Financial intermediaries exist to reduce transaction and information costs for lenders and borrowers. They develop expertise in efficiently processing loans and use economies of scale to lower costs. Intermediaries also help address information asymmetry between lenders and borrowers, which can lead to adverse selection and moral hazard problems. They are better able to screen borrowers and monitor loans. Financial intermediaries are highly regulated to increase transparency for investors, ensure stability of the financial system, and aid monetary policy control.

1. Why Financial Intermediaries?
• Why financial intermediaries exist?
• To reduce transaction costs and information costs
• Transaction costs
• Which means the time and money spent on
carrying out financial transactions
• TC are major problem for people who have excess
funds to lend
• In absence of FIs, every lender will need a lawyer to
write a contract for him which will be very costly
• Institutions pay lower commissions like mutual funds
• Institutions can take advantage of latest technology

2. Transaction and Information costs
• Financial intermediaries can reduce these
costs as they have developed expertise in
lowering them and their large size allow them
to have economies of scale
• For example, once a bank pays a lawyer for
one loan contract, the same contract can be
used in many other loan contracts

3. Asymmetric Information: Adverse
selection and Moral Hazard
• Another reason for the presence of financial
intermediaries is that one party often does not know
enough about the other party to make accurate
decision of lending
• Asymmetric information means the inequality in the
level of information between two parties
• For example, a borrower usually have better
information about the potential returns and risks of the
project for which funds borrowed than the lender does
• The analysis of how asymmetric information affect
economic behavior is called agency theory

4. Information Problems: Adverse
Selection and Moral Hazards
• Information asymmetry creates two problems
in the financial system:
– A. Before the transaction is entered into
– B. After the transaction
• Adverse Selection: Borrowers that can create
undesirable outcome will actively seek out a
loan and are thus most likely to be selected.
Adverse selection means making a mistake by
giving away loans to undesirable borrowers

5. Moral Hazards
• Moral hazard is the risk that the borrower might
engage in activities that are undesirable from
lenders perspective.
• Moral hazards needs frequent monitoring of the
borrowers activities
• It is also referred to as conflict of interest
• Financial intermediaries have better earnings to
pay for information and screen out bad
borrowers from good borrowers (solving adverse
selection problem)

6. Cont…..Financial Intermediaries
• Financial intermediaries also have better
resources and can monitor and force
borrowers to act in accordance with the
provisions of the contract and reduce the
chances of misconduct of borrowers

7. Types of Intermediaries

8. Regulation of Financial intermediaries
• It is one of the highly regulated sectors. There
are three reasons why it is so:
• A. Increase information available to investors
• B. To ensure soundness of financial system
• C. To improve control of monetary policy

9. A. Increase information available to
investors
• Incomplete information leads to adverse
selection and moral hazard problems which
reduce efficiency of the financial system, this
is why govt tries to increase information
available to investors
• SECP requires corporations issuing securities
to disclose certain information about their
sales, assets, earnings
• Similarly, SECP prohibits insider trading

10. B. To ensure soundness of financial
system
• Asymmetric information can also lead to
widespread collapse of financial
intermediaries, called financial panic
• When geneal public lose trust in financial
institutions, they will withdraw funds from
both good and bad institutions
• To protect public and economy from financial
panic, govt implements six types of
regulations

11. To avoid Financial Panic
• 1. Restriction to entry
– Only citizens with good credentials and large
amount of initial funds get approval from SECP
• 2. Disclosure
– Stringent reporting requirement for FIs
• 3. Restrictions on assets and activities
• 4. Deposit insurance
• 5. Limits on competition
• 6. Restriction on interest rates

12. C. Improving control n monetary
policy
• Because banks play a very important role in
determining the supply of money, much of
regulations are intended to improve control
over monetary supply
• One such regulation is reserve requirements