BFF5916 · International Banking
Financial Intermediation
Financial intermediation is the business that gives a bank its reason to exist. The financial system has one job — move funds from those with a surplus (savers) to those who can use them (borrowers) — and that flow can run two ways: directly through markets (a saver buys the borrower's shares or bonds) or indirectly through an intermediary. A bank does indirect finance: it issues its own liability, a deposit, to the saver and holds the borrower's loan as its own asset, so the saver's claim is on the bank, not the borrower. Intermediaries exist because four frictions break direct finance — coincidence of wants, transaction costs, asymmetric information (adverse selection before the deal, moral hazard after) and maturity mismatch. The fix for the last one, maturity / liquidity transformation (short liquid deposits funding long illiquid loans), both defines a bank and makes it fragile. This chapter sets up the whole unit: it names the six parts of the system, defines a bank three ways, and draws the line from domestic to international to multinational banking.
What this chapter covers
- 01The financial system and its six parts (money, instruments, markets, institutions, regulators, central banks)
- 02Direct vs indirect finance — who holds the claim
- 03Why intermediaries exist — the four frictions
- 04Asymmetric information: adverse selection vs moral hazard
- 05Maturity & liquidity transformation — the defining trick and the danger
- 06What a bank is (function, services, law) and financial instruments
- 07Domestic → international → multinational banking; industry trends
Worked example: adverse selection vs moral hazard — get the timing right
- +1Recall the rule: asymmetric information splits into a problem of hidden type before the deal and hidden action after it.
- +1(a) The eager-but-risky borrowers are a hidden-type problem the lender can't screen out at one price — this is adverse selection, and it occurs before the loan is made.
- +1(b) Switching to a riskier project after funding is a hidden-action problem — this is moral hazard, and it occurs after the loan is made.
- +1How a bank fixes both: it produces information — screening up front curbs adverse selection, and monitoring throughout curbs moral hazard. That information role is the heart of intermediation.
Key terms
- Direct vs indirect finance
- Direct finance runs through markets and the saver's claim is on the borrower; indirect finance runs through an intermediary and the saver's claim is on the intermediary. Banks do indirect finance — they interpose their own balance sheet.
- Adverse selection
- A hidden-type problem that occurs before a deal: at a given rate the borrowers most eager to borrow are often the riskiest, so a lender who can't tell them apart attracts the worst pool. Curbed by screening.
- Moral hazard
- A hidden-action problem that occurs after a deal: once funded, the borrower has an incentive to take more risk with someone else's money. Curbed by monitoring and covenants.
- Maturity / liquidity transformation
- A bank issues short-term, liquid liabilities (deposits withdrawable on demand) and holds long-term, illiquid assets (loans). It is enormously valuable but is exactly what makes a bank vulnerable to a run.
- Financial instrument
- The written legal obligation of one party to transfer something of value (usually money) to another at a future date under specified conditions. The 'future date' clause is what separates an instrument from a spot payment.
Financial Intermediation FAQ
What is the difference between direct and indirect finance?
Under direct finance the saver's funds reach the borrower through markets — the saver buys the borrower's shares or bonds and holds a claim on the borrower. Under indirect finance the funds flow through an intermediary that issues its own liability (a deposit) to the saver and holds the borrower's loan as its own asset, so the saver's claim is on the intermediary. Banks do indirect finance; that substitution of the bank's own balance sheet is the heart of intermediation.
Why do banks (intermediaries) exist at all?
Because four frictions make matching savers and borrowers directly hard: coincidence of wants (matching amount and maturity at the same moment), transaction costs (search, negotiation, monitoring, enforcement), asymmetric information (the borrower knows more than the lender), and maturity mismatch (savers want short and liquid, borrowers want long and committed). A specialist intermediary overcomes each one — pooling, spreading fixed costs, producing information, and transforming maturity.
Adverse selection or moral hazard — how do I tell them apart?
By timing. Adverse selection happens before the deal and is about hidden type (which borrowers you attract). Moral hazard happens after the deal and is about hidden action (what the borrower does once funded). Examiners flip the timing to catch you; the one-liner is 'selection comes first, hazard comes after'.
When is a bank 'international' and when is it 'multinational'?
A domestic bank serves only residents in local currency. An international bank also serves non-residents and deals in foreign currencies, but with no operational presence overseas. A multinational bank (MNB) adds an operational presence abroad via foreign direct investment — branches, affiliates, M&A. Every MNB is international, but not every international bank is multinational; the test is an operational presence overseas, not just dealing in many currencies.
Exam move
Memorise three lists cold, because they are guaranteed recall items. First, the six parts of the system — money, instruments, markets, institutions, regulators, central banks — and the trap that markets are NOT institutions (direct finance runs through markets, indirect through institutions). Second, the four frictions and how an intermediary fixes each, with asymmetric information splitting into adverse selection (before, hidden type) and moral hazard (after, hidden action). Third, the domestic → international → multinational ladder, where the multinational step is an operational presence overseas via FDI. Anchor everything on maturity transformation: it is the one trick that both defines a bank and sets up the bank-run risk you meet later.
