Financial intermediaries and market’s main purpose is to create a mechanism where money can be reallocated to their most productive opportunities(Casu et al. 2006). However to find out why this Is Important and what other reasons there are for why they exist, this maln purpose must be looked at in more detail: why agents In the economy borrow and lend money, how this financing occurs, and what the barriers are without these markets and institutions. A company or individual may not have all the funding needed to invest in a project or item from their own resources. While another such company or individual may have excess funds and may want to lend their own money In order to get a return.

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The financial market creates an opportunity for the potential debtor, known as a surplus agent, who wants to lend heir money to offer it to the potential borrower, known as a deficit agent, for a small fee. This is a good example of how lending can give greater opportunity to individuals and organisations that would otherwise be impossible, in the short run, by internal funding: saving money or by raising funds from such people as shareholders. Nonetheless this is only an example of why lending is important.

Financial markets also provide lenders and borrowers with what can be seen as a fairer assessment of the agreement between them: they can compare their arrangement with others Ilke It n the market (the pricing function). The other difference between markets and individual lending is that markets are regulated. This regulation promotes deficit agents to not partake in any actions that may be detrimental to the value of their assets. An important part of this regulation is the Financial Services and Markets Act (2000), which Introduced the Financial Services Authority (Section 2).

This authority Is designed to regulate the financial sector In order to make It a safe environment for both borrowers and lenders. Another part of the legislation (Section 397) makes It a criminal offence’ to mislead a market or investors. It is not uncommon for this authority to takeactions against financial institutions. An example of this was (Odoi, 2007) when mortgage brokers created asymmetric information for investors by filling out the self assessment forms incorrectly.

Page 2 Explain the main reasons why financial markets Essay

However the FSA has come under criticism for Its ‘half hearted’ (Plender, 2011 ) regulation. This arguably negates the main purpose of thefinancial markets. If there Is Imperfect Information, and the market Is not regulated effectively, it may provide an inaccurate assessment of what the rrangement should be for the loan. Financial markets also, at least on their own, cannot provide an effective means of the transfer of funds due to nature of both deficit agents and the surplus agents.

This is due a difficulty in matching both the debtor’s and borrower’s requirements: lenders want a low risk, high return lending arrangement with high liquidity, while borrowers want an Inexpensive, long-term A financial intermediary is a good way to resolve this problem, as it can bring the surplus agent’s funds and combine them with the needs of the deficit agent. It was tated by (Buckle and Thompson, 1998) that financial intermediaries offer low risk return, with good liquidity, to those depositing funds by using them for suitable investments and loans.

It also reduces costs for lenders, as they do not have to worry about incomplete information nor do they have to pay transaction costs (Gurley and Shaw, 1960): the costs that relate to finding an organisation that wants to borrow the money, finding information on how reliable the borrowing party will be, and monitoring the transaction. This is argued as one of the main reasons that financial ntermediaries exist, as lender monitor on their own would either duplicate data on their potential borrower or investors, or the free-rider’ (Diamond, 1984) problem would occur.

Therefore it is left up to intermediaries to research borrowing and investing institutions by ‘delegated monitoring (Diamond, 1984). These benefits are also felt by borrowers as well when they are finding a suitable lender, however the benefits of a financial intermediary do not end with cost reduction. Potential surplus agents usually have small amounts of money relative to the loans required by those borrowing. This is due to the relatively large items usually being acquired by the borrower. This makes the intermediary very important for transforming the various small amounts of funding into one large loan for the deficit agent.

There is also the factor of how long the financing arrangement should be. To avoid a non-ideal solution for the lender, borrower or both parties, financial intermediaries can also deal with the fact that those who save their money usually only want to do it for a short time, while those who want to borrow want a long borrowing period. The final factor is that of risk and security. Intermediaries offer deficit agents the opportunity to take out loans for potentially high risk ventures, while offering those investing their money assurance or guarantee that they will keep their money if the borrower defaults on the loan.

This means that those borrowing can partake in risky, but potentially very profitable, ventures as intermediaries are willing to take the risks as long as adequate securities are provided. The above is why financial intermediation exists, however there is a counter argument for intermediation all together, however, that says the markets are ‘perfect nd complete’ and there is no need for intermediaries as they are an inefficient allocation of resources.

Furthermore, according to (Fama, 1980), individuals and companies can create ‘portfolios’ that counteract any value of intermediation. In this argument financial markets efficiently allocate resources. This means that intermediaries are not needed and only creates inefficiency. However there is a flaw in this argument in that financial institutions have been intermediaries for many years and have lead to the expansion of financial markets even in developing ountries (McKinnon, 1973), notwithstanding the evidence above.

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