Financial intermediaries help to channel funds from the lenders to the borrowers through indirect financing. Some examples of financial intermediaries are banks, credit unions, insurance companies and pension funds. The existence of financial intermediaries helps to solve and reduce market imperfections.
Asset transformation theory deals with difference in the preferences of lenders and borrowers. Lenders also known as savers, prefers to have low risk and short term claims with high interest income. The deposits from lenders tend to be in small amount. Borrowers also known as spenders, prefers to have long term claims with low interest payment. The loans are usually in large amount that are risky due to the nature of business. Financial intermediaries transform maturity by lending long to the borrowers and borrowing short from the lenders. Deposit amount on average tend to be smaller and financial intermediaries parcel these small amount of deposits and transform it to large loans required by the borrowers. Risky loans are transformed into riskless deposits to reconcile the preferences of the borrowers and lenders through three different methods. Screening loan applications through credit scoring, diversifying risk by avoiding heavy loan concentration and pooling risk by applying law of large numbers to reduce the variability of losses. Lastly, deposits are contracts that offer high liquidity with low risk while loans are illiquid with higher risk. Financial intermediaries can transform the assets with different liquidity features through diversification of their portfolio.
Transaction cost incurred because of time and money spent in performing financial transactions. Prior to granting loans, search costs is incurred by both the lenders and borrowers to search for the suitable counterparty. Verification cost is then incurred by lenders to verify the accuracy of information provided by borrowers to evaluate if they meet the credit criteria. After loan is being granted, lenders incurs monitoring costs, auditing costs and enforcement costs to ensure that the terms and conditions of the loan are adhered to and in the event that borrowers defaults payment, legal cost will be incurred when instituting debt recovery.
The existence of financial intermediaries reduce transaction cost with the economies of scale, with the increase in number of financial transaction, transaction cost per dollar of output reduces. Economies of scope is a cost advantage when more than one product is produce jointly rather than producing them separately. An example is that deposits are legal financial claims by which banks both collect funds to sustain their lending activities and satisfy request for payment services. Lastly, financial intermediaries are specialized in gathering and analyzing information. Even though transaction cost may cut down an investor’s profit, financial intermediaries help to reduce such costs. Despite this, there are several fees that are unavoidable but it would be usually worth the cost for the particular return of the financial market asset.