Introduction
Financial Intermediaries, also known as financial institutions, are institutions that facilitate flow of money from those who have excess (depositors) to those who have deficit (borrowers). In most cases, such institutions are banks. Banks are the backbone of any financial industry in any country. Financial intermediaries have a big role to play in any given economy. They facilitate both national and international trade by allowing concerned parties to conduct financial transactions.
As Bowe, Briguglio, and Dean (1998, p. 65) note, the financial sector will dictate the growth of all other sectors in a given country. Other sectors in the economy depend on banks in order to conduct business successfully. Financial intermediaries help other institutions in various sectors in several ways. The recent financial crisis in the US and other European countries was caused by a weakened financial sector. According to French, McNayr and Escher (2010, p. 56), financial intermediaries work hand in hand with other sectors in the economy to ensure growth in the entire economy.
Cost of Intermediation in the Banking System
Intermediation services come at a fee. The cost of intermediation can be analyzed in three major ways. The first approach is the cost to borrowers and lenders using intermediaries, the second approach is the cost to borrowers and lenders not using the intermediaries, and the last approach is the cost to intermediaries themselves.
Cost to Borrowers and Lenders Using Intermediaries
Financial intermediaries always act as a link between borrowers and lenders. They collect small savings from individuals who have excess and accumulate this amount to satisfy a borrower who needs a large sum of money as a loan. Similarly, they collect huge savings from individuals who have excess and distribute this amount to various individuals who need small amounts as loans (Hirschey, Kose & Makhija 2004, p. 89). This comes at a cost to both the borrower and the lender.
To the borrower, various fees are levied in the process of obtaining the loan. The financial intermediaries always charge some interest on the loan they give. Government would always determine the rate at which the intermediaries charge interest. In the United Kingdom, the government regulates interest rates charged by financial intermediaries through its central bank known as the Bank of England (Kent & Thompson 2005, p. 43). Although the government has ensured that the financial sector operates with minimal interference from the government, it has always been keen to ensure that the economy and the currency of the country remain stable. In case of inflation, it would intervene and set higher interest rates in order to regulate the amount of money in circulation. If this happens, borrowers always find themselves paying more for the loans they take. Other costs that borrowers incur in the process of securing loans include withdrawal fees. Whether the withdrawal is made through the automatic teller machine or over the counter, the borrower will have to incur this cost as he or she gets this money from the bank (Lall & Narula 2004, p. 465).
As expected, the lender would earn some interest from the amount they deposit in the bank, depending on the type of account the individual has used to save his or her money in a given financial intermediary. However, there are costs that such savers incur. The first cost is the account maintenance fee. Some banks charge some small fees to those who have accounts with them. This fee varies from one financial intermediary to another, depending on the financial policies of that given bank. Such maintenance may include replacement of the ATM cards or other related cards such as checkbooks fees. These individuals would also incur some costs when withdrawing their money from the bank.
Cost to Borrowers and Lenders Not Using Financial Intermediaries
Some individuals do not use financial intermediaries, though they are actively involved in various financial transactions. To borrowers who do not rely on financial institutions for their financial solutions, the biggest cost is always the inflated cost of the loan. Banks are always considerate and the government always regulates the fees they charge on the loan they give out. However, there are individuals who are always willing to loan out money to borrowers, though at their own terms. Their terms are always harsh, especially if the borrower fails to meet the set deadline (Lacity, Willcocks & Feeny 2004, p. 127). Such lenders always use mechanisms that have negative impacts on the borrower, such as reclaiming some properties belonging to the borrower.
To the lender, this process of loaning out money directly as opposed to using intermediaries comes at a cost. According to Safizadeh, Field and Ritzman (2003, p. 558), the biggest risk in such a transaction is the possibility of the borrower failing to pay the loan. Because the lender did not have the moral authority to conduct such a transaction according to the law of the land, the same law may not defend him or her in case one party fails in meeting his or her obligation. In the contrary, such an individual may have a case to answer in a court of law concerning such an unauthorized transaction. There is also the possibility of the borrower giving the principle amount without the interest as was previously agreed. As Moran (2011, p. 36) articulates, such transactions are always very risky. Although they might be tempting because they are more lucrative to lenders than depositing the same amount in a bank, the consequences that come with them are equally great. A client may fail to honor the agreement, forcing the lender to use other means to reclaim this amount. The cost associated with this process of reclaiming this money is great. It is even worse since the lender is not assured that this process will succeed.
