The role of banks in the operation of the money markets 7 / 13

The role of banks and other financial institutions in the operation of the money markets

Lenders or savers give money to Financial Intermediaries

Financial intermediaries then use this money for loans to borrowers/spenders

These financial intermediaries are banks, insurance companies, pensions etc

Therefore these banks and other financial institutions provide indirect finance to businesses. It’s also called financial intermediation

Why not borrow/lend money directly?

The banks and other financial institutions offer 2 advantages:

  • Transaction cost reduction
    These would be really high for individuals but banks with high volumes of transactions use economies of scale to reduce them

  • Credit Risk reduction
    This is due to information. The borrower knows a lot more about their ability to repay than the lender knows. This is asymmetric information. It causes credit risk

    Banks etc though have many specialists who can assess the borrowers ability to repay and at a cheaper cost than a lender could use individually. Hence they can reduce the credit risk for the lender

Securitisation

This turns illiquid assets into marketable securities (hence the name)

Banks, for example, could convert their long term receivable loans into securities and selling them to big institutional investors

For the banks these mortgages will have different maturity times but selling them as securities takes away this mis-match problem

The security will almost always be backed by an asset e.g. a house in a mortgage backed security