They reduce the transactions costs of borrowing for

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they reduce the transactions costs of borrowing for firms, and they reduce the transactions costs of lending for households. Lenders Suppose that you have $1,000 to invest. One opportunity may be to make a loan directly to a friend of yours who is starting a business who is looking for funds. But that may be a very risky investment option for your funds. You may have no way of forcing payment of the loan, and you are not really sure whether his idea is a good one because you have no experience in business planning. Besides, a loan may ruin your friendship, and you don’t want to put all of your eggs into such a risky basket. Banks provide another investment opportunity. You could deposit the money into a savings account, earn small interest payments, and allow the bank to lend your money to others. If the bank makes loans to different types of borrowers, then this enables you to diversify your risk. A savings deposit is a very safe investment, but the low risk is also accompanied by a low return. Perhaps you are willing to undertake a bit more risk in 70
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Econ 350 U.S. Financial Systems, Markets and Institutions Class 8 your investment to achieve a higher rate of return. So you seek to invest your $1,000 in debt or equity markets. Once you try to invest your $1,000 in debt or equity markets, you immediately face a problem – you do not have enough money. A stock broker may charge very high commissions before he is willing to invest such a small sum of money. Your potential return might be greatly diminished by the commissions you would have to pay. Most Treasury auctions are for bonds with a face value of $10,000, so with a meager $1,000, you don’t have enough to purchase a single Treasury bond. How do small investors seek higher returns than those provided by savings accounts? A financial intermediary that allows small investors to pool their funds is known as a mutual fund. Investors can purchase shares in a mutual fund, often for fairly small denominations, and by pooling their funds collectively they are able to make larger and more diversified investments. Mutual fund: A financial intermediary that pools the funds of small investors to purchase debt and equity securities. Mutual funds allow individual investors to participate in debt and equity markets that they might be excluded from otherwise, and to diversify their risk. Financial intermediaries, such as banks and mutual funds, would allow your $1,000 to be put to more productive uses than you could probably find on your own. How? Financial intermediaries, as we have repeated, help to reduce the transactions costs to lenders. They do so primarily by taking advantage of economies of scale in financial markets and by developing expertise in a particular area of lending. Economies of scale: A situation where an increase in all inputs results in a more than proportionate increase in output. For instance, a doubling of all inputs would result in a more-than-doubling increase in output. When economies of scale exist, a firm’s long run average cost curve is declining.
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