Cost to the Financial Intermediaries
The financial institutions also pay a price as they play their part in ensuring that this industry performs as per the laid principles and expectations. The costs incurred by such institutions are varied. The first cost is always the cost of location. The institutions pay rent in their places of work. The cost of rent depends on the area within which the premise is located and the size of the premise itself. The banks would also have to meet the agency costs. The agents who are charged with the responsibility of looking for borrowers must be paid commissions on their work. Other agents are also charged with the responsibility of ensuring that more investors open up accounts with such institutions. They must also be paid in form of commissions.
Kurtz and Boone (2010, p. 49) observes that the world is so dynamic due to increasing rates of technological advancements. Financial institutions must be in a position to respond to changes that come with technological advancements. They include improved communication systems and transitory procedures within the bank or between the bank and other institutions. The bank must also meet other costs related to its normal transactions. Such costs include payment of salaries and wages, payment of bills or any other cost that is incurred in the process financial transaction. The bank would also need to pay some individuals conduct market research. The market is full of changes and to ensure that banks remain on the track, the need to ensure that they carry out regular research to enable them adjust appropriately as per the requirements of the market. This research comes at a cost.
Benefits of Intermediation of a Banking System
To any given economy, the financial institutions play a very important role. Kline (2010, p. 51) says that without a proper banking system, the economy of a country may not experience any growth. The financial intermediaries play a pivotal role to a borrower, a lender and the government. To the borrower, there is reduced cost of search and transaction. The banks eliminate the need to look for lenders, a process that can take long time if such institutions were not there. They offer borrowers standard transactions and therefore make it easy for such individuals to plan before going for loans. These institutions also offer a variety of products to lenders. Barry (2005, p. 65) notes that there are various types of loans depending on the duration and the type of security required as collateral. The borrower only needs to choose the one that best meets his or her current requirements. Such institutions are also very important to borrowers in cases of emergencies. They offer borrowers quick financial solutions at considerably low interest rates (Manaschi 1998, p. 75).
To the lender, the financial intermediaries make work easier. They provide an avenue through which lenders can release their excess cash to borrowers at a fee. Such lenders always take their money to the bank in form of deposits. Andrzej and Buchaman (2007, p. 89) explain that when this money is loaned out to borrowers, the lender will be given a certain percentage of profit in form of an interest. This eliminates the need for such individuals to advertise themselves for borrowers to come to them directly. The institutions also eliminate the fear that is always accompanied by borrowing directly from lenders. A lender is assured that his money is safely invested and that after a given time, it will be ready for withdrawal however little the amount would be.
Financial Crisis Since 2007
The financial crisis that has been witnessed in the recent past has been a blow to the development of various economies in the world, especially in the developed nations. Other than the Great Depression of 1929 to1939, the world economies had not experienced any serious financial crisis (Clinton 2011, p. 101). However, by the close of 2007, there was a clear sign of recession setting in the western economies. The World Bank (2009, p. 43) reported that the catastrophe started in the US. Many large corporations started experiencing financial constrains. Although this was interpreted as, a simple financial problem that would soon sort itself out, more was still to come. On 15 September 2008, the Lehman Brothers Company, a large US Company that had been one of the most prestigious firms with strong financial base, was declared bankrupt. This was one of the shocking events in the economy of the US and other European nations. This company was considered too big to fall. The collapse of the bank was a blow to many shareholders since their shares could not be traced. Furthermore, other small companies were forced to close businesses since they had invested with Lehman Company. Other individuals who had their security bonds in the firm were also among the casualties of this event. Several individuals also lost jobs in the US and other countries where this firm was operating. This caused a shock in an already unstable economy of the US. The ripple effect of this incident was so strong that its effect was strongly felt in other economies in the world, especially in the United Kingdom. This was specifically because a number of UK firms operated in the US. A negative impact in the US economy would directly be transferred to the economy of the UK.
Consequently, the industrial sector started experiencing constrains. This was specifically caused by the fact that many large companies, which were the largest investors to this sector, started withdrawing money from banks to meet their increased costs of operation. Individuals who were keeping their money with banks were also forced to withdraw more than they were saving because of increased costs of living. Following the collapse of WorldCom due to the dotcom bubble in 19 July 2002, and the September 11 attack, the United States of America was keen to encourage investment, especially in the housing sector. The interest rates were reduced to a record low of 1%. This resulted to a rush for loans in form of mortgages. Investors were interested in venturing in the real estate market. This resulted to excess flow of funds in the US economy.
