Financial Intermediaries and Government Regulation

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Financial Intermediaries and Government Regulation 2

1. Define the term economies of scale and explain how a financial intermediary

can take advantage of such economies. 

Economies of scale are the cost advantage a firm experiences after increasing its output

level (Corporate Finance Institute., 2022). The inverse relationship between the fixed cost per

unit and the quantity produced is one of the main reasons behind the benefits of economies of

scale. Therefore, the more the output grew, the lower the fixed cost per unit (Corporate Finance

Institute., 2022). An increased production scale decreases the average variable costs because

large-scale production increases operational efficiency and synergy. Financial intermediaries

serve as middlemen between parties amid a financial transaction, such as mutual funds,

commercial banks, investment banks, or pension funds. Economies of scale help financial

intermediaries enjoy economies of scale by undertaking deposits from many customers and

lending the same money to multiple borrowers. As articulated in this paper, financial

intermediaries can leverage economies of scale to reduce operating costs in their daily business

routines.

2. Financial intermediation is not confined to bank lending but is also carried out

by nonbank firms such as mutual fund companies. How do mutual funds help overcome

information problems in financial markets? 

Financial intermediation can be carried out by nonbank firms such as mutual fund

companies. Mutual funds act as financial intermediaries that are experts at forming trust between

sellers and buyers (Hennie Van Greuning, & Sofija-Sonja Brajovic Bratanovic., 2020). Bridging

the information gap between two parties establishes transparency and optimizes the market

function. Mutual funds solve financial problems by eliminating asymmetric information and

providing prospective investors with relevant information regarding borrowers (Hennie Van
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Greuning, & Sofija-Sonja Brajovic Bratanovic., 2020). Mutual funds are companies that pool

money from many investors and reinvest it into securities such as stocks, short-term debt and

bonds. Investors buy shares in the portfolio or, instead, the combined holdings of the mutual

funds. Therefore, availing information to the public gives both investors and borrowers sufficient

knowledge regarding each other to facilitate them to make informed decisions.

3. Explain how a bank uses liability management to respond to a deposit outflow.

Why do banks prefer liability management to asset management in this circumstance? 

Deposit outflows are the losses of deposits when people demand payment or withdraw

from the bank. Banks obtain funds in the cheapest way possible through a strategy known as

liability management. The central role of liability management is to maintain its liquidity by

balancing the maturity of its assets and liabilities and facilitating lending without compromising

its balance sheets (Hennie Van Greuning, & Sofija-Sonja Brajovic Bratanovic., 2020). A bank

implements liability management by hedging against changes in interest rates. Subsequently,

asset management is developing, maintaining, operating, and selling assets cost-effectively. In

the event of a deposit outflow, banks prefer liability management since it is the quickest way to

solve the financial crisis at that particular moment. Using asset management would be less

profitable in dealing with deposit outflows since a bank would have to implement low pricing to

attract more prospects.

The critical thing in liability management in a bank is to ensure that bankers pay interest

on deposits and charge a rate of interest on loans. Therefore, bankers must balance the two

variables by tracking the net interest margin, the difference between the interest paid on deposits

and the interest earned on loans (Investopedia., 2015). Therefore, timing is the crucial thing that

makes liability management better than asset management in the case of deposit outflows. Banks
Financial Intermediaries and Government Regulation 4

must plan to pay liabilities on time while ensuring that assets are available to pay debts when

they are due. Managing assets and liabilities is applicable in different parts of the balance sheets

and helps banks remain profitable even after taking hits from economic recessions.

4. The financial sector is heavily regulated. Explain how government regulations

help solve information problems, increasing the effectiveness of financial markets and

institutions. 

Government regulation increases the effectiveness of the financial markets and

institutions, holding the senior management of companies accountable for accurate financial

statements. Government regulation has both positive and negative impacts on business because it

ensures that companies increase their internal controls, increasing the workload for financial

industry staff members. However, government regulation helps to protect investors from fraud

and mismanagement, thus creating a better environment for business and boosting investor

confidence. Therefore, based on the regulatory measures that governments implement, the

overall corporate investment concept thrives under the guarantee of the validity of the existing

investment portfolios provided in the financial markets.

Another influence of government oversight on financial markets is that it prevents

companies from undertaking too much risk (Investopedia., 2015). For instance, the 2008

financial crisis could have been averted easily if there had been stricter regulations to stop the

Lehman Brothers from engaging in risky behavior (Investopedia., 2015). Laws like the Sherman

Anti-Trust Act limit monopolies from abusing their power due to a lack of regulation. Therefore,

without government regulation, the market creates asset bubbles that arise when speculators bid

on the price of houses, gold and stocks. When the bubble bursts, it creates crises and economic

recessions (Investopedia., 2015). The government is a moderator between financial

intermediaries and consumers, mainly to improve the economic environment by reducing the

risks involved in the financial market. However, too much government regulation can increase

costs and contribute to corruption, mismanagement and collapse, thus making it difficult to

determine the exact impact of government regulation on the financial services sector.

Concisely, economies of scale can help financial intermediaries yield profits by managing

risks and offering an investment platform that allows them to direct assets profitably for the

benefit of many clients. Although compliance with government regulations regarding

information and accountability increases the workload for people working in the financial

market, it helps maintain valid operations and attracts investors to legitimate investment

opportunities.
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References

Corporate Finance Institute. (2022, February 11). Asset and liability management

(ALM). https://corporatefinanceinstitute.com/resources/knowledge/strategy/asset-and-

liability-management-alm/

Hennie Van Greuning, & Sofija-Sonja Brajovic Bratanovic. (2020). Asset-liability management

| Analyzing banking risk (Fourth edition): A framework for assessing corporate

governance and risk management. Stand Alone

Books. https://elibrary.worldbank.org/doi/10.1596/978-1-4648-1446-4_ch12

Investopedia. (2015, March 3). How government regulation affects the financial services

sector? https://www.investopedia.com/ask/answers/030315/what-impact-does-

government-regulation-have-financial-services-sector.asp