Five Theories Of Financial Intermediation

Financial Intermediation is the process in which financial institutions take in funds from depositors also referred to as the ultimate lender, and then lend a large proportion of the funds to prospective borrowers. To fully evaluate the importance of this process we will explain the five theories of financial intermediation and discuss the main benefits of financial intermediation to the ultimate lender.

The five theories that will be explained below are 1) Delegated Monitoring, 2)Information Production, 3) Liquidity Transformation, 4)Consumption Smoothing, 5) Commitment Mechanism.

1. Delegated Monitoring -

The hard work only begins when the credit facility has been issued! To ensure that funds are repaid within the agreed covenant, the

Financial institutions have the required economies of scale and experience to reduce information costs by regular lending.

3.Liquidity Transformation -

Depositors hold relatively undiversified portfolios. Without the opportunity to diversify, the undoubted risk will increase for the depositor who wishes to lend directly to the proposed borrower. Financial Institutions however are in the business of taking risk. The institution / bank will record deposits on their balance sheet as liabilities, however low risk. They will then convert a large proportion of these liabilities in to loan assets. This is a transformation of deposit to liquidity.

4.Consumption Smoothing -

Consumption smoothing is the economic concept used to express the desire of people to have a stable path of consumption. This can alter when shocks occur to the consumers circumstances. Given the unexpected nature of these shocks, liquidity constraints will only further exacerbate the issue. Where depositors may not have the appetite to lend in these cases due to the uncertainty, financial institutions have the capabilities to offer the required products to allow the consumer to remain on a stable

However the types and levels of risks taken must be constantly reviewed. Given that the majority of funds the bank is lending is from from deposits, the banks must keep in mind that depositors may request their funds to be returned at any time. While it is unlikely that all depositors will request all the funds at the same time it does however mean that the banks must be prudent in the risks they are willing to take on.

While the above theories explain financial intermediation,there are also additional benefits to the ultimate lender. Institution’s generate trust from the profits created by lending funds at a higher rate than the return paid to depositors. Given that ultimate lenders are looking for low risk and security, trust and confidence in the bank is extremely important.

In addition, financial Institution allow depositors access to funds under agreed terms, with a fixed rate of return and low costs, in the main. This security allows depositors to plan for the future with the knowledge of what to expect from their investment.

Another benefit to the ultimate lender of financial intermediation is that they do not have to take on the risk of the financial concept known as Asymmetric Information. This concept refers to the situation where one party to a transaction has more information than the other party. In financial transactions that party is generally the