1.

0 Introduction

Nowadays, the rapid growth of information technology significantly has changed the
financial services industry, especially banking. In this phase, the growth of electronic banking
in the financial services industry has paved the way for the growth and development of
financial technology in the second half of the 20th century and beyond (Kaur, 2023). This has
created a flexibility of regulation and barriers in the market has created opportunities and
conducive environment for new entrants such as banks and fintech startups to transform from
traditional into modern financial intermediation models. However, its vast grow also leads to
increased exposure of vulnerabilities such as cybercrime to fintech infrastructure has
increased accordingly ( Daley, 2022).

The financial intermediation process is the operation and services provided by financial
institutions like banks, who acts as the link between the saver and borrower to allocate
financial resources effectively (Chen, 2020). Bank is commonly used as a financial
intermediary because of its role to collect money from the depositors and lend it to the
borrower, which is usually known as the process of fractional reserve banking. Nowadays,
banks have leveraged technology to further improve its function and digitalize the financial
intermediation process through digital channel (Klimenko, 2023). These digital channels have
eased the customer’s access to financial services like digital banking and E-wallet. To
contrast, digital banking allows the customer to manage bank accounts and financial
information, as opposed to E-wallet, which only focuses on storing payment information
. In
(Mobile Wallets and Mobile Banking, What’s the Difference? A Simple Guide, 2023)

addition, the appearance of marketplace platforms has significantly affected the traditional
financial intermediation process.

With that being said, the purpose of this report is to discuss the function of the financial
intermediation process in the financial system and how banks play an important role in this
process. In addition, the discussion will also emphasize the importance of its digital channel
including digital banks, e-wallet, and online marketplace platform. Aside from that, this
report will suggest some recommendations for the financial business to further improve their
financial services to customers.
2.0 Discussion & Analysis

2.1 The Financial Intermediation Process

As explained in the introduction, financial intermediation process refers to a system where

financial intermediary acts as facilitator of channelling the funds between savers and
borrower. This process is crucial in the global economies as its function is to allocate capital
and resources effectively. With this function, financial intermediary has balanced the interests
of savers and borrowers while promoting the stability and growth of modern global economy.

From the study by Molnar (n.d.), it’s stated that information asymmetry is inherent in
financial intermediation process. In this context, information asymmetry refers to a situation
where borrower have more information than lender. The same study also mentioned how
information asymmetry may eventually leads to both adverse selection and moral hazard.
Adverse selection occurs when borrower and lender have asymmetric information before the
transaction. On the other hand, moral hazard happens when borrower and lender asymmetric
information and change in behaviour after transaction
(The Difference between Adverse Selection and Moral Hazard, 2020)
.

From these findings, it’s possible to further analyse how asymmetric information may affect
the stability and efficiency of the financial system. In the context of financial system,
information asymmetry may arise when making investment decision between investor and
financial intermediary. Financial intermediaries such as investment banks tend to have better
knowledge of securities pricing than investor. This informational advantage may
disadvantage investor because of inaccurate security pricing and hindered access to
investment opportunities, which makes it difficult for the investors to make well informed
investment decision. This eventually will discourage the investor and leads to reduced
investment. Reduced investment means fewer resources are allocated to produce the desired
economic output (ideal economic productivity). Therefore, reduced investment can lead to a
decline in economic growth.
2.2 The Special Role of Banks

According to Barone (2023), bank is financial institution that is licensed to accept checking
and savings deposits and make loans. The bank loan is commonly used by the borrowers for
investment, business expansions, etc. In financial intermediation process, bank is commonly
believed to be the solution to the discrepancy of information between borrower and saver.
The reason is because bank collects big amount of financial information from the customer
and thoroughly conduct risk assessment to measure the borrower’s creditworthiness with the
aim to prevent adverse selection and moral hazard risks. These capabilities are usually
regarded as the special role of banks because other financial intermediaries cannot allocate
the funds as efficient as banks.

However, it’s notable that bank cannot fully prevent information asymmetry as the study by
(Diamond, 1984), states that banks only rely on financial information provided by borrowers
and lender regardless of its accuracy in representing their actual financial situation. This
shows how banks might face challenges in differentiating high and low risk borrowers,
especially when the borrowers have better information than the banks. In addition,
Stighlitz & Weiss (1981)
emphasizes that banks cannot predict unforeseen circumstances in the
financial market, which may significantly affect borrower’s ability to pay the loan in future.

