Role of Banks in Financial Markets
Banks are very important institutions in any economy. They take deposits as savings and then led to borrowers. It is important to ensure that there is efficiency in directing these savings to productive activities to ensure there is continued growth in the economy. Banks play a major role in this process. Some of their main roles in the world financial markets include (Allen & Carletti, 2008).
Banks act as delegated monitors. This is need to monitor the borrowers tom ensure they utilize the borrowed amount wisely. Lenders can only monitor the borrowers if they pay a fixed cost. In a financial market, there are many lenders thus creating the free-ride problem. Each lender is small making it not worth paying the fixed cost. The only solution is for all the lenders to hire one monitor. The problem of who will monitor the monitor arises. Here comes in the banks (Allen & Carletti, 2008). They commit to monitor the borrowers and promise the lenders a fixed return. The banks do not need to be monitored since if they do not monitor, they will not be able to pay the lenders.
Banks also act as intermediaries between the lenders and the borrowers. Borrowers such as big corporations borrow a huge amount of money to invest. It is impossible for a single lender to lend such an amount. This requires a number of borrowers to come together for risk diversification. In this case banks will collect the lenders money as deposits and then lend to the corporation (Allen & Carletti, 2008). The banks bear the risk since failure of the corporation to pay does not mean that the lenders cannot withdraw their deposits.
Banks also share in risk in the financial markets. A lot of people hold their assets inform of equities thus exposing their assets to high risks. There is thus need to diversify the risks but some risks can...