Financial Intermediation and Delegated Monitoring Essay Example

of borrowers and lenders.

Generally, lenders want to lend their funds for a short periods and the highest possibility of return while borrowers require a cheap and long periods liabilities. In this occasion, financial intermediaries can bridge the gap between borrowers and lenders by offering safe and liquid funds and minimise the transaction cost derived from information asymmetries (Casu, B. & Girardone, C. & Molyneux, P. , 2006). The major problem for the lenders is the time and money spent in carrying out financial transitions, which is called transaction costs.

Financial intermediaries take advantage of economies of scale to reduce the cost per dollar of transaction when the size of transactions increases. Low transaction costs can provide liquidity services to customers so that depositors can earn interest on their savings and pay bills through accounts. On addition, banks and such financial intermediaries help to reduce the exposure of risk and promote risk sharing by diversification which entails to invest a portfolio of assets whose returns and risk do not move together as a result that overall risk is lower than individual assets (Mishkin, F. S. 2004).

Through performing transformation functions, banks bridge the gap between lenders and borrower. It is known that the main role of banks is to collect deposits from units of surplus and then lend loans to the units of deficit. Banks can provide important sources of external funds to finance business and other activities. The modern banks have three main functions which are size transformation, maturity transformation and risk transformation. Because of the economies of scale, banks can access to a larger number of depositors than individual borrowers

so that perform size transformation.

By transforming a short term funds into medium and long-term loans, banks perform maturity transformation function. Banks can diversify investments so that minimise the risk of individual loans. Information is the core factor for all the financial transactions and contracts. However, information is not available to both sides of the transaction. Actually, transactions involve asymmetric have happened everywhere. It is difficult for two parties to do business together when asymmetric information exists.

Therefore, asymmetric information is an obstacle to the direct finance (Casu, B. & Girardone, C. & Molyneux, P. , 2006). In financial system, imperfect distribution of information can generate problems on two fronts which are before transition is entered into and after (Mishkin, F. S. , 2004). One of the problems created before transaction occurs is adverse selection. The potential borrowers who are actively seek a loan are the most likely to produce an adverse which would face a bad credit risks. Lemon problem is referred as adverse selection.

This happened especially in the second hand car market, which buyers do not know the quality and only the seller know whether it is a lemon that it is a bad car (Akerlof, 1907). Another issue created by asymmetric information arises after transaction is moral hazard. It occurs in financial market when a contract between two parties creates incentives for them to behave against the interest of the other party. Principal-agent problem arise also due to asymmetric information because agents (managers) have expertise and they usually act as their own interest rather than shareholders’ (Meckling, 1976).

Varieties of financial institutions are engaged in financial intermediation

such as banks, insurance companies and those intermediaries act as principals to create new financial assets and liabilities. Banks delegated the role of monitoring borrowers in terms of default and credit risk. Since it is costly to carry on the task of monitoring, depositors delegate responsibility to banks which have the superior expertise and economies of scale to process the information in terms of risk (Diamond, 1984).

In addition, financial intermediation is also benefit to the whole society. Funds can be efficiently utilised due to the improvement of lending opportunities (Casu, B. & Girardone, C. & Molyneux, P. , 2006). In conclusion, financial intermediaries play a significant role in the economy and undertake the task of channelling funds from units in surplus to units in deficit. By perform the functions of size transformation, maturity transformation and risk transformation; banks efficiently match the needs of different borrowers and lenders.

Banks delegated monitoring due to imperfect distribution of information among parties. Asymmetric information also raises the problems of adverse selection, moral hazard and principal-agent problem. Strengthening the supervision can be one solution to these problems. It is obvious that financial intermediaries play a crucial role in improving the performance of whole economy and they are also successful factors of finance system (Mishkin & Eakins, 2005).