1. Money and Banking
Lecture 21

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

3. Topics Under Discussion
Role of Financial Intermediaries
Pool Savings
Safekeeping, accounting services and access to the payments system
Liquidity
Risk diversification
Information Services

4. 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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

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