This article seeks to unbundle the key role that banks play in an economy which is the financial intermediation process. It is worth noting that the theories of financial intermediation were first developed by Gurley and Shaw in 1960.
Financial intermediation is usually understood as a process of connecting lenders and borrowers, performed by banks and other intermediaries. According to Organization for Economic Co-operation and Development (OECD), the role of financial intermediaries for example Banks is to channel funds from lenders to borrowers by intermediating between them. Banks play an important role in our economies. The banking industry, as the classic and the most influential financial intermediaries, facilitates economic operations and contributes to the growth and development of economies through intermediation.
The question that then arises is Why is financial intermediation so important? Because it brings together economic agents with surplus who want to lend money and those with insufficient funds who need to borrow. In contrast to the free-market ideology that markets are perfect and that there is no information asymmetry, financial intermediaries have a function because financial markets are not perfect. As soon as markets are perfect, which I believe is not and will never be, intermediaries will be deemed redundant as they would have lost their function because savers and investors dispose of the perfect information needed to find each other directly, immediately, and without any impediments, so without costs and to deal at optimal prices. This then drives us to the forces that drive the financial intermediation process.
According to the modern theory of financial intermediation, financial intermediaries are active because market imperfections prevent savers and investors from trading directly with each other in an optimal way. Current financial intermediation theories build on the notion that intermediaries serve to reduce transaction costs and information asymmetries. Financial intermediaries mostly banks who act as agents and as delegated monitors – fill in information gaps between ultimate savers and investors. This is because they have a comparative informational advantage over ultimate savers and investors. They screen and monitor investors on behalf of savers. This is their basic function, which justifies the transaction costs they charge to parties.
Financial intermediation offers a myriad of benefits to all parties involved. Banks can pool small chunks of funds together that might be needed for huge capital investments. Listed below are some of the benefits brought by financial intermediation:
1. Financial intermediaries, offer a diversity of financial assets with different yields and maturities to suit savers and investors with different requirements: improve the efficiency of resource allocation. Financial intermediaries are meant to bring together those economic agents with surplus funds who want to lend (invest) to those with a shortage of funds who want to borrow.
2. Savers wish to lend for short periods and investors borrow for long periods, which brings conflict, and therefore financial intermediaries can overcome this problem by borrowing short-term and lending long-term (e.g., the bank makes a five-year interest loan which it finances with a series of ten six-month deposits).
3. Financial intermediaries reduce transaction costs, this avoids savers having to find suitable borrowers.
4. Financial intermediaries can specialize in certain areas of business which reduces information costs and credit risk associated with lending, that is they improve the efficiency of resource allocation.
5. Investment projects are larger than the savings of any one individual or group and as such intermediaries can put together large amounts of finance.
6. Investment is no longer confined to the sector in which saving takes place. In this regard, investment can freely occur in the most productive sector.
However, there are also a few disadvantages to financial intermediaries.
1. Lower investment returns: Because the intermediary has its financial interests, the returns are not as high as they would be without the middleman. Additional commission fees or expenses may be charged.
Author: Tillas Gopoza is an Economist. He writes in his capacity as the Chief Economist for the Bankers Association of Zimbabwe. He can be contacted at tillas@baz.org.zw