How do depository institutions create liquidity, pool risks, and lower the cost of borrowing?

Question

What will be an ideal response?

Answer 1

Liquidity is the property of being easily convertible into a means of payment without loss in value. Depository institutions create liquidity when they offer deposits that can be withdrawn as money at short (or no) notice and then use these deposits to make long-term loans.
Depository institutions pool risk because they use funds obtained from many depositors to make loans to many borrowers. As a result, if a borrower defaults, no one depositor bears the entire loss because the loss is spread over all depositors. By spreading the risk, depository institutions are pooling risk.
Depository institutions lower the cost of borrowing because they specialize in borrowing. For instance, a firm that wants to borrow a large sum of money need only visit one depository institution to arrange such a loan. In the absence of depository institutions, the firm would need to undertake many transactions with many lenders, which would be a costly process.