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According Matthews and Thompson (2008). certain assets/liabilities are transformed to different assets/liabilities. savings banks. pension funds and investment trusts that purchase securities. Functions of Financial Intermediaries Financial intermediaries ensure steady flow of funds from surplus to deficit units through performing the following functions: .0: INTRODUCTION What is Financial Intermediation? Financial intermediation is the process which involves firms with surplus funds depositing such funds to financial institutions who then lend to firms with deficits. businesses. In the process of financial intermediation. There are two types of financial intermediaries. etc. credit unions. thus providing capital indirectly rather than advancing loans. financial intermediaries channel funds from economic units with surplus (savers) funds to economic units which have deficits (borrowers) and these intermediaries attract funds from individuals.CHAPTER ONE 1. and governments. i) Banks These are deposit financial institutions that advance loans directly to borrowers and include commercial banks. As such. ii) Non-bank financial intermediaries These types of intermediaries lend through purchase of securities and include insurance companies.

irrespective of the mix of debt and equity finance. which illustrated how imperfect information between buyers and sellers can cause market malfunctioning. Convenience denomination: This is through matching small deposits with large loans and large deposits with small loans. 1. Under the assumptions that financial markets are complete and information and transaction costs are non-existent. policy makers must have an accurate assessment of the timing and effects of their policies on the economy. This includes an understanding of the monetary transmission mechanisms through which monetary policy affects the decisions of firms. the market price reflects buyers’ perception of the average quality . households. the Modigliani and Miller (1958) theorem states that the mix of debt and equity used to finance firms’ expenditures does not affect the expected profitability of the project – the same investment decisions would be made.Maturity transformation: This is through converting short term liabilities to long term assets. While the complete market assumption remains important in economics. financial intermediaries and investors that alter the level of economic activity and prices. With imperfect information.1: THEORITICAL FRAMEWORK To conduct monetary and fiscal policies successfully. Risk transformation: This is through converting risky investments into relatively risk-free ones through lending to multiple borrowers to spread risk. Banks deal with large number of lenders and borrowers and reconcile their conflicting needs. the assumption of zero information and transaction costs (or perfect information) has come under increasing criticism since Akerlof’s (1970) seminal paper. Fama’s (1980) extension of the Modigliani-Miller theorem to the entire financial system allows the abstraction from considerations of credit market conditions in macroeconomic models.

Intermediaries. They are designed to account for deposit taking institutions and insurance firms which issue policies and channel funds to firms. One such theory is the Arrow Debreu theory by Arrow and Debreu (1954) which examined the dynamics of the whole economic system and was able to prove the existence of a multimarket equilibrium in which there is no excess demand or supply. and thus the macroeconomic models used by policy makers. Financial intermediaries thus exist because there are information and transactions costs that arise from imperfect information between borrowers and lenders. can help overcome the information problem.2: Traditional Theories of financial Intermediation (The perfect model assumption) Traditional theories of intermediation are based on transaction costs and information asymmetry. The theory is based on assumptions that a competitive equilibrium exists if each person in . In financial markets. As a result.of the product being sold. and monitoring borrowers’ performance. 1997). which specialize in collecting information. an information asymmetry arises between borrowers and lenders because borrowers generally know more about their investment projects than lenders do. Efficient markets require some mechanisms for overcoming the imperfect information problem. do not hold. evaluating projects and borrowers. This implies that the assumptions upon which the Modigliani-Miller theorem is based. 1. They are built on the models of resource allocation based on perfect and complete markets suggesting that it is frictions such as transaction costs and asymmetric information that are important in understanding intermediation (Allen and Santomero. Conditions in financial and credit markets can affect the real economy. and sellers of low quality products will receive a premium at the expense of those selling high quality goods. which will lower the average quality of the product and price of the product even further. and interest and exchange rates are an incomplete description of the monetary transmission mechanism. The process will continue and may preclude the market from actually opening. leading more high quality sellers to stay out of the market. some high quality sellers will stay out of the market.

