A central function of the financial system is to facilitate an efficient allocation of resources in the economy... Discuss.
to make good the original loan as well as additional profits expected from the venture. The job of the intermediary is to bridge this problem through allowing lenders to invest in the short run, with the pooled together short term deposits, larger and long term loans are made available to borrowers. Maturity transformation is the name given to this process, and is made possible due to the large number of deals between lenders and borrowers.
Similar to the differences of wishes in maturity transformation, lenders and borrowers again differ when faced with levels of risk they wish to taken on. Savers who are willing to lend the money will want to lend it at the lowest risk level possible, while on the other hand, those who are taking out the loans will no doubt be taking on a level of risk some what higher than the individual saver would like. Some savers may be willing to lend at a high risk, if the rate of return was high enough.
In this situation, the financial system allows all parties to exist by pooling all savings from savers, and making a large number of small loans. Through risk transformation, the risk is spread right across the board, rather than concentrating the high levels of risk associated with making less frequent substantial loans.
Of all the intermediaries within the financial system, the bank is the most frequent, both in size and number. In its most basic form, a bank is a financial institution that accumulates deposits from savers and provides credit to firms, individuals, and government agencies (Gitman & Madura, p.23). There are many types of banks that serve different purposes depending on what you’re in the market for, these range from specialist banks concentrating on specific markets, to the more generalist banks that offer a whole variety of services such as; loans, deposit accounts and stock broking to name a few. Once funds are gathered from savers and repackaged out to borrowers, profits are made by earning higher rate of interest on loans than the rate they pay on deposits.
Without banks in the financial sector, mobilisation of resources would be a non starter. For a start, who would bring the borrowers and lenders together? A second underlying problem also tells us that borrowers and lenders have different liquidity preferences. In order to eliminate this problem and aide the efficient allocation of resources, banks will conduct four types of information costs that would otherwise have been a much longer and costly process for and individual saver. Firstly, there are search costs, which involve obtaining information, negotiating etc in order to bring the borrowers to the lenders. Secondly, verification costs exist due to the need to verify the accuracy of information given by the borrower. Any asymmetric information given will lead to the process of adverse selection and will thus lead to inefficiencies in the allocation of resources. Thirdly, once a loan is made, monitoring costs are created, all payments must be monitored whereby any missed payments must [next page]