Function of Financial Intermediaries

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As shown in Figure 1 (p. 24), funds can move from lenders to borrowers by a second route, called indirect finance because it involves a financial intermediary that stands between the lender-savers and the borrower-spenders and helps transfer funds from one to the other. A financial intermediary does this by borrowing funds from the lender-savers and then using these funds to make loans to borrower-spenders. For example, a bank might acquire funds by issuing a liability to the public (an asset for the public) in the form of savings deposits. It might then use the funds to acquire an asset by making a loan to General Motors or by buying a GM bond in the financial market. The ultimate result is that funds have been transferred from the public (the lender-savers) to GM (the borrower-spender) with the help of the financial intermediary (the bank).

The process of indirect finance using financial intermediaries, called financial intermediation, is the primary route for moving funds from lenders to borrowers. Indeed, although the media focus much of their attention on securities markets, particularly the stock market, financial intermediaries are a far more important source of financing for corporations than securities markets are. This is true not only for the United States but for other industrialized countries as well (see Box 1). Why are financial intermediaries and indirect finance so important in financial markets? To answer this question, we need to understand the role of transaction costs, risk sharing, and information costs in financial markets.

Transaction Costs Transaction costs, the time and money spent in carrying out financial transactions, are a major problem for people who have excess funds to lend. As we have seen, Carl the Carpenter needs $1,000 for his new tool, and you know that it is an excellent

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