These findings have risen a question on how bank plays a special role as financial
intermediary. Firstly, banks can mitigate the risk of money being misused by evaluating the
creditworthiness based on borrower’s financial information. With this, the bank will be able
to offer wider option of credit sources for borrowers in accordance with borrower’s paying
ability and needs, thus lowering the risk of moral hazard to occur instead of fully eliminating.
The reason is because bank cannot forecast and control the external factor with 100%
certainty, which may lead to information asymmetry between the initial risk assessment and
actual financial performance. Additionally, the banks can contribute to economic stabilization
by utilizing some financial instruments such as open-market operations and fractional reserve
requirements, which will also ensure the financial system runs smoothly.
2.3 Digital Channels of financial Intermediation

Due to emergence of financial technology, financial intermediation process has evolved

digitally, which resulted in the rise of various digital channels such as e-banking, e-wallet,
and other online platforms. These digital channels offer similar services to traditional banks,
including the ability to transfer money, manage account balances, and invest. The key
distinction is that all these activities can be carried out remotely. However, this doesn’t
necessarily eliminate traditional bank’s relevance in financial intermediation process. One of
the reasons is because bank follows stringent regulatory frameworks and adhere to stringent
security procedures to ensure the customer’s fund and information are secured.

A study from Boot (2020), states the rise of digital channels during Covid-19 crisis has
fundamentally changed the way financial services are distributed. In the same study, it’s
found that digital channels can interject themselves between banks and their customers,
introducing another layer of intermediation. This emphasizes the significance of digital
channels as financial intermediaries in the current trend. However,
Colarik & Janczewski (2012)
, explained that digital channels may imposes cybersecurity risks as not all of them are
immune to cyber threats despite of its advancement.

With that being said, it’s essential to analyse the effectiveness of digital channel in financial
intermediation. In terms of the functionality, digital channel has utilized technological
advancement to provide convenient, effective, and accessible financial services for
individuals especially for individuals in remote area. This certainly will enhance the
customer’s confidence to conduct financial transaction and promote economic growth.
Additionaly, the varying features of digital channel has driven innovation within fintech
startups, which leads to creation of new financial solution / instruments such as digital wallet.
In contrary, its effectiveness can be hindered by the fact that digital channel is prone to
cybersecurity risks, which may cause monetary losses, identity fraud, and a decrease in
consumer’s trust in digital financial services.
2.4 Digital Banks and Related Initiatives

Like traditional bank, digital bank is basically a bank which operates mainly through digital
platforms like website and application (Tavaga Invest, 2023). In this context, related
initiatives refer to the development and innovation that contributes to growth of digital
banking such as fintech partnership and regulatory support. According to Boot (2020), the
rise of digital banking and related initiatives are caused by the leveraging technology
advancement and adjusting customer’s preference. Aside from that, the support from
government in terms of the regulation has encouraged the growth of digital banking and
fintech startups.

In the same study, Boot (2020) states banks can compete with other digital channels by
investing in the digitalization of bank, which is commonly known as digital banking
nowadays. In addition, if banks do not offer digital banking services, they could lose direct
connection to their consumers and run the risk of vertical disintegration. However, the
appearance of digital banking may be interpreted differently in different countries. According
to (Kerse & Staschen, 2021), digital bank can be regulated to deepen financial inclusion
depending on the regulatory support.

From this issue, we can analyse how digital bank and related initiatives have contributed to
financial industry. Firstly, the ability of digital bank to provide remote banking services has
encouraged individuals to open bank account and start financial transactions through mobile
banking, which eliminates the need to visit physical bank. Furthermore, the significance of
digital bank and its initiatives are gradually increasing due to supportive regulatory
frameworks. In financial system, a supportive regulatory usually provides direct guidelines,
fair market competition, safeguards customers and promotes innovation. With supportive
regulatory from government, it’s possible for digital bank to establish partnership with other
financial institutions, which allows for fruitful collaboration and knowledge exchange. This
partnership may eventually lead to innovation of digital solutions, which paves the way for
customer’s financial inclusion and advanced financial system.
2.5 E-Wallet

During the emergence of cashless payment method, E-wallet has gained significant
popularity due to its convenience. E-wallet is an application that allows the user to create a
savings, carry out transactions, and track past payments on device (Kagan, 2023). Similar to
other digital channels of financial intermediation, E-wallet also promotes financial inclusion
because e-wallet allows individual without bank account to conduct transactions digitally.
Additionaly, some E-Wallets may offer tempting features such as discount and voucher to
further boost customer spending. Despite of its convenience, this e-wallet could impose risks
like the possibility of the funds being used by the provider for high-risk investment.

