A financial intermediary is an institution which creates and issues financial claims against itself and uses the proceeds to acquire and hold financial claims against others. Examples of financial intermediaries include commercial banks and mutual savings banks. Households, businesses and any other owner of savings can hold large valuable amounts of direct securities. Financial intermediation can facilitate these amounts by offering a variety of services; the availability of equity and debt securities with different features that will be reflected in differences in liquidity, the availability of large amounts of information and analysis concerning a number of direct securities and the availability of trading facilities in both primary and secondary markets to facilitate sales and purchases.
Lenders typically have less information than borrowers and as a consequence they are faced with the problems of adverse selection and moral hazards. There are many ways in which financial intermediaries can reduce adverse election and moral hazards in the market. Adverse selection occours when the potential borrowers who are the most likely to produce an adverse outcome are the ones who most actively seek out a loan and hence are most likely to be selected. Financial intermediaries can help solve the problem of adverse selection in many ways. To explain how they can help it is easier to look at the used car market structure and it is similar to the structure of a financial intermediary.
The most important feature of a used car market is that cars are not sold directly from one person to another. An individual considering to buy a car may seek advice from a magazine such as Exchange and Mart. However, doing this background reading would not solve the problem of adverse selection as even though a car may have a good reputation, the specific car that is trying to be sold to them maybe faulty.
The buyer might then hire a mechanic to evaluate the car but has to consider if the mechanic can be trusted and if there is going to be a high fee for the cars evaluation. Because of all these various obstacles it makes it hard for an individual to acquire good complete information without high costs and time being consumed. Most cars are not sold directly from one consumer to another but through an intermediary i.e. a used car dealer. This is because a used car dealer produces information in the car market by becoming experts on deciding whether a car is going to sell and what sort of price and profit it would make. People are more likely to buy through a used car dealer because of the good reputation that the dealer may have and a guarantee that the car dealer will make to the customer.
So like used car dealers help sole adverse selection problems in the used car market, financial intermediaries play the same role in financial markets. This is because the cost of obtaining information and the analysing of direct securities is very high. People that do not obtain expert knowledge at regular intervals of their business cycle about their securities will find it costly in terms of both time and money to gather and analyse information.
This would be especially true for people who have only small amounts to invest in. A financial intermediary such as a bank becomes an expert in the production of the information about companies so they can tell a good credit risk from a bad one. They can then acquire funds from the savers of firms and lend them to other good firms. Because financial intermediaries have good sound information it is likely that they would lend money to the firms that would give them a higher rate of return, resulting in a profit for themselves.
A moral hazard is the asymmetric information problem that occurs after a financial transaction has taken place and is associated with the monitoring and enforcement stages. It is when the seller of a security may have incentives to hide information and take part in activities which are undesirable for the purchaser of the security. It is also the risk that the borrower might engage in objectionable behavior because they make it less likely that the loan in repaid.
Financial intermediaries have the ability to avoid the moral hazard due to venture capital firms. Venture capital firms collect and save money and preserve resources and then help first time entrepreneurs set up their own business. The new entrepreneur in return gives the venture capitalist firm a share of the new businesses equity. To eliminate problems of reporting profits and earning, the venture capitalist firms usually insist on having members of their own company joining the managing board of the new firm. This is so that they can keep an eye on the firm's activities.
Financial intermediaries can also reduce moral hazards by using restrictive covenants. These are provisions written into a debt contract that restricts borrowers activities. An example of this is a mortgage loan that requires a borrower to carry life assurance that pays off the loan in the event of the borrower dying. Covenants can be designed to lower moral hazards by making sure borrowers do not undertake in risky investments and projects. Some banks restrict borrowing to specific activities such as the purchasing of stock and assets.
Covenants help reduce the moral hazards that borrowers and lenders face but it can never eliminate the hazards completely. Restrictive covenants have to be monitored so that borrowers wont infringe the rules and take illegal paths. Financial intermediaries can stop moral hazards to some extent as long as they only make private loans. Private loans eliminate moral hazards as they are not traded so no one else can free ride on the financial intermediaries enforcing of the restrictive covenants. The intermediary making private loans thus reduces the benefits of monitoring and enforcement and will work to shrink the moral hazard problem inherent in debt contracts.
If financial intermediaries collapsed for any reason it is called a banking panic. The main reason for this panic is due to the problem of asymmetric information. In a financial crisis, borrowers and lenders will become fearful that their savings are not safe at the financial intermediaries. In fear of loosing money they will withdraw all their savings from the bank. When all customers start to do this the bank will fail as it will have no more money to keep on running.
The failure of many banks has dire consequences for the economy. When financial intermediaries fail there is a loss of information in the market, hence the loss of financial intermediaries as a whole. People will be less willing to invest their money in financial intermediaries as they will not be sure of the outcome. Because of this there will be a decrease in money available to borrowers as not enough money is coming in. This will lead to higher interest rates for the people that want to borrow money.
A banking panic will result in higher adverse selection and moral hazards as people will be unwilling to invest their securities in banks and turn elsewhere for help. It is clear to see that financial intermediaries play a crucial role in our economy. They help investors make crucial decision by giving them advice and help at low costs. If financial intermediaries were to fail it would put the economy into depression and make information costly and time consuming to obtain.