by Leon (1934-1910) studied a theoretical economic system in which all consumers were utility maximizers and firms were perfectly competitive. and tradable in the international financial centers in the world. showing that a unique stable equilibrium can exist under such conditions. but are declining due to the cost efficiency of ICT and efficiencies of scale. on a global scale. The liberalization and deregulation give a strong stimulus towards the securitization of financial instruments. Savers and investors interact easily because there is perfect information in the market at no cost. Households can construct portfolios which offset any position taken by an intermediary and hence intermediation cannot create value (Fama. making them transparent. In so . Only taxes are discriminating. homogeneous. present value prices of investment projects are well defined. The views above seem to be supported by the fact that increasingly. The General equilibrium theory. With complete information. owing to the developments in information and communication technology. The Arrow-Debreu Theory is based on the paradigm of complete markets. Modigliani-Miller theorem applied in this context asserts that the financial structure does not matter. In the case of complete markets. The communication revolution has also reduced information costs tremendously. financial markets have been and continue to be highly liberalized and deregulated. Financial instruments are constructed and traded cost free and they fully and simultaneously meet the needs of both savers and investors. 1980).the economy possesses some quantity of every good available for sale in the market and that exploitable labor resources exist which are capable of being used in the production of desired goods / services. it is expected that market parties have homogenous expectations and act rationally. Firms can now issue shares over the Internet and investors can put their order directly in financial markets. Transaction costs still exist. All information on important macroeconomic and monetary data and on the quality and activities of market participants is available in ‘real time’. within countries.

the assumption of zero information and transaction costs (or perfect information) has come under increasing criticism. On the contrary.3: Modern Theories of Financial Intermediation The modern theories of financial intermediation revolve around optimality. Therefore. arbitrage and equilibrium. Equilibrium means that markets are cleared by price adjustment – through arbitrage – at each moment in time (Scholtens and Wensveen.far as this does not occur naturally. internationalization and so on. It would be expected that financial intermediation should be fading away. This suggests that intermediation is something which exploits a situation which is not perfect. Akerlof’s (1970) seminal paper. Optimality refers to the notion that rational investors aim at optimal returns. One might think so from the forces shaping the current financial environment: deregulation and liberalization. All deviations from this model which exist in the real world and which cause intermediation by the specialized financial intermediaries are seen as market imperfections. With imperfect . with all intermediaries becoming redundant. intermediaries are useful to bring savers and investors together and to create instruments that meet their needs. 2003). intermediaries are at best tolerated and would be eliminated in a move towards market perfection. This model is the starting point in the present theory of financial intermediation. Modern theories therefore try to explain this paradox:1. Arbitrage implies that the same asset has the same price in each single period in the absence of restrictions. therefore is undesirable and should or will be temporary (Scholtens and Wensveen. communication. illustrated how imperfect information between buyers and sellers can cause market malfunctioning. 2003). the perfect state of disintermediation. economic importance of financial intermediaries is higher than ever and appears to be increasing. While the complete market assumption remains important in economics.

but their magnitude does not in many cases appear sufficient to be the sole cause and suggested that informational asymmetries may be a primary reason that intermediaries exist. some high quality sellers will stay out of the market. and sellers of low quality products will receive a premium at the expense of those selling high quality goods. 1970). leading to more high quality sellers to stay out of the market. . ultimate lenders might just as well purchase the primary securities directly and avoid the costs which intermediation must involve. Below are some of the theories or lines of reasoning that try to explain the existence of financial intermediation thus: Transaction Costs theory Liquidity Insurance theory Information sharing/asymmetry theory Delegated monitoring theory     Transaction Costs Theory (Benston and Smith 1976) The transaction costs approach holds that financial intermediaries exist because they have a transaction costs advantage over individuals.information. As a result. Leland and Pyle. (1977) noted that traditional models of financial markets have difficulty explaining the existence of financial intermediaries. the market price reflects buyers’ perception of the average quality of the product being sold. The process will continue and may preclude the market from actually opening. They concluded that transactions costs could explain intermediation. Efficient markets require some mechanisms of overcoming the imperfect information problem (Akerlof. which will lower the average quality of the product and price of the product even further. They argued that if transactions costs are not present.

