What are the economic functions that financial intermediaries perform that benef

Question

What are the economic functions that financial intermediaries perform that benefit society? In your answer, discuss the relationship of financial intermediaries and financial markets to the savings-investment process within an economy and to each other. As part of your discussion provide an analysis of the differences in preferences among economic agents as an explanation for the wide variety of primary and secondary securities found in financial markets.

Be sure to explain how depository intermediaries, like banks, differ from other financial institutions such as investment banking firms or securities brokerage companies, and how financial intermediaries profit from the transformation of primary securities into secondary claims.

Carefully, DEFINE YOUR TERMS.

Explanation / Answer

Financial intermediation can improve economic efficiency in at least five ways, by: 1) facilitating transactions; 2) facilitating portfolio creation; 3) easing household liquidity constraints; 4) spreading risks over time; and

5) reducing the problem of asymmetric information.

Brokerage: Brokerage is acting as an agent to bring buyers and sellers together in order to complete financial transactions. Financial institutions such as stockbrokers specialize in brokerage, while some financial institutions engage in brokerage in addition to intermediation.

Externalities: Spillover effects, negative or positive, generated by the actions of financial institutions in particular, and the financial system in general, are called externalities. Negative spillover effects are often used as a justification for government regulation of the financial system.

Relationship of financial intermediaries and financial markets to the savings-investment process:

In Financial Market borrowers borrow funds directly from lenders selling securities (also called financial instruments), which are claims on the borrower’s future income or assets. Securities are assets for the person who buys them but liabilities (IOU's or debts) for the individual or firm that sells (issues) them.

The primary market is where securities are created. It's in this market that firms sell (float) new stocks and bonds to the public for the first time. For our purposes, you can think of the primary market as being synonymous with an initial public offering (IPO). The secondary market is what people are talking about when they refer to the "stock market". This includes the New York Stock Exchange (NYSE), Nasdaq and all major exchanges around the world. The defining characteristic of the secondary market is that investors trade among themselves. That is, in the secondary market, investors trade previously issued securities without the issuing companies' involvement.

Investment banks focus on initial public offerings (IPOs) and large public and private share offerings. Merchant banks tend to operate on small-scale companies and offer creative equity financing, bridge financing, mezzanine financing and a number of corporate credit products. While investment banks tend to focus on larger companies, merchant banks offer their services to companies that are too big for venture capital firms to serve properly, but are still too small to make a compelling public share offering on a large exchange. In order to bridge the gap between venture capital and a public offering, larger merchant banks tend to privately place equity with other financial institutions, often taking on large portions of ownership in companies that are believed to have strong growth potential.

Merchant banks still offer trade financing products to their clients. Investment banks rarely offer trade financing because most investment banking clients have already outgrown the need for trade financing and the various credit products linked to it.

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