Discuss the Theory of Financial Intermediation and Relate It to Zimbabwe

UNIVERSITY OF ZIMBABWE

NAME: TOMBO ENOCK

REG NO: R096881P

COURSE: BANKING THEORY AND PRACTICE (BS 004)

QUESTION: DISCUSS THE THEORY OF FINANCIAL INTERMEDIATION AND RELATE IT TO ZIMBABWE? (30)

INTRODUCTION

The motive of this paper is to discuss the theory of financial intermediation then relate it to the Zimbabwean scenario. According to Thomas (1971), financial intermediation is the flow of funds from savers to deficit spenders by way of financial institutions or financial intermediaries. These financial intermediaries are basically middlemen who obtain funds from savers and make them available to deficit-spenders(borrowers).A financial intermediary issues debt or equity claims(secondary claims) against itself in order to attract the individual savings of thousands of citizens, for example saving, life insurance policies and shares in mutual funds. The funds attracted from the saving units are then utilised to purchase debt or equity claims issued by borrowers, such instruments are known as primary claims, because they are the claims issued by ultimate borrowers. Examples of primary claims are Zimbabwe government securities, commercial paper, bonds, mortgages and common stocks. Examples of these intermediaries are commercial banks, life, fire and casualty insurance companies and pension funds.

LITERATURE REVIEW

Scholtens and Wensveen (2003) argued that there are two strands in the literature that formally explains the existence of financial intermediaries. The first strand emphasises financial intermediaries' provision of liquidity. The second strand focuses on financial intermediaries' ability to transform the risk characteristics of assets. In both cases, financial intermediation can reduce the cost of channelling funds between borrowers and lenders, leading to a more efficient allocation of resources. Diamond and Dybvig (1983) analysed the provision or liquidity by banks, that is, the transformation of illiquid assets into liquid liabilities. In Diamond and Dybvig's model, ex ante identical investors (depositors) are risk averse and uncertain about the timing of their future consumption needs. Without an intermediary, all investors are locked into illiquid long term investments that yield high pay-offs only to those who consume late. Financial intermediaries are able to transform the characteristics of assets because they can overcome a market failure and resolve information asymmetry problems. Information asymmetry in credit markets arises because borrowers generally know more about their investment projects than others do.Stiglitz and Weiss (1981), developed amodel of credit rationing, where some borrowers receive loans and others do not. They assume that the interest rate directly affect the quality of loans because of an adverse selection effect or moral hazard effect. Banks making loans are more concerned about the interest rate they receive on a loan and the riskiness of the loan.

The current theories of the economic role of financial intermediaries build on the economics of imperfect information that began to emerge during the 1970s with the seminal contributions of Akerlof (1970), Spence (1973) and Rothschild and Stiglitz (1976). To better glimpse the theory of financial intermediation, it is important to analyse the economic basis for the existence of financial intermediaries.Kroos and Blyn (1971) were of the view that financial intermediaries exists because they can reduce information and transaction costs that arise from information asymmetry between borrowers and lenders. Financial intermediaries assist the efficient functioning of markets and and any factors that affect the amount of credit channelled through financial intermediaries can have significant macro-economic effects.

Thomas (1971) emphasised the point that the economic basis for the existence of financial intermediaries lies in the fact that various aspects of the instruments which borrowers prefer to issue in order to finance deficits are not compatible with the preferences of the millions of savers, that is, the problem of effectively matching the individual borrowers' needs with that of the lenders. By pooling funds, financial intermediaries are able to take advantages of insurance principles and efficiencies of scale which permits diversification, specialisation and division of labour. In this way financial intermediaries are able to provide a service both to ultimate savers and ultimate borrowers. Financial intermediation overcome obstacles such as highly regressive transaction cost, poor access to certain markets, lack of availability of many financial instruments in small denominations and lack of financial expertise.

However, financial intermediation also has consequences. Gup (1979) stressed the point that financial intermediation produces a lower level of interest rates in financial markets. This result is attributed to two factors: the existence of financial intermediaries reduces the demand to hold money and increases the incentive to save out of current income. In the absence of financial intermediation, households may hold