Existence of financial intermediaries is a key element for smooth functioning of an economy. Financial intermediaries refer to all the financial institutions such as bank and non-bank financial institutions that are established within an economy (Richard, Burton & Norman, 2004, p.2). Financial intermediaries play a significant role in linking the deficit and the surplus units of finances. This means that they bring into contact the supply and demand side of finances. The demand side is referred to as the deficit unit and consists of all individuals seeking finances from financial institutions to invest in various sectors of the economy. On the other hand, the supply side is the surplus unit and consists of individuals who have finances and deposit them in these financial institutions so as to earn an interest. Through the process of intermediation, the financial institutions are able to ensure that there is effective flow of funds. This is due to the fact that financial intermediation is able to link the deficit side with the surplus side (Mathews, Saunders & Cornett, 2008, p.3). This means that financial intermediation facilitates the process of investing and saving.
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During the process of financial intermediation, certain costs are incurred. According to Mathews et al (2008, p.3), the cost incurred in the process of financial intermediation refers to all the costs that are incurred during placement of finances with a certain financial intermediary. The cost of financial intermediation is affected by a number of factors. These include bank regulation, market structure and institutions. The discussion of this paper entails a critical evaluation of the theoretical and empirical literature that has been advanced to explain the impact of bank regulations, market structure and institutions on the cost of financial intermediation.
Impact of bank regulation
Considering the sensitive nature of financial institutions especially the banks, regulation is paramount. This is due to the fact that banks are a part of human welfare and they affect the society when they fail (Slovenia, 200, p.1). There are various regulations that have been advanced in relation to banks by various institutions. Some of these regulations are advanced by the central bank. However, increased bank regulation has an impact on the cost of intermediation in a number of ways.
Cost of entry and market structure
Cost of entry refers to the cost that a firm incurs in the process of introducing a new product or service to a particular sector of the economy. There is increased regulation within the banking industry by various governments through the central bank. Some of the regulations relate to the amount of capital reserve that is required in the process of entering into the industry. Capital requirement regulations are formulated to ensure that there is a certain degree of security to the depositor’s funds. Some of the capital regulation requirement relate to capital adequacy. High capital adequacy requirement results into an increase in the shareholder’s interest. However, this culminates into an increase in financial intermediation costs. In addition, capital requirement limits the number of firms entering the industry (Sammy & Magda, 2007, para.1).
According to Kunt, Luc and Ross (2003, p. 3), increased bank regulation in relation to reserve requirement tends to increase the cost of entry into the banking industry. This culminates into an increase in the cost of financial intermediation. This is due to the fact that increased cost of entry results into a few firms controlling the banking industry. This means that there is a monopolistic effect within the industry since competition is eliminated.
Degree of concentration
Increased regulation results into and increase in bank concentration. According to Kunt et al (2003, p. 5), bank concentration refers to a fraction of assets of a particular that are held by 3 largest banks in a particular country and are averaged over a given duration of time. According to Structure Conduct Profitability framework, concentration is used as a representative of a market structure. This model asserts that there is a strong positive correlation between concentration degree and the profit that a firm earns.
According to Kunt et al (2003, p.4) concentration is also positively correlated with the net interest margin. This means that an increase in concentration within the banking industry results into an increase an increase in the costs involved in financial intermediation. Firms which are in a competitive market structure earn a normal profit. On the other hand, monopolistic firms earn abnormal profits.The ultimate effect is an increase in bank concentration which culminates into a reduction in efficiency. Due to existence of few monopoly firms in the banking industry, the firms can collude so as to continue benefiting from increased profit. In addition, these firms will collude so as to increase the degree of entry barrier.
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According to the SCP model, banks respond in a similar manner to an increase in the degree of market concentration through strengthening the collusive power amongst themselves. (Jacob et al, 2007, p.3). This enables them to equally benefit from the changes in the market.
In relation to the market structure, the size of financial institution also has an impact on the cost involved in the process of financial intermediation. Large firms tend to have a relatively high market share. Market share refers to the ratio between a banks assets to the all the bank assets of all commercial banks in an economy (Kunt et al, 2003, p. 12). A bank that has a relatively high market share earns a higher net income compared to those with a low market share. The large banks can exert a high market power as a strategy to increase their net margin interest.
According to Kunt et al (2003, p.29), small banks are associated with high financial intermediary costs. This is due to the fact that these firms have a net margin which is relatively high. This is also associated with the fact that small banks tend to incur large overhead costs compared to large banks. Overhead cost refers to a ratio between the total costs that a bank incurs with its total assets. The overhead cost is determined by the cost structure that the bank has adopted its asset allocation and product mixes.
