Role of Transaction Cost in Intermediation Process Assignment

Role of Transaction Cost in Intermediation Process - Assignment Example For instance, when the bank acts as intermediary it connects individuals with different needs, financial inputs at different point of time. It allows people to save money into various accounts like savings account, time deposits, salary account, pension funds, and so on. After the bank accepts deposits from an individual it invests that sum into projects which have returns greater than or equal to the cost of investment which is also the bank’s liability. Now, if any corporate or individual approaches the bank for loan, the bank will charge interest on that loan. This interest will increase the transaction cost of the individual or corporate. The interest charged on loans by the bank on the borrower will obviously higher than what the bank has to pay to the depositors. This is because in order to operate in the market and serve the community it has to maintain a profit margin for all transaction which otherwise would lead to collapse of business. The advantage that an individu al or a corporate will get from an intermediation process is that the credit risk is transferred from individual borrower to the bank. This is because when a corporate raises funds from market directly without any intermediation, the credit risk of parties to transaction has to be evaluated personally. This is true in case of over-the-counter markets where the contracts are much customised according to individual requirements and parties to contract enter into agreement with each other without any intermediary. This reduces their transaction cost but also increases the credit risk. When an intermediary is introduced in the same model as in case of exchange traded funds, the transaction cost increases due to brokerage charges, maintenance fee, printing and advertising charges, commissions, and so on. The various costs are passed on to the fund raiser and hence decreasing the transaction cost of the individual from intermediation process (Buckle and Thompson, 2004, p.37). From the abo ve discussion, the role of transaction cost in the intermediation can be summarised as follows. The intermediation process aims to connect the individuals with surplus funds with individuals with deficit funds in order to channel funds properly in the economic system. In the process of intermediation the individuals and corporate is able to reduce search cost of raising funds, verification cost, monitoring cost, and credit worthiness of the parties involved in transaction. Since the intermediary provides these services, it charges a fee or commission for providing these services which increases the cost of transaction from intermediation process but such cost is much less compared to the benefit from intermediations (Mishkin and Eakins, 1998, p.369). For instance, the banks offer standardised services and products that reduce cost of transaction and the risk of investment. The OTC market mainly operates without intermediation and is hence a much more risky option. Role of Asymmetric Information in Intermediation Process In order to understand the role of asymmetric information in the intermediation process, it is important to understand the concept of asymmetric information. Asymmetric information arises from a situation when one party to transaction has more information compared to the other. This is generally