surplus economic units to deficit economic units. Without sound financial intermediaries, much of the savings of the ultimate lenders will not be available to the ultimate borrowers. There are numerous examples in underdeveloped countries where individuals keep their savings in the form of notes and coins (under their proverbial mattresses) as opposed to deposits with unsound banks.

This function may also be described as a savings and wealth storage function, i.e. surplus economic units have an outlet for their funds and are thus able to store (preserve) their wealth in low-risk (certain non-government securities) or risk-free (government securities) or even risky (other non-government) financial instruments.

2.4.3. Efficient allocation of funds

Financial intermediaries have the expertise to ensure that the flow of funds is allocated in the most efficient manner. Intermediaries, particularly the banks, are aware of the existence of asymmetric information and its two by-products, the problems of adverse selection and moral hazard.5 Asymmetric information means that the potential borrower has more information than the bank does about his/her business.

The presence of asymmetric information leads to adverse selection and moral hazard problems. Adverse selection means that bad risk borrowers are more likely to want loans than good risk borrowers. Moral hazard purports that once a loan is granted the borrower may be inclined to take risks with the money that are not disclosed to the bank in the application. These are two of the many real-life risks faced by banks. They are keenly aware of them, and this ensures that available funds are allocated to borrowers that are expected to utilize the funds prudently, which in turn leads to an increase in economic activity.

2.4.4. Assistance in price discovery

Closely allied with efficient allocation of funds is price discovery. The financial intermediaries are the professionals / experts on the financial system (after all, they also make up a large part of the system), and are therefore keenly involved in price discovery. They are actively involved in the pricing of financial services and securities.

The central bank plays a major role in this regard via its KIR. As we will see in more detail in a separate section, the KIR, when made effective by a liquidity shortage engineered by the central bank, represents the genesis of interest rates. As this is implemented via the banking sector, this sector also plays a major role in the discovery of interest rates.

Certain institutions also play a major role in the discovery of other asset prices. For example, the retirement funds (managed usually by fund managers) are active in differentiating between the market price and the fair value of equities, and influence the pricing of equities via their actions in the equity market. Interest rates are also a major factor in the valuation of equities.

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