According to a study by Lumpkin & Schich (2019), there is a possibility that the funds in
digital wallets could be invested by the provider in risky, longer-term fixed maturity and/or
illiquid assets. This statement emphasizes how E-wallet provider may use the fund to invest
in high-risk assets that requires long time for a return and not easily liquidated into cash. As
supplementing information, Hidalgo-Oñate (2023) suggests that adequate prudential
regulation is required to imposes some rules to E-wallet providers with the aim to safeguard
the customer’s fund and financial information.

From these two findings, the significance of e-wallet can be further analysed and evaluate
how prudential regulation is necessary for e-wallet provider. Firstly, the potential of e-wallet
funds being used for risky investments emphasizing how the deposited fund might be put at
greater risk, which may devalue the user when the investment is suffering losses. Unlike
bank, E-wallet do not operate with fractional reserve system. As high-risk investment often
involves illiquid assets, the lack of liquidity might hinder the user from withdrawing funds
promptly, which creates inconvenience for E-wallet daily user. To minimize this risk,
prudential regulation is usually imposed to E-wallet provider to ensure the provider adhere to
risk management practices and capital requirements. Therefore, with prudent investment
guideline, the regulators can safeguard the user funds, which eventually leads to stability and
credibility of E-wallet.
2.6 Marketplace platforms (Peer to Peer, Online, Mobile platforms)

Marketplace platform is an online platform that links borrower’s and lender or investors and
facilitates the allocation of capital (Friedman, 2016). Through these platforms, individual or
business in need of capital can connect with a wider network of potential lenders or investors
outside of traditional financial institutions, which is the reason behind the popularity of
marketplace platform. This digital channel operates by allowing the borrowers submit loan
request alongside with required information, while lenders or investors can browse several
loan requests and choose which one suits with their objectives.

Boot (2020) mentioned the internet has given rise digital channel as powerful intermediaries
that enable peer-to-peer financial transaction between borrower and lender/investor. Unlike
bank, these marketplace platforms use alternative source of data to measure the
creditworthiness of borrower, which may include social media’s data, mobile phone usage,
utility and rent bills (FM Contributors, 2023). On the other hand, Marketplace platforms
usually operate within uncertain regulatory (regulatory grey area), which means that
marketplace platforms are not subject to same credibility of regulation as traditional financial
intermediaries (Luther, 2020).

Furthermore, the effectiveness of marketplace platform can be analysed by evaluating the use
of alternative source of data and regulation. With peer-to-peer marketplace platform, it’s
easier for individual and business to participate in economic transactions. This convenience
may drive the community to foster innovative digital solution in healthy competition, which
contributes to economic growth and stabilization. However, it’s notable that marketplace
platform still lacks regulatory oversight, which means the marketplace platform may provide
risky environment for transactions. This may disadvantage the user in the way that user is not
being adequately protected and higher risk being the victim to fraudulent activities.
Additionally, in the lack of regulatory oversights, marketplace platform might not have
enough controls or systems in place to adequately handle liquidity risk. This implies that it
might be difficult for investors to find buyer or sellers for their securities, which would result
in illiquidity.
3.0 Recommendation
3.1 Improve transparency and disclosure of information

As information asymmetry is almost inevitable in both traditional and digital financial

intermediation processes, the quality and availability of information to public must be
enhanced to mitigate the risk of information asymmetry. This can be achieved by focusing
the financial intermediaries to improve the clarity of financial reports and elaborate
thoroughly their information such as financial status, risk management procedures, and
investment plans
(The Role of Disclosure in Risk Assessment and Enhancing the Usefulness of Corporate Re
. The clarity of financial information
should be followed by regular and timely updates, which is essential for the investors to
adjust their decision-making based on the updated information (IOSCO, 2017). For instance,
the IMF has developed a Central Bank Transparency Code, which aims to encourage
improved communication between central banks and their many stakeholders
(Adrian et al., 2020)
.

