Learning Objectives:

  • Explain the concept of financial intermediation.

  • Understand the economic rationale for financial intermediaries.

  • Analyse the role of banks in economic growth and development.

  • Explain the consequences of asymmetric information and transaction costs on banking.

3.1 The Concept of Financial Intermediation

Financial intermediation is the process of channelling funds from savers to borrowers. The HSE University course requires students to “estimate the consequences of asymmetric information and transaction costs on banking” . The LSE external programme notes that “the development of the economic systems are determined by the international capital flows, channeled by banks and other financial intermediaries” .

The financial intermediation process involves:

  • Savers/Depositors: Individuals and businesses with surplus funds.

  • Financial Intermediaries: Banks and other institutions that collect funds from savers.

  • Borrowers: Individuals and businesses seeking financing.

3.2 The Economic Rationale for Financial Intermediaries

The HSE University syllabus covers “economic analysis of financial structure” and “why do financial intermediaries exist?” as core topics . Key reasons include:

Transaction Costs: Reducing the costs of bringing savers and borrowers together. The LSE course applies a “transactions cost and asymmetric information approach to financial structure” .

Information Asymmetries: Overcoming adverse selection (pre-contract information problems) and moral hazard (post-contract information problems). The LSE course emphasises “asymmetric information” as a core analytical framework .

Risk Transformation: Diversifying and transforming risk.

Maturity Transformation: Converting short-term deposits into long-term loans.

3.3 Banks and Economic Growth

Banks support economic growth by:

  • Channelling savings into productive investments.

  • Providing working capital for businesses.

  • Facilitating trade and commerce through payment systems.

  • Supporting innovation and entrepreneurship through access to credit.

The course notes that “the development of the economic systems are determined by the international capital flows, channeled by banks and other financial intermediaries” .

3.4 The Consequences of Asymmetric Information

The HSE course requires students to understand the “consequences of asymmetric information and transaction costs on banking” .

Adverse Selection: The problem that occurs before a transaction, where the parties with the highest risk are most likely to seek financing. Banks address this through credit screening and underwriting.

Moral Hazard: The problem that occurs after a transaction, where the borrower may take on more risk than agreed. Banks address this through monitoring, covenants, and collateral requirements.

Transaction Costs: The costs of bringing buyers and sellers together, including search costs, negotiation costs, and enforcement costs. Banks reduce these costs through economies of scale.

 

PreviousNext