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UNIVERSITY OF ZIMBABWE

SurnameNcube Name.............Bongani Reg NumberR101816J Programme.HBBS (Finance & Banking) QuestionDiscuss the theory of financial intermediation as it relates to Zimbabwe. Due date20 September 2011

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Introduction
The purpose of this paper is to discuss the theory of financial intermediation as it relates to Zimbabwe. A financial intermediary is a financial institution that connects surplus and deficit agents. An example
of a financial intermediary is a bank that transforms bank deposits into bank loans. Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money (savers) to those who do not have enough money to carry out a desired activity (borrowers). A financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages.

The paper is structured in four parts (a) literature review which focuses on theories of financial intermediaries (b) methodology-in which the methods used to link the theory of financial intermediation to the practical Zimbabwean structure are explained. (c) Findings and analysis-reviews the results of the discussion and (d) which is the conclusion of thee discussion Literature Review Definition of terms Asymmetry information- the borrower is likely to have more information than the lender about the risks of the project for which they receive funds. Akerlof (1970), defines asymmetric information as a situation where one of the potential trading partners, before a commercial transaction takes place, is uninformed of the quality of the commodity being traded resulting in the adverse selection. This deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry. Examples of this problem are adverse selection and moral hazard

Transaction costs- The relevant transaction costs consist of search, verification, monitoring and enforcement costs A transaction cost is a cost incurred in making an economic exchange (restated: the cost of
participating in a market). For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal. In this case the commission would be going to the financial intermediaries.

Moral Hazard- arises when a borrower engages in activities that reduce the likelihood of a loan being repaid. An example of moral hazard is when firms owners siphon off funds (legally or illegally) to themselves or to associates, for example, through loss-making contracts signed with associated firms. Adverse selection-A problem that arises when an increase in interest rates leaves a more risky pool of borrowers in the market for funds. Financial intermediaries are then more likely to be lending to

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high-risk borrowers, because those who are willing to pay high interest rates will, on average, be worse risk Theories

1.

The theory of Financial Intermediation: An Essay on what it does (not) explain by Bert Scholtens and Dick van Wensveen Abstract This essay reflects upon the relationship between the current theory of financial intermediation and real-world practice. Current financial intermediation theory builds on the notion that intermediaries serve to reduce transaction costs and informational asymmetries. As developments in information technology, deregulation, deepening of financial markets, etc. tend to reduce transaction costs and informational asymmetries, financial intermediation theory shall come to the conclusion that intermediation becomes useless. This contrasts with the practitioners view of financial intermediation as a value-creating economic process. In our opinion, the concept of value creation is risk and risk management that drives this value creation. The absorption of risk is the central function of both banking and insurance. The risk function bridges a mismatch between the supply of savings and the demand for investments as savers are on average more risk averse than real investors. Financial intermediaries can absorb risk on the scale required by the market because their scale permits a sufficiently diversified portfolio of investments needed to offer the security required by savers and policyholders. They are active counterparts themselves offering a specific product that cannot be offered by individual investors to savers, namely cover for risk. The Perfect Model Financial intermediaries, have a function only because financial markets are not perfect according to theory introduced by Marshall and Walras of the perfect market .They exist by the grace of market imperfections. As long as there are market imperfections, there are intermediaries. As soon as markets are perfect, intermediaries are redundant; they have lost their function because savers and investors dispose of the perfect information needed to find each other directly, immediately and without any impediments, so without costs, and to deal at optimal prices. This is the general equilibrium model la Arrow-Debreu in which banks cannot exist. Obviously, this contrasts with the huge economic and social importance of financial intermediaries in highly developed modern economies. Empirical observations point at an increasing role for financial intermediaries in economies that experience vastly decreasing information and transaction costs. Risk management is the core issue in understanding this behavior. Transforming risk for ultimate savers and lenders and risk management by the financial intermediary itself creates economic value, both for the intermediary and for its client. Accordingly, it is the transformation and management of risk that is the intermediaries contribution to the economic welfare of the society it operates in. This is, in our opinion, the hidden or neglected economic rationale behind the emergence and the existence and the future of real-life financial intermediaries.

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2.

