1.1.3The creation of assets and liabilities

There are two general consequences of nancial intermediation. The rst is that there

will exist more nancial assets and liabilities than would be the case if the community

were to rely upon direct lending. The case above makes this clear in Box 1.3. In

the direct lending case, the saver acquires an asset of £140,000; the borrower incurs

a liability of £140,000. Assets and liabilities each equal £140,000. If, however, an

intermediary intervenes and takes in deposits of £140,000 which it then lends out,

savers (depositors) have assets equal to £140,000 and the borrower has a liability equal

to £140,000.

Asset:Any piece of property, the ownership of which provides a ow of benets

over time.

Liability:A debt owed to someone else.

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Chapter 1 • Introduction: the nancial system

Box 1.3

The creation of assets and liabilities

(a)	Direct lending
	Lender	Borrower

Liability	Asset	Liability	Asset
	140,000	140,000
Total	140,000	140,000

(b)	Via an intermediary
	Lender(s)	Intermediary	Borrower

LiabilityAsset	Liability	Asset	Liability	Asset
40,000 30,000 25,000 45,000	140,000	140,000	140,000
Total140,000 (A) Total assets(A + C) Total liabilities(B + D)	140,000 (B)280,000 280,000	140,000 (C)	140,000 (D)

Supercially, things are as they were before. But notice, looking at the gures, that

the intermediary itself has assets and liabilities. In accepting £140,000 as deposits

from savers (their assets), it has simultaneously created for itself a liability (the

need to pay interest and repay the deposit) of £140,000. Fortunately, on the other

side of its balance sheet, it has created for itself an asset in the form of an interest-

earning loan to the borrower. Total assets and liabilities in the community are now

£280,000.

The second general consequence of the intervention of nancial institutions is that

lending and borrowing have become easier. It is now no longer necessary for savers

to search out borrowers with matching needs. In this sense nancial intermediaries

have lowered the ‘transaction costs’ of lending and borrowing.

Neither will lenders have to demand such high rates of interest to compensate

them for the risk and inconvenience involved in lending long term to unknown

borrowers. In this sense nancial intermediaries are taking on and managing the

risk more effectively and cheaply than could ever be done by individuals. There are

advantages to the borrower too. The borrower is saved the cost of search, and with

savers willing to lend at modest interest rates, the cost of borrowing (even allowing

for a margin for the intermediary) will be much lower than it would otherwise be.

In the language of economics we can say that for any given rate of interest the

equilibrium level of lending and borrowing will be greater in the presence of inter-

mediation than it will be without it.

We shall return to these two fundamental consequences and to extensions of them

many times.

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