The notion of transaction costs encompasses not only exchange or monetary transaction cost (Tobin. Provided that shocks are not perfectly correlated across individuals. 1976). consumers are unsure of their future liquidity requirements in the face of unanticipated events and hence they maintain a pool of liquidity. One reason for this advantage is that financial intermediation avoids duplication of information collection (having a financial intermediary collect and process information means that investors do not have to duplicate one another’s efforts). and Hellwig (1991). Fischer. 1991).This is based on non convexities in transaction technologies. whereas the provision of diversification increasingly is being appreciated in personal and . ii. The role of the financial intermediaries here is to transform particular financial claims into other types of claims (qualitative asset transformation). because of their past experience with borrowers. resources can be allocated more efficiently. Also. 1983) but also search costs and monitoring and auditing costs (Benston and Smith. As such. Financial intermediaries have a cost advantage in acquiring or processing information. This cost advantage means that the intermediaries have to specialize in the provision of financial services and. as a result. Liquidity Insurance Approach / Theory Attributed largely to the works of Pyle (1971). 1974. The provision of liquidity is a key function for savers and investors and increasingly for corporate customers. financial intermediaries are better able to assess the likelihood that a prospective borrower will default. They consider banks as coalition of depositors that provide households with insurance against shocks that adversely affects their liquidity position. 1963. Towey. whereby the financial intermediaries act as coalition of individual lenders or borrowers who exploit economies of scale or scope in the transaction technology. Diamond and Dybvig (1983). 1971) and diversification opportunities (Hellwig. they offer liquidity (Pyle. They argued that in the absence of perfect information. portfolio theory suggests that total liquid reserves needed by financial institutions will be less than the aggregation of reserves required by individual consumers acting independently.

An intermediary promising investors a higher payoff for early consumption and a lower payoff for late consumption relative to the non-intermediated case enhances risk sharing and welfare. deposit insurance can rule out runs without reducing the ability of banks to transform assets. Banks can improve on a competitive market by providing better risk sharing among agents who need to consume at different (random) times. A bank run is caused by a shift in expectations. Without an intermediary. In Diamond and Dybvig (1983) the illiquidity of assets provides both the rationale for the existence of banks and for their vulnerability to runs. When normal volumes of withdrawals are known and not stochastic. In Diamond and Dybvig’s model. Information Asymmetry Theory This theory contends that financial intermediaries exist because there are information and transactions costs that arise from imperfect information between borrowers and lenders. iii.institutional financing. suspension of convertibility of deposits will allow banks both to prevent bank runs and to provide optimal risk sharing by converting illiquid assets into liquid liabilities. The information asymmetry theory is attributed to the works of Leland and Pyle (1977). Diamond and Dybvig (1983) analyse the provision of liquidity (the transformation of illiquid assets into liquid liabilities) by banks. In financial markets. ex ante identical investors (depositors) are risk averse and uncertain about the timing of their future consumption needs. all investors are locked into illiquid long-term investments that yield high payoffs only to those who consume late. In the more general case (with stochastic withdrawals). an information asymmetry arises between borrowers and lenders because borrowers generally know more about their investment projects than . Holmström and Tirole (2001) suggest that this liquidity should play a key role in asset pricing theory. Numerous markets are characterized by informational differences between buyers and sellers. Diamond and Dybvig (1983) and Diamond (1984) among others. Those who must consume early receive low payoffs because early consumption requires premature liquidation of long-term investments.

since there may be substantial rewards for exaggerating positive qualities and verification of true characteristics by outside parties may be costly or impossible. Financial intermediaries seem to overcome these costs at least partly. Information asymmetries generate market imperfections that lead to transaction costs. . Without information transfer. Diamond and Dybvig. Borrowers typically know their collateral. the depositors will save their deposits with the intermediaries and at times withdraw their deposits to discipline the intermediary in his monitoring function. can help overcome the information problem. Intermediaries. evaluating projects and borrowers. Borrowers cannot be expected to be entirely straightforward about their characteristics. 1977). Information asymmetry can cause a problem of adverse selection which can generate a moral hazard resulting to auditing or costly verification and enforcement.lenders do. nor entrepreneurs about their projects. they can be interim. (1983) consider banks as coalitions of depositors that provide households with insurance against idiosyncratic shocks that adversely affect their liquidity position. generating moral hazard. markets may perform poorly (Leland and Pyle. Monitoring involves increasing returns to scale. These asymmetries can be of ex ante nature. generating adverse selection. and they can be of ex post nature resulting in auditing or costly state verification and enforcement. Lenders would benefit from knowing the true characteristics of borrowers. and monitoring borrowers’ performance. But moral hazard hampers the direct transfer of information between market participants. which implies that specialization may be attractive. entrepreneurs possess "inside" information about their own projects for which they seek financing. and moral rectitude better than do lenders. Diamond (1984) shows that these intermediary coalitions can achieve economies of scale and also act as delegated monitors on behalf of ultimate savers. which specialise in collecting information. industriousness. Individual households will delegate monitoring activities to those specialists.

