Money and Banking Lecture 21

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

Topics Under Discussion Role of Financial Intermediaries 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 Financial intermediaries perform five functions: They pool the resources of small savers; They provide safekeeping and accounting services as well as access to the payments system; They supply liquidity; They provide ways to diversify risk; and 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 Goldsmiths were the original bankers; 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 Financial intermediaries also reduce the cost of transactions and so promote specialization and trade, helping the economy to function more efficiently. According to the principle of comparative advantage, people and companies concentrate on the activities 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 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 Role of Financial Intermediaries Pool Savings Safekeeping, accounting services and access to the payments system; Liquidity; Risk diversification Information Services