Week 4

Function of the Financial Intermediaries: Indirect Finance

Function of the Financial Intermediaries: Indirect
Finance

 Previously we discussed Direct Finance and Indirect Finance

 Direct finance is the transfer of funds from savers to the investors directly
through financial markets i.e. stock exchanges
 Indirect finance is the transfer of funds form savers to the investors through a
third party i.e. financial intermediaries (the financial institutions of banks,
insurance companies and investment companies)
 In indirect finance, the profit of savers and investors in an investment
opportunity is also shared by the financial intermediaries
 Then question arises why the people choose to invest via indirect finance?
 Answer to this question lies in the functions performed by the financial
intermediaries as explained below
Function of the Financial
Intermediaries: Indirect Finance
 Following basic functions are performed by the financial intermediaries:
1. Transaction Cost
2. Risk Sharing
3. Asymmetric Information
4. Economies of Scope
 Transaction Costs:
 The time and money spent in carrying out financial transactions are known as transaction costs. For
example you want to withdraw money from ATM machine then the time and money you spent to
withdraw the money from your bank is your transaction cost
 Similarly, saver and investor have to bear transaction costs when they utilize the facility of direct
finance
 Because they have to spend time and money for searching each other, and to consult a lawyer for
writing up of the contract and to arrange for collateral etc.
 This transaction cost is relatively higher in case of direct finance
Function of the Financial
Intermediaries: Indirect Finance
 As an alternative the facility of indirect finance is also available
 In case of indirect finance major players are banking institutions, insurance
companies and investment companies
 These financial institutions also have to bear transaction costs. But these
transaction costs are relatively lower because of economies of scale. These
institutions have plenty of such transactions so there time and money
spending along with lawyer’s consultations and collateral problems are
minimized.
 Hence, it could be concluded that financial intermediaries helps the savers by
lowering the transaction costs of the investment opportunities

Function of the Financial
Intermediaries: Indirect Finance
 Risk Sharing
 In case of direct finance risks of defaults are existed for savers and all such
losses have to bear by the savers themselves.
 Whereas in case of indirect finance there are very low chances of losses for
financial intermediaries because these institutions have plenty of such
investments and there is minimal chances that losses have to bear in all the
investment projects.
 It could be concluded that these financial institutions are sharing the risk of
savers in case of indirect finance
 Therefore, financial intermediaries share the risk of the savers
Function of the Financial
Intermediaries: Indirect Finance
 Asymmetric Information:
 There are two types of information:
1. Symmetric information: If a transaction is completed in such a way that both the parties in
transaction have the same level of information then such situation is known as symmetric
information
2. Asymmetric information: If a transaction is completed in such a way that both the parties in
transaction have not the same level of information. One of the party have more information
while the other party have less information, then such situation is known as asymmetric
information. In case of asymmetric information following two problems arises in financial
markets:
A. Adverse Selection: There is chance that saver may choose a wrong investor on account of low
level of information
B. Moral Hazard: Even if the choice of saver is satisfactory, there is chance that the investor may
behave inappropriately after the transaction is initiated
Function of the Financial
Intermediaries: Indirect Finance
 The direct finance is the perfect case of asymmetric information because
individuals have not perfect information about the investors’ credit rating,
financial health and market phenomenon whereas the investors normally belong
to financial market and have much more information about financial markets
 On the other hand in case of indirect finance when financial intermediaries are
involved in a transaction, the information level for both the saver and investor is
the same i.e. the case of symmetric information
 Hence, when a saver invests through financial intermediaries there is most
likelihood that he will not involve in any of the problem of adverse selection and
moral hazard
 Hence, financial intermediaries helps savers to minimize the problems arises
due to asymmetric information
Function of the Financial
Intermediaries: Indirect Finance
 Economies of Scope
 Another service provide by the financial intermediaries to the savers is the
economies of scope
 Economies of scope is an economic concept that the unit cost to produce a
product will decline as the variety of products is increasing. For example
resources used to prepare burgers and shawarmas are the same. In case you produce only
burgers you have to bear the cost. But when you add shawarma too in your production
line then cost is reduced for both the burgers and shawarmas because same resources are
useful in production of both.
 The financial intermediaries provide multiple services at the same time e.g.
loaning, selling the bonds on behalf of investors etc. In all such services
information about the investors play an important role and the same
information e.g. credit rating, is useful in all such services.
Function of the Financial
Intermediaries: Indirect Finance
 However, economies of scope could also raise the problem of conflict of
interest
 Conflict of interest, a type of moral hazard problem, arise when a person or
institution has multiple objectives and these objectives conflict with each
other
 For example a bank knows that credit rating of an investor is poor. The bank
will never issue loan to such investor. But if the same investor hires the bank
for selling of its bonds then there is possibility that bank will conceal the
information or disseminate misleading information on account of conflict of
interest