Question

Suppose that there are 10 individuals, each with $10,000 in savings that they would like to
lend. Suppose there is another person who wants to take out a $100,000 loan. Use this
example to show how pooling small deposits through financial intermediation can increase
the efficiency of financial markets.

Answer 1

Banks collect deposits and lend money. In this way banks become financial intermediaries. In the process of doing so they increase efficiency of financial market by making quick connections, quick allocations, and by keeping price level down.

As per the example, there are 10 lenders having their money in savings account. Pooling those lenders under one roof becomes possible because of that intermediary (bank). They keep faith on bank because their monies are safe and they earn interest.

Once the saving deposit increases, it increases money supply too which brings down borrowing interest rate. Borrowers know that banks give loan; they contact there and get loans at lower interest rate. Therefore, it sorted out quick connection and quick allocation both. Total amount of loan is (10 × $10,000 =) $100,000 and it becomes possible because of easy connection between depositors and borrowers; bank doesn’t give any amount from own pocket.

Now, efficiency increases further once banks pools down interest rate for borrowers. At increasing supply of money and by giving smaller interest to savers a bank can able to cut short the interest rate to borrowers.