Money, Banking & Finance
Lecture 1
The Nature of Financial
Intermediation
K Matthews
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.