ABSTRACT
This chapter analyzes the salient characteristics of both direct and indirect financing routes along with their role in mitigating various frictions, including information asymmetry and higher transaction cost in the market. It critically examines the rationale put forth by the theories on the existence of financial intermediaries. The chapter discusses the critical roles of banks that justify their existence as distinct financial intermediaries besides the capital market. It argues that the bank-based financial system better serves in mobilizing and allocating capital, and ensures better monitoring. The chapter explains the center of the theory of financial intermediation preoccupied by the concept of market friction, including the asymmetry of information, positive transaction costs, and indivisibilities of investment opportunities. It also discusses the differences in the empirical findings can be attributed to the differences in theoretical and methodological approaches, the differences among countries' level of economic development, and the prevailing political and institutional frameworks.