This is most relevant in the case of small and medium enterprises (Mathew and Thompsons2008) The basic idea behind the theory of delegated monitoring is that not all savers (depositors and the other creditors) have the time. A key element in this theory is the analysis and benefits of monitoring. Monitoring of a borrower by a bank refers to information before and after a loan is granted including screening of on going creditworthiness and ensuring that the borrower conforms to the contract. Monitoring of borrowers involves increasing returns to scale which reinforces the view that it is efficiently performed by specialist intermediacy. Banks are able to perform as delegated monitors and to transfer loan that require costly monitoring into deposits that do not depends critically on their use of portfolio diversification. A bank often has privileged information in the process because when it operates the client’s current account then it can observe the flows of income and expenditures. The monitor must have an incentive to perform properly. One possibility is through reputational effects and banks have developed substantial amounts of repopulation capital as monitors of debt (loan) contracts issued to them by the borrowers that they fund and issue unmonitored debt (deposit) contract. inclination of or expertise to monitor institution borrowers for defaults risk. .iv. If the bank is sufficiently diversified across independent loans with expected repayments in excess of the face value of deposit then the probability of the bank defaulting on its deposit approaches zero. They engage in indirect finance through using an intermediary rather than direct financing. Theory of delegated monitoring of borrowers This is one of the most influential theories in the literature on the existence of banks. Diamond (1984) is of the view that financial intermediaries act as delegated monitors on behalf of ultimate savers. The theory shows that diversifying the loan portfolio enables low-cost delegated monitoring. The collection of private information by intermediaries results in some benefits from using this additional information in lending. The net demand for monitoring depends on the cost of monitoring which in turn depends on the number of lenders who contract with a given number of borrowers.

Regulation however. So. There are the direct costs of administration and of employing the supervisors. and there are the indirect costs of the distortions generated by monetary and prudential supervision.Regulation of financial intermediaries. since it may hamper market entry as well as exit. . It must be noted that. especially of banks. most of the literature in this category focuses on explaining the functioning of the financial intermediary with regulation as an exogenous force. once again. there is a true dynamic relationship between regulation and financial production. is costly. may also generate rents for the regulated financial intermediaries. Kane (1977) and Fohlin (2000) attempt to develop theories that explain the existence of the very extensive regulation of financial intermediaries in the dynamics of financial regulations.

borrow from banks with higher monitoring incentives. volatility increase and credit ratings get Firms that are required to provide worse. suggesting that the performance of these firms is more difficult to measure. assets increases.0: EMPERICAL EVIDENCE Evidence on the Determinants and Economic Consequences of Delegated Monitoring: Anne Beatty. Scott Liao and Joseph Weber (December 2008) The study objective was to investigate the factors that determine the cost and benefit  trade-offs of delegated monitoring and to examine the factors that determine delegated monitoring. level of leverage. firms credit rating and the standard deviation of returns. They used a sample of firms that entered into both public and private debt contracts during the period January 1994 to February They studied 426 firms that had bank loans outstanding before public debt issuances and 480 firms that issue bank debt while the public debt is outstanding by analyzing several variables such as the size of the firm. This suggests that firms with cross-acceleration provisions. with the lead lender holding a relatively larger share of the loan. on average. In terms of the control variables. firms are charged larger interest rates. and have worse credit ratings implying that the firms are riskier while firms using cross-acceleration provisions have larger absolute value of discretionary accruals. They concluded that firms with cross. the consequences of delegated monitoring and whether the borrower compensate the delegated monitor for their efforts through increased interest rate on the loan.CHAPTER TWO 2. have a larger returns variance. collateral are also charged a relatively larger rate but the rate decreases as return on . return on assets. The result showed that firms with cross-acceleration provisions are smaller.acceleration provisions also appear to have a more concentrated group of lenders. they found that riskier borrowers have larger More specifically as leverage and return spreads on their private debt agreements.

