As Bain (1992; p.5) states, ‘Financial intermediaries are institutions which attempt to serve the needs of both lenders and borrowers and are often able to reconcile the divergent requirements of borrowers and savers.’ It is important to highlight that there are several different financial intermediaries; banks, building societies, insurance companies and pension scheme companies, but in this case the role of the bank as an intermediary will mostly be considered.
In everyday lending transactions the use of the direct method (ultimate savers and borrowers dealing directly with each other) is uncommon. It has now become widely accepted that the existence of financial intermediaries actually makes direct contact unnecessary. It is true that if savers and borrowers dealt directly with each other then it would remove costs associated with using an intermediary. However, the direct method is an expensive and inefficient method of lending as it gives rise to many problems relating to information costs, administration costs, portfolio preferences, risk, lender of last resort and contracts and enforcement. Problems associated with the direct route and the ways in which intermediaries can solve these problems will be identified:
Savers and borrowers have to find each other, obtain information about each other, meet each other and negotiate a contract. If dealing directly with each other, the individuals concerned would have to incur these costs. It is often difficult for savers and borrowers to locate each other. They could use a broker but this is an expensive method.
Before the loan is given, lenders must verify the accuracy of information being provided about the borrower. If this process is not carried out correctly this may lead to asymmetric information between the borrower and the lender and may result in adverse selection and moral hazard. Asymmetric information is where all parties in the transaction have different information. This results in moral hazard because the more information you have the more you can exploit the counterpart as the individual with more information has an incentive to behave badly. Adverse selection increases the riskiness of the transaction. This is because asymmetric information increases the likelihood of the customer behaving badly. For example, if a borrower has more information than the lender concerning his/hers ability to repay the loan then this will increase the risk incurred during the transaction; the borrower has an incentive to behave badly and default on the loan.
Once the loan has been negotiated the post borrowing activities of the borrower must be monitored. If default occurs, monitoring the borrower will help to identify legitimate and illegitimate reasons for missing a payment.
Heffernan (1996; p.19) states ‘Information costs will be incurred whether the direct method is taken or whether there is a use of an intermediary.’ However, the
advantage of using an intermediary is that the bank can allow lenders to offer loans with lower associated information costs in comparison to those negotiated directly with the borrower. This is possible because intermediaries (banks) benefit from economies of scale (As the Economist online explains, ‘Bigger is better. In many industries, as output increases, the average cost of each unit produced falls therefore lowering overall costs.’).
When savers and borrowers deal directly with each other, the opportunity cost (‘the true cost of something is what you give up to get it’: The Economist online (2005)) of finding out information about each other is extremely high. It is possible for both parties to find out information about each other but it would be too expensive and time consuming. The direct route also lends itself to asymmetric information problems; all the individuals in the transaction know different amounts of information which can be seen...
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