Money and Banking: Lecture 21

Money and
Banking

Lecture 21


Review of the Previous Lecture
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Theory of Efficient Markets
Investing in Stocks for Long Run
Stock Markets’ Role in the Economy
Financial Intermediation


Topics Under Discussion
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Role of Financial Intermediaries
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Pool Savings
Safekeeping, accounting services and
access to the payments system

Liquidity
Risk diversification
Information Services


Role of Financial Intermediaries
• As a general rule, indirect finance through
financial intermediaries is much more
important than direct finance through the
stock and bond markets
• In virtually every country for which we
have comprehensive data, credit extended
by financial intermediaries is larger as a
percentage of GDP than stocks and bonds
combined



Role of Financial Intermediaries
• Around the world, firms and individuals
draw their financing primarily from banks
and other financial intermediaries
• The reason for this is information;
• financial intermediaries exist so that individual
lenders don’t have to worry about getting
answers to all of the important questions
concerning a loan and a borrower

• Lending and borrowing involve transactions
costs and information costs, and financial

intermediaries exist to reduce these costs


Role of Financial Intermediaries
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Financial intermediaries perform five
functions:
1. They pool the resources of small savers;
2. They provide safekeeping and accounting
services as well as access to the payments
system;
3. They supply liquidity;
4. They provide ways to diversify risk; and
5. They collect and process information in ways that
reduce information costs


• International banks handle transactions
that cross borders, which may mean
converting currencies
• Taking deposits from savers in one country
and providing them to investors in another
country
• Converting currencies to facilitate transactions
for customers who do business or travel


Pooling Savings
• The most straightforward economic function of

a financial intermediary is to pool the resources
of many small savers
• To succeed in this endeavor the intermediary
must attract substantial numbers of savers
• This is the essence of indirect finance, and it
means convincing potential depositors of the
soundness of the institution
• Banks rely on their reputations and government
guarantees like deposit insurance to make sure
customers feel that their funds will be safe


Safekeeping, Payments System
Access, and Accounting
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Goldsmiths were the original bankers;
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people asked the goldsmiths to store gold in
their vaults in return for a receipt to prove it
was there
People soon realized that trading the
receipts was easier than trading the gold
itself.
Eventually the goldsmiths noticed that there

was gold left in the vaults at the end of the
day, so it could safely be lent to others


Safekeeping, Payments System
Access, and Accounting
• Today, banks are the places where we put
things for safekeeping;
• we deposit our paychecks and entrust our
savings to a bank or other financial institution
because we believe it will keep our resources
safe until we need them

• Banks also provide other services, like
ATMs, checkbooks, and monthly
statements, giving people access to the
payments system


Safekeeping, Payments System
Access, and Accounting
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Financial intermediaries also reduce the cost
of transactions and so promote specialization
and trade, helping the economy to function
more efficiently.
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According to the principle of comparative

advantage, people and companies concentrate on
the activities
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at which they are the best and
for which their opportunity cost is lower

This leads to specialization in a particular activity
More specialization => more trading => more
financial transaction => calls for low cost of
transaction


Safekeeping, Payments System
Access, and Accounting
• The bookkeeping and accounting services
that financial intermediaries provide help us
to manage our finances
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Pay-cheques

House-rents
Utility bills
Loan payments
Food clothing and other expenses
Savings and retirement plans


Safekeeping, Payments System
Access, and Accounting
• Providing safekeeping and accounting
services as well as access to the payments
system forces financial intermediaries to
write legal contracts, which are standardized
• Much of what financial intermediaries do
takes advantage of economies of scale,
• The average cost of producing a good or service
falls as the quantity produced increases
• Information is also subject to economies of scale


Summary
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Role of Financial Intermediaries
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Pool Savings
Safekeeping, accounting services and
access to the payments system;
Liquidity;
Risk diversification
Information Services