They found out that a view of banks as primary liquidity transformers does not appear to have a solid empirical foundation. These data was obtained from the Central Bank of Kenya and the sample ran from July 1991 to December 1999 for all data set except the inter-bank rate. and loan commitments. The paper showed that the most important regulatory initiative for facilitating liquidity transformation through deposit insurance has only modest impact. provision for bad loans. credit risk. which was only available from April 1993. which together controlled over 75% of total assets in the US commercial banking sector.They used data from the Reports of Condition and Income filed by all federally regulated US commercial banks. and liquidity and cash ratios. The found out those additional insured deposits largely replaces uninsured liabilities rather than expanding the deposit base of the bank or encouraging it to make more loans while credit risk has a substantial impact on crowding out liquidity risk from bank portfolios. Are Banks liquidity transformers?: Akash Deep and Guido Schaefer (May 2004) The study objective was to gauge the extent of liquidity transformation performed by individual banks . The explanatory variables that they considered were deposit insurance coverage. commercial bank loans and deposits. The sample consists of the 200 largest banks based on asset size in June 2001. 2001) The study aimed to explain the factors determining interest rate spread for Kenya’s banking sector the data consisted of monthly observations of treasury bill rates. bank size. lending rates. deposit rates.Cointergaration tests were carried out to ensure long run relationship. inter-bank rates. . The quarterly data used ranged from the second quarter of 1997 to the second quarter of 2001.  An empirical analysis of interest rate spread in Kenya: Rose W.Ngugi (May. Only banks that had data available for all these quarters were included in the sample.

Modern day financial theory is faced with questions and challenges on what forces really drive the financial intermediation theory.e. In the process financial intermediaries have been known to perform four main critical functions namely: • • • • Optimization of transaction costs Provision of liquidity insurance Bridging the information asymmetry gap. which was pursued with increased liquidity and cash ratio requirements.The result showed that the interest rate spread increased because of yet-to-be gained efficiency and high intermediation costs. Delegated monitory. She showed that fiscal policy actions saw an increase in treasury bill rates and high inflationary pressure that called for tightening of monetary policy which resulted in banks increasing their lending rates but were reluctant to reduce the lending rate when the treasury bill rate came down because of the declining income from loans. the so called financial institutes as channels or media of exchange where funds from units who have surpluses are given to the financial intermediaries who then channel these funds to areas of deficit units who need these funds. The banks responded by reducing the deposit rate. High implicit costs were realized with the tight monetary policy. and. A lot of research has gone into these four key theories of financial intermediation which seek to show and explain the behavior of financial intermediaries and their relation to savers and to investors/entrepreneurs. however the key question of why financial institutions exist still lingers on. thus maintaining a wider margin as they left the lending rate at a higher level.0: UNRESOLVED ACADEMIC ISSUES IN FINANCIAL INTERMEDIATION The main focus on financial intermediation theory what can be said to be the traditional view of financial intermediation theory has been a focus on financial institutions i. what keeps them alive and what is their contribution to the national and/or international economic welfare. . CHAPTER THREE 3.

do not explain. the approach to financial intermediation that seek to answer why there is demand for financial intermediaries and why financial intermediaries are willing and able to take on the risks involved in their activity has brought about a new way of looking at financial intermediation theory. and the neo-classical market theory on which the financial intermediation theory is based. The growing importance of risk and the growing need of risk absorbing institutions and instruments can explain the growing importance of the financial industry to the national income. the first is about why there is demand for financial intermediaries and the second is why financial intermediaries are willing and able to take on the risks involved in their activity. Risk. 2003). and not asymmetric information fuels its activity and risk taking basically determines the value addition of financial intermediation to national income. rather than only with information. Economies of scale and scope as well as the delegation of the screening and monitoring function by these intermediaries apply to dealing with risk itself. Bert Scholtens & Dick van Wensveen noted that all studies on the reasons behind financial intermediation focused on the functioning of intermediaries in the intermediation process but did not in themselves examine the existence of the real-world intermediaries.It has been observed that despite the globalization of financial services. In light of all these. something related to information production but not covered by the theory of financial intermediation. Two issues are of key importance arose. and despite strong price competition. This seems paradoxical as it points to something important which the financial intermediation theory. . the financial services industry is not declining in importance but it is growing (Bert Scholtens & Wensveen. driven by deregulation and information technology. under the increasing volatility of interest rates. stock prices and foreign exchange rates. namely. The demand for risk covering instruments grows and will continue to grow. meaning that the existing theories are actually leaving something out. It has been proposed that risk management rather than informational asymmetries or transaction costs is the reason why there is demand for financial institutions.