The theory of financial intermediation Franklin Allen, Anthony M. Santomero

Abstract Traditional theories of intermediation are based on transaction costs and asymmetric information. They are designed to account for institutions which take deposits or issue insurance policies and channel funds to firms. However, in recent decades there have been significant changes. Although transaction costs and asymmetric information have declined, intermediation has increased. New markets for financial futures and options are mainly markets for intermediaries rather than individuals or firms. These changes are difficult to reconcile with the traditional theories. We discuss the role of intermediation in this new context stressing risk trading and participation costs (Elsevier Science B.V. 1998) In this paper we review the state of intermediation theory and attempt to reconcile it with the observed behavior of institutions in modern capital markets. We argue that many current theories of intermediation are too heavily focused on functions of institutions that are no longer crucial in many developed financial systems. They focus on products and services that are of decreasing importance to the intermediaries, while they are unable to account for those activities which have become the central focus of many institutions. We offer in its place a view of intermediaries that centers on two different roles that these firms currently play. They are facilitators of risk transfer and deal with the increasingly complex maze of financial instruments and markets. Risk management has become a key area of intermediary activity, though intermediation theory has offered little to explain why institutions should perform this function. In addition, we argue that the facilitation of participation in the sector is an important service provided by these firms. We suggest that reducing participation costs, which are the costs of learning about effectively using markets as well as participating in them on a day to day basis, play an important role in understanding the changes that have taken place. Review and critique of current intermediation theory In the traditional Arrow Debreu model of resource allocation, firms and households interact through markets and financial intermediaries play no role. When markets are perfect and complete, the allocation of resources is Pareto efficient and there is no scope for intermediaries to improve welfare. Moreover, the Modigliani Miller theorem applied in this context asserts that financial structure does not matter: households can construct portfolios which offset any position taken by an intermediary and intermediation cannot create value (Fama, 1980). A traditional criticism of this standard market-based theory is that a large number of securities are needed for it to hold except in special cases. However, the development of continuous time techniques for option pricing models and the extension of these ideas to general equilibrium theory have negated this criticism. Dynamic trading strategies allow markets to be effectively complete even though a limited number of securities exist. Such an extreme view that financial markets allow an efficient allocation and intermediaries have no role to play is clearly at odds with what is ob-

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served in practice however, the development of intermediaries tends to lead the development of financial markets themselves (see McKinnon, 1973). These theories of intermediation have been built on the models of resource allocation based on perfect and complete markets by suggesting that, it is frictions such as transaction costs and asymmetric information that are important in understanding intermediation. Recent changes in markets and intermediaries The reality is that the financial systems in many countries have undergone a dramatic transformation in recent years. Financial markets such as the stock and bond markets have grown in size at the same time, there has been extensive financial innovation acceleration in the 1970s and 1980s. This includes the introduction of new financial products, such as various mortgage backed securities and other securitized assets, as well as derivative instruments such as swaps and complex options. At the same time, new exchanges for financial futures, options and other derivative securities have appeared and become major markets. Interestingly, this increase in the breadth and depth of financial markets has been the result of increased use of these instruments by financial intermediaries and firms. They have not been used by households to any significant extent. In fact, the increased size of the financial market has coincided with a dramatic shift away from direct participation by individuals in financial markets towards participation through various kinds of intermediaries. The importance of different types of intermediary over this same time period has also undergone a significant change. New types of intermediary such as non-bank financial firms like GE Capital have emerged which raise money entirely by issuing securities and not at all by taking deposits. In short, traditional intermediaries have declined in importance even as the sector itself has been expanding. Arguably the most important change in intermediaries' activities that has occurred in the last thirty years is the growth in the importance of risk management activities undertaken by financial intermediaries. As we noted, the change in the breadth of the markets that are available for hedging risk has not led very many individual or corporate customers to manage their own risk. Rather, it has meant that risk management has now become a central activity of many intermediaries. Most current theories of intermediation have little to say about why risk management should play such an important role in the activities of intermediaries. 3 WHAT DO FINANCIAL INTERMEDIARIES DO? By Franklin Allen and Anthony M. Santomero Traditionally, transaction costs and asymmetric information have provided the foundation for understanding intermediaries. The emergence of intermediaries resulting from such imperfections in the capital market has been formalized in the contributions of Dewatripont and Tirole (1994) and Freixas and Rochet (1997). In fact, the two major reviews of intermediation theory, Santomero (1984) and Bhattarcharya and Thakor (1993) illustrate how central such imperfections are to the intermediation literature of the past two decades. The apparent implication of this view is that, if these frictions are reduced, intermediaries will become less important. There has been a significant reduction in transaction costs and asymmetric information in recent decades. Over this same period, the importance of traditional banks that take deposits and make

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loans has, by some measures, been reduced. However, other forms of intermediaries such as pension funds and mutual funds have grown significantly. In addition, new financial markets such as financial futures and options have developed, as markets for intermediaries rather than for individuals. All of this seems, if not contrary to standard theory, at least inconsistent with it. First, it is pointed out that while it is true that the share of assets of traditional commercial banks has shrunk relative to other intermediaries in the U.S, it is also the case that relative to GDP banks assets have increased. Clearly, banking is not disappearing. Second, they question whether risk management is a new phenomenon. They mirror a view that argues that banks have always been in the risk management business, suggesting that the origins of banking and insurance lie in their risk transforming and management functions. Although the precise way in which risk is managed may have changed, intermediaries have always been engaged in risk management, broadly defined. Third, they suggest that the theory of financial intermediation needs to have an understanding of the dynamic process of financial innovation to adequately address the transformation of the financial sector that is currently taking place globally.