According to Jacob, Laura and Paul (2007, p.2), competition within the banking industry is necessary. This is due to the fact that it results into improvement in the quality of service delivered and lowers the costs incurred. In addition, banks are compelled by increase in the rate of competition to improve on their efficiency of operation thus enhancing the rate of economic growth. According to Jacob et al (2007, p.2), market structure within the banking industry is determined by the size, number and concentration of banks. These variables are used in explain the intensity of competition in a particular banking industry. Lack of competition in the banking industry results into market inefficiencies and increase in the overhead costs. This culminates into an increase in the cost of intermediation.
The rampant growth in Information Communication Technology (ICT) has resulted into an increase in the degree of competition within the industry. To cope with the intense competition, banks have adopted the consolidation strategy. However, there still exists an institutional regulation that restricts entry of foreign investors into the banking industry. This results into a reduction in competition with the industry. In addition, increased regulation in the banking industry results into a reduction of the degree of economic freedom. Economic freedom measures the degree to which individual and institutional investors are free to invest in various economic sectors (Kunt et al, 2003, p.17).
Increase in net interest margins
According to Kunt et al (2003, p.22), an increase in the degree of regulation to banks results into an increase in the net interest margin. Net interest margin is a variable that is used to determine the gap that exists between what a particular bank pays to the source of its funds that is the supply side and what it obtains from individuals and institutions that use bank credit as a source of their finances, that is the demand side. According to Jude (n.d, p.1), net interest margin is used in determining the cost of financial intermediation. According to a study conducted by Kant and his colleagues (2003, p.22), countries that have adopted a higher restriction of new firms entering the banking industry have a high margin. This means that the cost of intermediation is relatively high. In addition, restricting entry of new firms into the banking industry acts as a protection measure to the existing banks of a particular country.
This enables them to benefit from a relatively high interest margin. This means that the cost of intermediation becomes relatively high compared to countries which do not have such entry restriction. For example, according to a research conducted by Kunt and his colleagues on Mexico and South Korea, these countries had almost the same amount of restrictions in relation to the activities that a bank could involve themselves in. The study indicated that a drop of 1% in the standard deviation of the countries activity restriction towards the banks would result into a 1% drop in their net interest margin. This means that there is a strong relationship between activity restriction and the net interest margin. This would culminate into a reduction in the costs involved in the process of financial intermediation.
Jude (n.d, p.2) asserts that increase in the net interest margin results into financial disintermediation. Disintermediation means that the financial institutions will be eliminated from the supply chain. This culminates into a slow down in the rate of a countries economic growth since there the deficit and surplus side are not effectively linked.
Increase in the rate of inflation within an economy results into an increase the cost of intermediation. This is due to the fact that it results into a robust and positive force on the banks overhead cost and net interest margin. In addition, inflation results into informational asymmetry within the market which culminates into an increase in interest margin (Kunt et al, 2003, p.18).
Regulation on non-tradition activities
There are some regulations that have been advanced in various economies restricting banks from participating in various economic activities. This means that banks are supposed to only operate as financial intermediaries and should not invest in non- traditional activities. Some of the non-traditional activities that banks have been restricted from involving in include securities underwriting, owning other firms such as insurance and other non-financial companies and investing in real estate (Phillip, 2004, para.7). The objective of these regulations is to minimize the magnitude of risk exposure towards the banks. Activity restriction is used to gauge the degree of restriction that a bank faces in relation to their operational activities. Activity restriction can affect the bank efficiency through a reduction in competition and also through restricting the economies of scope. Activity restriction indicators mainly vary from 0-4. According to Kunt et al (2003, p.12), a higher value of activity restriction indicator shows that there is a greater restriction of a bank involving in certain activities. Different economies have varying degree of restriction. For example, Japan and Indonesia have a higher restriction of in relation the banking industry. The activity restriction rate for Japan is 3.5 while that of Indonesia is 3.75. On the other hand, countries such as Germany, United Kingdom, Switzerland and Austria have not imposed numerous activity restrictions towards their banking industry. This is evident from the fact that their activity restriction is 1.75.
Due to these regulatory restrictions, banks tend to increase their net interest margin. Considering the fact that banks are business entities with the objective of maximizing their profit levels, the banks increase the net interest margin. This enables them to maximize on the returns from the spread. This means that the cost of intermediation is increased.