Regulation interferes in the intermediation process and it makes the financial sector an even more imperfectly competing – in more than one respect industry. operational risk. 1. 6. Studies that move away from banks. political risk amongst others .organizational structures. as regulation by its nature is based on imperfect information for all other market participants. What are the issues in banking system design . These are. What is the role of financial institutions in financial innovation? Is this to the welfare of the society and the economy or themselves? 2. common trend of mergers and acquisitions amongst others? 4. 5. What are the economic bases for differences among financial systems across countries and through time due to technological differences and globalization? 3. risk transformation and value creation Financial intermediaries and their orientation to their customers both real investors and savers These four distinct roles form the backbone of the unresolved academic issues in financial intermediation. The risks that are faced by the financial institutions such as credit risks.• • • • Role of financial intermediaries in product and market innovation Role of financial intermediaries as an entrepreneurial provider of financial services Role of financial intermediaries in asset transformation. foreign exchange risk. Battacharya & Thakor in 1993 listed some of the issues which they regarded as key questions and puzzles for financial intermediation research which Scholtens and Wensveen branded as “unresolved issues” in 2003 and to the best of our knowledge these issues have still not been conclusively resolved and could cover grounds for future research. technology risk. How securities markets and non-bank financial intermediaries should be structured and regulated.

CONCLUSION In summary according to the modern theory of financial intermediation. Consequently. financial intermediaries are active because market imperfections prevent savers and investors from trading directly with each other in an optimal way. they do not examine the existence of the real-world intermediaries as such. The studies that appear in most academic journals analyze situations and conditions under which banks or other intermediaries are making markets less imperfect as well as the impediments to their optimal functioning. fill as agents and as delegated monitors of information gaps between ultimate savers and investors. It appears that the latter issue is regarded to be dealt with when satisfactory answers on the former are being provided. All studies on the reasons behind financial intermediation focus on the functioning of intermediaries in the intermediation process. To ensure the sustainability of financial intermediation. The most important market imperfections are the informational asymmetries between savers and investors. settlement and clearing system. which justifies the transaction costs they charge to parties. Market optimization is the main point of reference in case of the functioning of the intermediaries. They also bridge the maturity mismatch between savers and investors and facilitate payments between economic parties by providing a payment. This is their basic function. Regulation also provides the basis for the intermediaries to enact in the production of their monetary services. Perfect markets are the benchmarks and the . Financial intermediaries. banks specifically. They screen and monitor investors on behalf of savers. This is because they have a comparative informational advantage over ultimate savers and investors. they engage in qualitative asset transformation activities. safety and soundness regulation has to be put in place.

Ideally. On the other hand. A fourth service financial intermediary will be called upon to offer is information. or to repackage and resell risk. This service will be provided both explicitly and implicitly. financial intermediaries should not be there and. being there. One such service is access to the payments system. There will always have to be some mechanism for channeling the savings of households into the investments of firms which is the fundamental role of a financial intermediary. Some financial intermediaries will continue to have access to the central bank. and even increase market imperfections when their risk aversion creates credit crunches. they maintain market imperfections as long as they do not completely eliminate informational asymmetries. they at best alleviate market imperfections as long as the real market parties have no perfect information. So. It is predicted in Cecchetti (1999) that financial intermediaries of the future will provide a host of services that are essential to the functioning of a modern economy. . Finally. financial intermediaries will remain a means through which government guarantees will be provided. even despite the fierce competition amongst themselves? Financial intermediaries have a crucial and even increasing role within the real-world economy. They increasingly are linked up in all kinds of economic transactions and processes. there appears not to be a heroic role for intermediaries at all! But if this is really true. A third service financial intermediary will have to offer a service related to a traditional banking function is to package and sell risk. A second service financial intermediary will continue to provide is access to liquidity. This service could be provided through a number of different institutional arrangements. which will operate as a lender of last resort. The provision of information will include the certification of the quality of assets together with credit review and possible follow-up. why are still in business.intermediating parties are analyzed and judged from the viewpoint of their contribution to an optimal allocation of savings. This service may be thought of as trade execution. which means to market perfection.

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