4. Financial intermediation O. AP Gwilym Abstract In capital markets, firms and individuals borrow on a long-term basis. In money markets, the borrowing and lending is on a short-term basis, that is, with claims maturing within one year. In capital markets, the firms and individuals can be categorized as: (a) deficit units who wish to spend more than their current income; and (b) surplus units whose current income exceeds their current expenditure. In the broadest sense, the capital markets include both direct financing (issue and sale of securities such as bonds and shares) and intermediated financing (dealings through financial intermediaries). Matthews and Thompson (2008, p.35) identify that financial intermediaries can be distinguished by four criteria: Their main category of liabilities (deposits) are specified for a fixed sum which is not related to the performance of a portfolio The deposits are typically short-term and of a much shorter term than their assets A high proportion of their liabilities are chequeable (can be withdrawn on demand) Their liabilities and assets are largely not transferable. There are exceptions such as certificates of deposit and securitisation It is important to distinguish between banks as financial intermediaries (who accept deposits and make loans directly to borrowers) and non-bank financial intermediaries who lend via the purchase of securities. The latter category includes insurance companies, pension funds and investment trusts who purchase securities, thus providing capital indirectly rather than making loans. These types of intermediary do not meet the four criteria listed above.

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The most important contribution of intermediaries is a steady flow of funds from surplus to deficit units. Financial institutions fulfill the following main functions: The brokerage function: Financial intermediaries match transactors and provide transaction and other services. As a result, they reduce transaction costs and remove information costs. The asset transformation function, financial institutions issue claims that are far more attractive to savers (in terms of lower monitoring costs, lower liquidity costs and lower price risk) than the claims issued directly by corporations. Financial intermediaries hold the long-term, high-risk, largedenomination claims issued by borrowers and finance this by issuing short-term, low-risk, smalldenomination deposit claims. This process is often described in the literature as qualitative asset transformation (QAT). Within the brokerage function, banks bring together providers and users of capital without changing the nature of the claim, whereas asset transformation processes risk in altering the nature of the claim. The asset transformation function includes an asset diversification function and an asset evaluation function. In the first case, a critical role of intermediation is the transformation of largedenomination financial assets into smaller units. Banks have the ability to exploit the sub-optimal portfolio choice of depositors and can offer the risk-return combination of financial assets that households demand. Banks are able to provide loans which fit in with customer demands, by providing divisibility services. Furthermore, because banks are able to break down assets into small units, they can reduce transaction costs and also employ diversification for the benefit of both their customers and equity holders. Secondly, banks act as evaluators of credit risk for the depositor. They function as a filter to evaluate signals in a financial environment with limited information. It is argued that as a result of these asymmetries of information individuals find it difficult to evaluate other agents credit risks. This gives rise to financial intermediaries who play an important role in the evaluation and purchase of financial assets. As part of the asset transformation process, banks are addressing the very different requirements of lenders and borrowers. Despite these different requirements, one could still envisage that the shorter chain of transactions involved in direct financing would be less costly than intermediated financing. In a situation of perfect knowledge, no transaction costs and no indivisibilities, financial intermediaries would be unnecessary, but these conditions are not present in the real world. There are four further reasons for the dominance of intermediation over direct financing: Transaction costs (e.g. Benston and Smith, 1976) Liquidity insurance (e.g. Diamond and Dybvig, 1983) Information-sharing coalitions (e.g. Leland and Pyle, 1977) delegated monitoring (e.g. Diamond, 1984, 1996).

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4 CURRENT THEORIES OF FINANCIAL INTERMEDIATION 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). Financial intermediaries exist because they can reduce information and transaction costs that arise from an information asymmetry between borrowers and lenders. Financial intermediaries thus assist the efficient functioning of markets, and any factors that affect the amount of credit channeled through financial intermediaries can have significant macroeconomic effects. There are two strands in the literature that formally explain the existence of financial intermediaries. The first strand emphasizes 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 channeling funds between borrowers and lenders, leading to a more efficient allocation of resources. Diamond and Dybvig (1983) analyze the provision of liquidity (the transformation of illiquid assets into liquid liabilities) by banks. In Diamond and Dybvigs model, (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 payoffs only to those who consume late. Those who must consume early receive low payoffs because early consumption requires premature liquidation of long-term investments. Banks can improve on a competitive market by providing better risk sharing among agents who need to consume at different (random) times. An intermediary promising investors a higher payoff for early consumption and a lower payoff for late consumption relative to the non-intermediated case enhances risk sharing and welfare. Financial intermediaries are able to transform the risk characteristics of assets because they can overcome a market failure and resolve an information asymmetry problem. Information asymmetry in credit markets arises because borrowers generally know more about their investment projects than lenders do. Financial intermediaries develop special skills in evaluating prospective borrowers and investment projects. They can also exploit cross-sectional (across customers) information and re-use information over time. Diamond (1984) argues that diversification within the financial intermediary is the main reason financial intermediaries exist. He also develops a model, in which the outcome from firms investment project is not known ex post to external agents, unless information is gathered to assess the outcome, i.e. there is costly state verification (Townsend, 1979). This leads to a moral hazard problem because it provides an incentive for borrowers to default on a loan even when the project is successful.

