FINANCIAL INTERMEDIARIES

Explain the different functions provided by financial intermediaries and financial markets in the allocation of funds between savers and borrowers. How have these different aspects of the financial system been affected during the ongoing global credit crunch?

Explain the different functions provided by financial intermediaries and financial markets in the allocation of funds between savers and borrowers. How have these different aspects of the financial system been affected during the ongoing global credit crunch?

The financial system consists of financial markets and institutions. Financial markets are where people buy and sell, win and lose, bargain and argue about the price and the product/services. The only difference between financial markets and normal market that we know is that in the financial markets people buy and sell financial instruments like stocks, mortgage contracts, and bonds and so on. Financial institutions, as part of financial system, they also play an important role in economic development by facilitating the flow of funds from surplus unit (savers) to the deficit unit (borrowers). They are firms such as credit unions, commercial banks, finance institutions, insurance companies and etc.

Economic elements or parties that are involved can be divided into households, business organizations, and government. Business often needs capital to implement growth plans; government requires funds to finance building projects; and households frequently want loans for example to purchase homes, cars and so on. Fortunately, there are other individuals or households and firms with incomes greater than their expenditures (surplus budget position). Therefore financial markets bring together people and organizations needing money with those having surplus funds. In other words, the purpose of the financial system is to transfer funds from savers to the borrowers in the most effective and efficient possible manner. And that job can be done by direct financing or by indirect financing. Despite the method of transferring the resources the objective is to bring the involving parties together at the lowest possible cost.

Direct Financing: In direct financing borrowers and savers exchange money and financial instruments directly. Borrowers or deficit units issue financial claims (they are claims against someone else's money at a future date) on themselves and sell directly to savers or surplus units for money. The savers hold the financial claims as interest bearing instruments and they can sell it in financial markets. Upon agreed time or maturity date borrowers have to give back the savers principle plus the agreed interest rate.

Indirect financing: A problem that arises from direct financing brought the usage of indirect financing. Sometimes the savers or surplus units can't wait to hold financial claims till maturity date therefore they sell the financial claims to the financial intermediation and take their funds from them to do whatever they please.

BENEFITS OF FINANCIAL INTERMEDIATION (INSTITUTIONS)

Financial intermediaries have three main sources of proportional advantage compare to others. First, financial institutions can achieve economies of balance through specialization of what they offer and do, because they handle large numbers of transactions, they are able minimize the fixed cost through spreading between ...