There were other reasons for the fall of the financial sector in the US, which had a direct impact to the economy of the UK and other nations in the world. One such cause was the rampant fraudulent underwriting practices, especially in the mortgage sector. Many individuals obtained loans without following the laid down procedures, always faking the documents due to the ease with which the loans were given out. Such individuals were not able to repay loans, causing serious constrains to firms that issued such loans. Other institutions offered predatory loans to unsuspecting borrowers. This involved advertising loans that were considerably cheap but with terms that were hidden to consumers. The loans would be advertised to earn as low as 1% interest rates. However, this rate would be adjusted upwards as time goes by and the borrower would end up paying more than the amount they expected to pay. This weakened their financial strength and their ability to save. In effect, banks started experiencing low savings and high withdrawals.
This reduced the capacity of many banks in the economy. They could not operate as per the expected capacity. As inflation set in, the value of currency dropped. Fearing the loss that would be caused by this, many individuals withdrew their savings due to speculative reasons. This worsened the situation of these banks. Although governments in various countries such as the US and UK tried to intervene, the situation was already worse.
Investors had already lost faith as regards to the financial intermediaries. Some had considered withdrawing their investments from such institutions, a fact that further worsened the situation of banks. Emerging economies is another threat that developed countries have to deal with in their effort to maintain growth in their financial sectors. Countries such as Brazil and China have gained momentum and their aggression can no longer be assumed. China for instance has replaced both the United States and the United Kingdom as the preferred trading partner in Africa. This is a blow to the financial sector of these developed nations.
Although the current economic situation seems to have stabilized, some measures should be put in place to ensure that the economy of the country do not revert to the tribulations it experienced in the recent past. Developed nations should re-estimate the risk of financial institutions in their economies. Such countries should realize the importance of distribution of assets within this sector.
Regulation in the Banking Industry
As stated above, banking industry is very important to any economy. It affects all other industries because financial transactions take place in one way or another in the economy. For this reason, many governments have always regulated the performance of many financial institutions in the market. United Kingdom is not exceptional. Although the government has given this industry a lot of freedom, some rules and regulations have been put in place to help govern this industry.
As Lacity, Willcocks and Feeny, (2004, p. 133) state, financial institutions have very strong impact to the economy. Any effect on such institutions will have a direct impact to other sectors of the economy. As these scholars maintain, when a financial institution is declared bankrupt, many other firms will be affected by this outcome. Those firms that had their deposits with such an institution may also close down due to bankruptcy. As Barry (2005, p.49) puts it, such institutions are always too large to fall. To ensure there is stability in this industry, some regulatory procedures need to be observed.
General Principles
There are some basic principles that guide the general performance of this industry. Before an institution can be considered for approval by the central bank as a financial intermediary, it must meet the minimum capital ratio set in the economy, within which it wishes to operate. This standard varies from one country to another. This is always important as it helps in ensuring that the approved intermediaries are able to meet the demands of the economy.
These institutions are also expected to exercise market discipline. They are expected to disclose all necessary information to investors before they take loans. They are also expected to exercise fair practice within the economy. They should not be involved in such activities as fraud, which may affect the stability of the economy. In particular, they are not expected to hoard foreign currencies for speculative or any other reason because this can result in the fall of the strength of the local currency.
Regulation of Liquidity in the Economy
Liquidity refers to the amount of cash in the economy. Governments are always keen on ensuring that the amount in circulation within the economy is closely monitored. The amount of money in circulation within the economy should be enough to facilitate investments. Investors need money in order to start or expand their business units. It is the responsibility of the financial institutions to provide this. On the other hand, the amount in circulation should not exceed the requirements of the economy. This would ensure that there is no inflation in the country. They do this by adjusting their interest rates upwards in order to discourage borrowing, hence reduce the rate of borrowing.
Interest Rates
Financial intermediaries are expected to charge a certain amount of interest rate within a given economy. Governments would always encourage investment within a given economy. For this to be realized, commercial banks must charge interest rates that are as attractive to investors as possible. The central bank would lower its interest rates to loans it issues to intermediaries. This is done with the expectation that banks would do the same to investors and other borrows.
Conclusion
Financial intermediaries are very important as regards to the economic growth of any country. They are stimulants that always affect other sectors of the economy. There are costs that are always associated with intermediation processes. Lenders, borrowers and the financial institutions always incur the costs. Intermediation is very important to any given economy. Lenders, borrowers, and the government heavily depend on it for their normal operations.
Since 2007, several countries in the world have experienced some degree of financial crises. The US financial sector was strongly affected by the 2008 economic slump. Because many firms and citizens of the UK have invested in the US, any slight change in the economy of the US has a direct bearing on the economy of the UK. This sector has been under strict control by various governments. The regulatory procedures put in place to govern this sector are meant to ensure that this sector is relatively stable.
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