Management Issues Facing Global Managers as We Enter the 21st Century

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  • Topic: Bank, Money market, Financial market
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  • Published : January 28, 2013
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Financial Intermediation
Introduction “In this chapter we introduce the process of financial intermediation. We consider its nature and explain why most lending/borrowing takes place through intermediaries rather than lenders lending directly to borrowers. In considering this issue we are also considering the fundamental reasons for the existence of banks. We identify the advantages that institutions such as banks have which enable them to undertake intermediation. However we also argue that traditional intermediation services provided by banks have declined in many countries in recent years and banks have sought to maintain profits by expansion into other areas of business” The nature of financial intermediation A company planning to invest in a new production line may not be able to finance all the investment from his/her own resources and will have to borrow some or all of the required funds. An individual with surplus funds out of his/her current income may want to lend these funds in order to obtain a return. It would therefore seem logical for the firm wanting to borrow funds to seek out the individual wanting to lend funds, and vice versa. In practice direct lending, like this, does not generally happen and instead funds are channeled through a financial intermediary such as a bank.

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Prepared by : Prabath. S . Morawakage |B.B Mgt (Finance) Special, 1st Class Honours

To ask the question why does most lending/borrowing take place through a financial intermediary is to also ask the question of why financial intermediaries exist. There are three main reasons why financial intermediaries exist: 1. Different requirements of lenders and borrowers 2. Transaction costs 3. Problems arising out of information asymmetries.

Different requirements of lenders and borrowers Firms borrowing funds to finance investment will tend to want to repay the borrowing over the expected life of the investment. In addition the claims issued by firms will be have a relatively high default risk reflecting the nature of business investment. In contrast, lenders will generally be looking to hold assets which are relatively liquid and low-risk. To reconcile the conflicting requirements of lenders and borrowers a financial intermediary will hold the long-term, highrisk claims of borrowers and finance this by issuing liabilities, called deposits, which are highly liquid and have low default risk. Transaction costs The presence of transaction costs makes it very difficult for a potential lender to find an appropriate borrower. There are four main types of transaction costs: 1. Search costs: both lender and borrower will incur costs of searching for, and finding information about, a suitable counterparty. 2. Verification costs: lenders must verify the accuracy of the information provided by borrowers. 3. Monitoring costs: once a loan is created, the lender must monitor the activities of the borrower, in particular to identify if a payment date is missed. 4. Enforcement costs: the lender will need to ensure enforcement of the terms of the contract, or recovery of the debt in the event of default.

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Prepared by : Prabath. S . Morawakage |B.B Mgt (Finance) Special, 1st Class Honours

Asymmetric information This is an important concept in finance and needs to be fully understood. Asymmetric information refers to the situation where one party to a transaction has more information than the other party. In the case of a financial transaction, the borrower will have more information about the potential returns and risks of the investment project for which funds are being borrowed compared to the lender. The existence of asymmetric information creates problems for the lender, both before the loan is made, at the verification stage and after, at the monitoring/enforcement stages. The first problem created by asymmetric information occurs when the lender is selecting a potential borrower. Adverse selection can occur before the transaction...
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