1. What are recent challenges that financial institutions have faced given curre

Question

1. What are recent challenges that financial institutions have faced given current economic conditions? Have they faced challenges? Has the financial system faced challenges? Explain.

2. How are financial intermediaries able to generate profits?

3. For many years there were specific regulations separating the specific financial functions a given institution could perform. For example, banks could not also serve as brokerage firms. What were some of these divisions? Why the separation? How is it changing?

Explanation / Answer

How are financial intermediaries able to generate profits?

Financial intermediation is the process by which financial institutions mediate unmatched preferences of ultimate borrowers (DSUs) and ultimate lenders (SSUs). Financial intermediaries buy financial claims with one set of characteristics from DSUs, and then issue their own liabilities with different characteristics to SSUs. Thus, financial intermediaries "transform" claims to make them more attractive to both DSUs and SSUs. This increases the amount and regularity of participation in the financial system, thus promoting the 3 forms of efficiency, allocation, informational, and operational.

The ways to generate profit for Intermediaries pay SSUs less than they earn from DSUs. Operating costs absorb part of this margin. Risks taken by the intermediary are rewarded by any remaining profit. Intermediaries enjoy three sources of comparative advantage:         

Economies of scale –

large volumes of similar transactions;

transaction cost control,

finding and negotiating direct investments less expensively; and

risk management expertise bridging the "information gap" about DSUs' creditworthiness

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