Financial Intermediaries Case Study

Current theories of the role of financial intermediaries are built on the failure in the financial market. Five the main theories explain why financial intermediaries exist: Delegated monitoring, information production, liquidity transformation, consumption smoothing and commitment mechanisms. One of these five main theories concerns the ability of financial intermediaries in producing information.
The expression “asymmetric information” refers to the imperfect distribution of the information. Indeed, it describes a situation in which one party in a transaction has more or better information compared to the other party. For instance, when the sellers know more than the buyers, we can indeed speak about asymmetric information. The information is key to all financial transaction and this is why asymmetric information makes transaction more difficult. Asymmetric information lead to two main issues: adverse selection (ex ante) and moral hazard (ex post). In other words, the lack of information creates troubles before and after the loan. Financial intermediaries use their size and expertise to remedy to this market failure.
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Financial intermediaries are able to reduce its costs through economies of scale and thus benefit from an expertise in gathering reliable information at reduced cost. In other words, financial intermediaries are able to overcome the market failure concerning the information by transforming the risk characteristic of assets. Therefore they can extend financing to all the firms and individuals who would not got financed in the absence of financial intermediaries. For instance, a bank will more likely lend to risky borrowers because they are willing to pay higher interest rate. In order to reduce adverse selection, financial intermediaries check the history of the fund applicant using the databases that are at their