Financial intermediaries obtain funds by issuing financial claims against themselves to market participants and then investing those funds. The investments made by financial intermediaries—their assets—can be in loans and/or securities. These investments are referred to as direct investments. As just noted, financial intermediaries play the basic role of transforming financial assets that are less desirable for a large part of the public into other financial assets—their own liabilities—which are preferred more by the public. This transformation involves at least one of four economic functions: (1) providing maturity intermediation; (2) risk reduction via diversification; (3) reducing the costs of contracting and information processing; and (4) providing a payments mechanism.
Maturity intermediation involves a financial intermediary issuing liabilities against itself that have a maturity different from the assets it acquires with the fund raised. An example is a commercial bank that issues short-term liabilities (i.e., deposits) and invests in assets with a longer maturity than those liabilities. Maturity intermediation has two implications for financial markets. First, investors have more choices concerning maturity for their investments; borrowers have more choices for the length of their debt obligations. Second, because investors are reluctant to commit funds for a long period of time, they will require that long-term borrowers pay a higher interest rate than on short-term borrowing. In contrast, a financial intermediary will be willing to make longer-term loans, and at a lower cost to the borrower than an individual investor would, by counting on successive deposits providing the funds until maturity (although at some risk as discussed below). Thus, the second implication is that the cost of longer-term borrowing is likely to be reduced.
To illustrate the economic function of risk reduction via diversification, consider an investor who...
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