In general increased, bank regulation results into an increase in the net interest margin which results into an increase in the costs incurred in the process of financial intermediation.
The government has an impact on the banking industry through regulation by the central bank. In addition, some of the banks are state owned. State ownership refers to a system where the government is in control of more than 50% of a particular economic sector. According to Kunt et al (2003, p.15), ownership of the banking system by the government indicates the efficiency of a banking system in availing finances to the private sector. Banking systems in which most of the institutions are owned or dominated by the government are inefficient. In addition, these banking systems are inefficient and not easy to enter. Increased bank regulation results into a reduction in competition within the industry. In addition, these firms face increased restriction in their activities. According to Kunt et al (2003, p.15) approximately 60% of the banks in Egypt, Bangladesh, Burundi, Belarus, Romania, India and Russia markets are owned by the government. To improve on their profitability level, these institutions increase their net margin interest. This culminates into an increase in the degree of cost incurred in the process of financial intermediation.
Kunt et al (2003, p. 17) asserts that effective institutional establishment result into effective business environment by enhancing competition in various sectors of the economy. There are a number of ways through which institutional environment can be improved. For instance, this can be achieved by ensuring that there is effective contract enforcement, judicial efficiency and superior property rights. Superior property rights will result into a reduction in the net interest margin. This means that the cost of intermediation is reduced. Ensuring that there are superior property rights, contract enforcement and judicial efficiency will culminate into an increment in the value of security in relation to bank loans. According to Kunt et al (2003, p.17), the ultimate effect is a reduction in the cost involved in the process of financial intermediation for the borrowers. In addition, these improvements will enable the banks to extend their credit market to borrowers who are rated as being of lower grade. This will also enable them to increase on the mean interest rate that is paid on loans.
In addition, if the institutional environment is favorable to the private sectors, there will be increase in the degree of competition. Kunt et al (2003, p. 24) asserts that increased degree of competition will result into a reduction in the interest margins.
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Financial intermediation is paramount for the economic growth of a country. This is due to the fact that it links the deficit unit with the surplus unit. Financial intermediation is facilitated by various financial institutions such as banks. In addition, it facilitates the process of investing and saving. There are various costs that are incurred in the process of financial intermediation. These costs are affected by various factors such as the bank regulations, market structure and institutions.
Banks are a part of human welfare and hence the need to control them to minimize the chances of them collapsing. Considering the sensitive nature of the banks, various regulations have been advanced. The regulations instituted to the banking industry vary according to the various economies. These regulations have an impact on the cost of financial intermediation. Some of the regulations relate to capital requirement. Both domestic and foreign investors who desire to venture into the banking industry are required to have a certain minimum capital requirement. This capital requirement is determined by the government through the central bank. If a high amount of capital is required, only a few investors will be able to venture into the industry. This will result into a reduction in the number of banks within the industry. The result will be a reduction in competition within the industry. This means that there will be inefficiency in the market since the degree of concentration within the banking industry will be skewed to only a few firms. The effect is that there will be an increase in the cost of intermediation due to creation of a monopolistic market structure. Banks will increase the cost of intermediation as a strategy to achieve abnormal profits. In addition, increased regulation within the banking industry results into an increase in the net interest margin. Net margin interest is a measure that is used to indicate the gap between the interest paid by a bank to its source of funds and the interest charged to its customers. Net interest margin is directly related to the cost of intermediation. This means that an increase in the net interest margin results into an increase in the cost of intermediation.
There are also regulations that restrict banks from investing in certain sectors of the economy such as investing in real sector, insurance and underwriting of securities. Such regulations are imposed as a strategy of minimizing the degree of risks exposed to the to the depositors funds. This limits the scope of banks increasing their profit level. To increase on their profits, banks increase their net interest margin. This results into an increase in the cost of intermediation.
The cost of financial intermediation is also affected by the presence of an effective business environment. This can be attained by ensuring that there is effective contract enforcement, superior property rights and judicial efficiency. Existence of these structures will result into an improvement in the value of security used in securing bank loans. This will result into a reduction in the cost of intermediation since the banks will be able to increase on their profits by lending to a large number of individuals.
Cost of intermediation is also affected by the relative size of a firm’s market share. Large banks have relatively high market share compared to the small banks. This makes their overhead costs to be low and hence their cost of intermediation.
A favorable institutional environment results into an increase in the efficiency of competition within the banking industry. Economic freedom can be enhanced by the government through reduction in the amount of regulations towards the banking industry.This is due to the fact that more investors can easily venture into the industry.
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