3.2 Upgrade risk-assessment capabilities of banks

For the banks to further advance their risk-assessment capabilities, banks can collaborate with
other institutions especially fintech companies. By collaborating with fintech companies,
banks can utilize advanced data analytics techniques, which allows the bank to gain insights
into potential threats in advance and make well-prepared decision to minimize the risks
effectively (Boiko, 2023). For instance, in Malaysia, the partnership between CIMB Bank
and TNG Digital has launched ”GOpinjam”, a comprehensive digital personal loan offer,
which is accessible through Touch 'n Go e-Wallet (Syazmeena, 2022). The partnership may
also enable the banks to improve their risk modelling, including scenario analysis, credit
grading, and stress testing, using both the credit bureau and e-Wallet expenditure data set
(Paule Laurent et al., 2020).
3.3 Implement effective cybersecurity precautions

To further support the previous recommendations, it’s essential to implement effective

cybersecurity precautions especially in fintech’s infrastructure protection. To do this,
financial intermediary can establish a robust access control and authentication mechanism,
which aims to prevent unauthorized access and cybercrime (Ryan Pratama, 2023). Without
precautions, the stability of financial intermediation process especially during the emergence
of fintech may be disrupted significantly by cyberattacks. Aside from one-time precaution,
every financial intermediary should regularly maintain the fintech infrastructure's security.
The maintenance may include access control test, vulnerability monitoring, and data
encryption management. According to Chepurnol (2023), the number of cyberattacks towards
fintech sector has increased by 28% in 2022. With this data, it’s emphasized that
cybersecurity precautions must be taken with the aims to prevent money theft / laundering,
which may gain customer’s credibility and gives good impression of financial institution.

3.4 Implement and develop regulatory framework

Other than financial institution, government also plays significant role alongside with other
regulatory entities. These entities are assigned to create and enforcing regulations that protect
the financial system's integrity, fairness, and stability. Knowing that marketplace platform
still lacks regulatory oversight, it’s important to develop a regulatory framework. This
regulatory framework should provide measures that safeguard users from fraud activity,
implement legal licensing requirements, establish minimum capital requirements, and
enforcing transparency requirements (Ehrentraud et al., 2020). For example, Malaysia has
Regulatory Sandbox Framework, which is introduced by Central Bank Malaysia. This
regulatory framework has promoted innovation in fintech sectors. As evidence, it’s proven
that this framework has promoted cooperation, and ensures consumer protection, resulting in
the formation of successful projects and supportive comments from industry participants
(Tan, 2023).
4.0 Conclusion

As conclusion, the financial intermediation process plays significant role in allocating funds
between savers and borrowers. To mitigate information asymmetry, Banks as financial
intermediary have played special role by collecting anad assessing financial information.
However, the landscape of financial intermediation has significantly changed because of the
emergence of digital channels like digital banks, E-wallets, and marketplace platforms. These
digital channels provide convenient access to financial services, but they also impose
regulatory and cybersecurity issues.

Through remote banking services, digital banks have the ability to improve financial
inclusion and foster economic growth. However, digital banks are currently struggled with
assessing borrower risk and forecast unforeseen circumstances with 100% certainty. Aside
from digital banking, E-wallet also offers convenience although it may carry the risk of funds
being used for risky ventures. Therefore, prudent regulation is required to protect user funds
and guarantee the security, dependability, and reputation of e-wallet providers. Peer-to-peer
transactions are made possible through marketplace platforms, but they operate in a legal
grey area, putting customers at danger.

To improve financial intermediation process, enhancing transparency and information

disclosure is advised. Financial intermediaries should provide clear and comprehensive
financial reports to mitigate information asymmetry and enable informed decision-making.
Investors must be informed through tregular financial information updates. Additionally, it’s
also important to improve the regulatory frameworks, which aims to ensure the stability and
security of digital channels. E-wallet providers should follow prudent rules, and marketplace
platforms should be adequately supervised to safeguard customers and manage liquidity
concerns.

Overall, while digital channels provide opportunities for innovation and financial inclusion,
it’s important to adddres cybersecurity risks, enhancing transparency and bolstering
regulatory frameworks. With these, the financial intermediation process can continue to
develop and support a secure and effective financial system.
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