Money, Banking &
Financial Markets
LECTURE 3 – FINANCIAL INTERMEDIATION
Aims
Explain the theory and purpose of financial intermediation.
Describe the structure of financial markets
Show that financial intermediation is welfare superior to direct
transformation of current consumption to future consumption.
Describe the process of financial intermediation and the markets
that enable its efficient functioning.
Financial Intermediation
The mechanism whereby surplus funds from ultimate savers are matched to deficits incurred by
ultimate borrowers
The process by which ultimate savers are matched to ultimate borrowers.
Saving = Income – Consumption
Typically decisions to save are made independently of decisions to invest
Chanelling of Funds
In a simple economy we have firms and households
Households are the savers and firms are the investors.
The mechanism by which households save is by demanding securities from firms
The mechanism by which firms invest is by supplying securities to households
These securities are claims to the assets of the firm
Simple model of direct finance
FUNDS LENT
HOUSEHOLDS
FIRMS
FINANCIAL CLAIMS
Direct Finance
Lending and borrowing can occur as a result of direct transacting.
But there are costs associated with direct finance
Search costs – searching for potential transactors
Verification costs – costs in evaluating investment proposals
Monitoring costs – costs of monitoring the actions of borrowing
Enforcement costs – costs of enforcing contracts
Efficient Direct Finance
Some of these costs can be reduced through the organisation of a market.
Direct financing requires the existence of an efficient securities market.
However not all costs are minimised through a securities market.
An additional issue is that the maturity period of finance for the firm is long term.
The maturity period of the household is mostly short term.
The maturity mismatch of households and firms provide the incentive for the development of
intermediated finance.
Indirect (Intermediated) Finance
Funds Lent
HOUSEHOLDS
Financial
Intermediary
Financial Claims
FIRMS
Who are the savers and borrowers?
Savers or lenders are households, firms, governments and foreigners
Investors or borrowers are households, firms, governments and foreigners.
Savers can hold corporate securities (shares), government securities (bonds), currency, bank
deposits, foreign currency assets
Borrowers can sell shares, sell bonds, issue currency, take bank loans, issue foreign currency
liabilities
General Flow of Funds
Indirect
Finance
Financial
Intermediary
Borrowers – Spenders
Lenders – Savers
1. Firms
1. Households
2. Firms
FINANCIAL
MARKET
3. Government
2. Government
3. Households
Foreigners
4. Foreigners
Direct Finance
A Flow of Funds Analysis
S = Saving
I = private investment
G = government spending
T = taxes
X = exports
M = imports
Y=C+I+G+X–M
Y=C+S+T
0 = (I – S) + (G – T) + (X – M)
Financial Assets
H = high powered money = Currency + bank reserves
D = Stock of Bank deposits
L = Stock of Bank loans
Q = Stock of Private securities
B = Stock of government bonds
F = Stock of foreign financial assets
A superscript ‘d’ represents demand and a superscript
‘s’ represents supply.
Stocks and Flows
A stock is measured at a point in time
Stock of assets, money, bonds, physical capital measured at 31 December 2007
Flows are measured over a period of time
Examples of flows are GDP, Savings, Investment measured quarterly, or annually
Converting stocks into flows
Let Xt be the stock at a point in time t
X t  X t  X t 1
Flow of Funds
S  D  B d  Q d  F d
I  (G  T )  ( X  M )   Q s   L   B s   H   F s
S  I  (G  T )  ( X  M )
0  ( I  S )  (G  T )  ( X  M )
0  ( Q s  Q d )  ( B s  B d )  ( F s  F d )  ( L  H  D )
Implications of Financial Intermediation
Assumptions
Two-period analysis
Perfect capital market – (a) can borrow or lend at the same rate of interest, (b) perfect
information, (c) costless access to capital market.
Investment opportunities are infinitely divisible
PIF – physical investment opportunities frontier
FIL – financial investment opportunities line
Physical Investment Opportunity Frontier
Period 1
E
C1
Return on
investment
Cost of
investment
C0
Y0
Period 0
Financial Investment Opportunity Line
Period 1
B
0B = (1+r)0A
-(1+r)
0
A
Period 0
Borrowing
E
A’
A
Lending
B’
B
E
Structure of Financial Markets
Firm (or individual) obtains funds in the debt market or the equity market
A debt instrument (bond or mortgage) pays a fixed income stream over a
specified period.
The maturity of the debt instrument is short term if less than a year, long term if
more than 10 years and intermediate term if in between,
Equities (common stock) are claims to shares in the profits and assets of a
business.
Equities pay periodic sums called dividends.
The disadvantage of equity is that the holder is a residual claimant
Primary and Secondary Markets
Primary market is the market for new issues of securities, or initial public
offerings (IPOs)
Secondary market is where existing securities are traded (NYSE, NASDAQ, LSE,
etc)
Some IPOs are well known and advertised and attract a lot of attention but
many are of unknown enterprises and are underwritten by a known investment
bank.
Brokers are agents of investors who match buyers and sellers of securities.
Dealers link buyers and sellers by buying and selling securities at stated prices. A
Market Maker buys/sells at the quoted bid-ask spread with the aim of making a
profit on the spread.
Money and Capital Markets
Markets are sometimes distinguished on the basis of maturity of the
securities traded.
The Money Market is a financial market where short term debt
instruments are traded (less than a year) – Commercial paper, Bills
etc
The Capital Market is where long term debt (longer than one year
such as bonds) and equities are traded.
The money market is usually more liquid and more traded and so is
used by financial institutions to earn income on surplus funds.
International Financial Markets
Foreign bonds are denominated in the currency of the market in
which it is sold.
Eurobond is bond denominated in in a currency other than the
currency of the market in which it is sold.
Eurocurrencies are foreign currencies deposited in banks outside the
home country.
Eurodollars are dollars deposited in banks outside the USA
Summary
We have looked at the process and theory of financial
intermediation.
Efficient direct finance is conducted through the mechanism of an
efficient capital market
Indirect finance is through the process of a financial intermediary.
Financial intermediation is welfare superior to non-market direct
financing.