Teesside University
Teesside University Business School

International Finance

Lecture 1: Financial Intermediation

I Introduction

It is a common misconception that wealth comprises only financial assets: a person is described as wealthy because he or she is very rich or has a lot of money, or even has a high income. Wealth, in fact is defined much more precisely than these rather loose statements would suggest and although a large part of a person’s wealth may indeed be held in the form of financial assets, e.g. shares, it also includes other elements. The aims of the lecture therefore are to: consider meaning of wealth; look at how wealth and financial instruments – assets and liabilities - are connected; and investigate how one form of wealth can be converted into another.

This last is a process known as financial intermediation. At root therefore, this lecture is really about the rationale for financial intermediation and the benefits that arise from the presence of special financial instruments, markets and intermediaries in the economic system.

II Wealth and Financial Assets

National Wealth – this is the stock of tangible or real assets and intangible assets in a country. The real assets include capital goods, stocks of raw materials and finished goods. Intangible wealth includes human capital and social institutions, i.e. those non-physical attributes of society that contribute to economic well-being.

Personal/private wealth – this is made up of the assets owned by individuals. It includes: tangible assets financial assets intangible (including human) assets

Individuals also have liabilities, i.e. obligations outstanding or debts that they have to meet.
Net Wealth or Private Net Worth (ignoring human wealth) can be defined as: = total assets – total debts/liabilities

For a nation as a whole it is therefore possible to determine national wealth as the sum of private net worth.

Thus: sum of private net worth = national wealth = tangible assets.

Note that for the country as a whole, financial assets are not part of net wealth except where they are matched by real assets. This is because financial assets that are matched by liabilities cancel out, leaving claims only on tangible assets. Thus an alternative method of calculating national wealth is:

= sum of financial assets – sum of financial obligations.

A useful distinction:

Outside and Inside Assets
A useful distinction is between:
Outside – claims on tangible assets and government obligations.

Inside – financial claims matched by debts/liabilities.

III The Meaning of Financial Intermediation

Basic ideas
Financial intermediation is the channelling funds from parts of the economy with surplus funds to parts with a deficit.

Example: consider a simple economy with just two sectors – households and firms. Households – save some of their current income in order to acquire claims on future output (and income) by lending.

Firms – want to borrow funds to invest in productive equipment that will produce a return in future years.

Financial intermediation is the process by which households acquire claims on future income (assets) from firms and, equivalently, firms issue liabilities to households. Note that an important underlying reason for all financial intermediation is that different economic agents have different rates of time preference (see below).

Forms of intermediation
Direct – lenders and borrowers are in direct contact.

Indirect – funds are channelled from lenders to borrowers through specialist financial institutions, financial intermediaries, and markets

Most intermediation in modern economies takes the form of indirect intermediation, with the ultimate lenders holding claims on financial institutions (inside assets) rather than on the ultimate borrowers. Thus financial intermediation can be described as the process of