Economic well-being is inextricably tied to the health of the financial intermediaries that make up the financial system. From Chapter 3, we know that financial intermediaries are the businesses whose assets and liabilities are primarily financial instruments. Various sorts of banks, brokerage firms, investment companies, insurance companies, and pension funds all fall into this category. These are the institutions that pool funds from people and firms who save and lend them to people and firms who need to borrow, as shown in Figure 11.1 (50.0K) . They funnel savers' surplus resources into home mortgages, business loans, and investments. As we will see, financial intermediaries are involved in both direct finance—in which borrowers sell securities directly to lenders in the financial markets—and indirect finance, in which a third party stands between those who provide funds and those who use them. Intermediaries investigate the financial condition of the individuals and firms who want financing to figure out which have the best investment opportunities. As providers of indirect finance, banks want to make loans only to the highest-quality borrowers. When they do their job correctly, financial intermediaries increase investment and economic growth at the same time that they reduce investment risk and economic volatility.

Ensuring that the best investment opportunities and highest-quality borrowers are funded is extremely important. As we saw in Chapter 3, there is a strong relationship between financial development and economic development. Any country that wants to grow must ensure that its financial system works. When a country's financial system crumbles, its economy fails with it. That is what happened in the United States in the Great Depression of the 1930s, when a series of bank closings was followed by an increase of over 25 percent in the unemployment rate and a fall of nearly one-third in the level of economic activity (measured by GDP). The Asian crisis of 1997, in which the banking systems of Thailand and Indonesia collapsed, is a more recent example. And the Russian bond default of August 1998, described in Chapter 6, caused a significant deterioration in the Russian economy. Without a stable, smoothly functioning financial system, no country can prosper.

In theory, the market system may seem neat and simple, but the reality is that economic growth is a messy, chaotic thing. The flow of information among parties in a market system is particularly rife with problems—problems that can derail real growth unless they are addressed properly. In this chapter, we will discuss some of these information problems and learn how financial intermediaries attempt to solve them.