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Methodology
The method used to link the theories to the situation on the ground was mostly observation. The observations made by the writer as a resident in Zimbabwe will be used in the analysis of this article. Also to be considered, are newspaper articles and reports on the banking and finance sector.

Findings and Analysis

The literature review above has shown that financial intermediation has been existing in Zimbabwe until the its demise in 20004 due to inflation, low business confidence and a decrease in the banking confidence as savers (lenders) find it rational to consume their funds because funds were virtually losing value overnight and it was wiser to consume it today rather than save. According to an article by Dr. Tawafadza A. Makoni, called Overview of the Zimbabwean Banking Sector (2010), the loss of value of the Zimbabwean currency during the decade since 2000 had disrupted the functionality of financial intermediaries. The withdrawal of investors in the country meant that the number of borrowers was greatly reduced and hence the money creation and value creation cycle could not be complete.

Diversification within the financial intermediary is the main reason for financial intermediaries existence in Zimbabwe. Banks in particular offer business advisory services to individuals and businesses Financial intermediaries play an important role in financial markets because they reduce the cost of channeling funds between relatively uninformed depositors to uses that are information-intensive and difficult to evaluate, leading to a more efficient allocation of resources. Intermediaries specialize in collecting information, evaluating projects, monitoring borrowers performance and risk sharing. Even if the markets are perfect, the role of financial intermediaries will exist since they is no synchronization in the time lags involved in the process of lending and borrowing that is, most individual and organizational lenders prefer to lend on relatively short term, reducing the risk associated with lending on the other hand borrowers prefer long term periods so as to spread the costs over a long period. As we move to perfect markets with less transaction costs and perfect market information due to advances in Information Technology (I.T) governments would intervene to support financial intermediaries as they employee a significant proportion of the economy for example, Canada 3.7%, United Kingdom 4.4% and United States of America 4.8% by year 2000. (Source OECD, National Accounts) The financial intermediaries in Zimbabwe can operate under dual theories of financial intermediation that is traditional and current. This is due to the fact that the population of the country is such that, those in the urban areas have access to information (lenders and borrowers can come into contact without an intermediary) whilst those in the rural centers have limited or no access to information. The existence of the population structure will allow financial intermediaries to operate

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on traditional theories in rural areas and while there is evolution of financial intermediaries in urban areas where individuals have information on their finger tips.

Conclusion
The purpose of this paper was to discuss the role of financial intermediation as it relates to Zimbabwe. Theories of intermediation need to reflect and account for the fact that financial systems in many countries have changed substantially over the years. Over this period many traditional financial markets have expanded and new markets have come into existence. Transaction costs have fallen and information has become cheaper and more available.

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References
1. The theory of Financial Intermediation: An Essay on what it does (not) explain by Bert Scholtens and Dick van Wensveen 2. Bhattacharya, S. and A. V. Thakor, 1993, Contemporary banking theory, Journal of Financial Intermediation 3, 2-50. 3. What do Financial Intermediaries do? By Franklin Allen and Anthony M. Santomero 4. Fama, E.F., 1980, Banking in the theory of finance, Journal of Monetary Economics 6, 39-58. 5. Leland, H.E. and D.H. Pyle Informational asymmetries, financial structure and financial intermediation, Journal of Finance, 32(2) 1977, pp.37187. 6. Benston, G.J., and Smith Jr., C.W. (1976). A transactions cost approach to the theory of financial intermediation, Journal of Finance 31, 215-231 7. Allen, F. (1991). The market for information and the origin of financial intermediation, Journal of Financial Intermediation 1, 3-30. 8. Allen, F., and Gale, D. (1997). Financial markets, intermediaries, and intertemporal smoothing, Journal of Political Economy 105, 523-546. 9. Allen, Franklin and Anthony M. Santomero (1998). The Theory of Financial Intermediation, Journal of Banking & Finance, Vol.21. 10. Demirg-Kunt, A., and Levine, R. (1999). Bank-Based and Market-Based Financial Systems, Policy Research Working Paper 2143, Washington: World Bank. 11. (Financial gazette) Friday 06 2009. Financial disintermediaries.