Answers to Questions in Textbook
Financial markets are exchanges where securities or financial instruments, such as stocks and bonds,
are bought and sold. So borrowers obtain funds directly from savers in financial markets. Financial
intermediaries are institutions which issue liabilities, such as deposits in a bank, to savers and lend
those funds to borrowers. Thus, financial intermediaries indirectly provide the link between savers
Financial intermediaries exist for two reasons. For a saver with a small amount of funds, a financial
intermediary can spread the risk of lending among a large number of borrowers. As an example,
consider a person who has $5,000 in a savings account at a bank which has 10,000 outstanding loans.
The person is in essence lending 0.50 to each borrower, thereby considerably reducing the risk of
any one borrower defaulting on the loan. Furthermore, it is unlikely that the saver would be able to
find 10,000 people needing to borrow 0.50 each, and the cost of negotiating that many loans is likely
to outweigh the interest generated by the loans.
A second reason why financial intermediaries exist is that they are large enough to hire specialists
who can evaluate the risks involved in making loans to individual borrowers, something an
individual saver cannot do. For example, a loan officer at a bank is likely to have more information
than depositors concerning not only the general business conditions in an area, but also specific
information with respect to the ability of a particular borrower to repay a loan.
Borrowers in financial markets need to be large enough to either be widely known for repaying
loans and/or being able to pay the costs of providing the information that is legally required to sell
securities in financial markets. On the other hand, people and businesses who obtain funds from
financial intermediaries tend to either be too small to be able to afford to provide the information
legally required to use financial markets, or their reputations for repayment may only be known to
people at the financial intermediaries.
Despository institutions consist of commercial banks and thrift institutions. Commercial banks get
their deposits from both households and businesses and make loans to both groups. Thrift institutions
obtain funds mainly from the savings accounts of households, although they also obtain funds from
deposits into checking accounts. Traditionally, thrift institutions made real estate loans; they
continue to do so, but since deregulation, they have broadened their lending activities into other
Contractual savings institutions receive retirement savings from people and their employers. The
institutions invest these funds in financial markets and use the proceeds to pay out retirement
Investment intermediaries differ in how they obtain funds. Finance companies obtain funds in