Financial intermediary
Financial intermediation consists of “channeling funds between surplus and
deficit agents”. A financial intermediary is a financial institution that connects
surplus and deficit agents. The classic example of a financial intermediary is a
bank that transforms bank deposits into bank loans.[1]
Through the process of financial intermediation, certain assets or liabilities are
transformed into different assets or liabilities.[1] As such, financial intermediaries
channel funds from people who have extra money (savers) to those who do not
have enough money to carry out a desired activity (borrowers).[2]
In the U.S., a financial intermediary is typically an institution that facilitates the
channeling of funds between lenders and borrowers indirectly. That is, savers
(lenders) give funds to an intermediary institution (such as a bank), and that
institution gives those funds to spenders (borrowers). This may be in the form of
loans or mortgages. Alternatively, they may lend the money directly via the
financial markets, which is known as financial disintermediation.
Contents
1 Functions performed by financial intermediaries
2 Advantages of financial intermediaries
3 Types of financial intermediaries
4 Summary & conclusion
Functions performed by financial intermediaries
Financial intermediaries provide 3 major functions:
1. Maturity transformation
Converting short-term liabilities to long term assets (banks deal with large
number of lenders and borrowers, and reconcile their conflicting needs)
2. Risk transformation
Converting risky investments into relatively risk-free ones. (lending to
multiple borrowers to spread the risk)
3. Convenience denomination
Matching small deposits with large loans and large deposits with small loans
Advantages of financial intermediaries
There are 2 essential advantages from using financial intermediaries:
1. Cost advantage
over direct lending/borrowing[citation needed]
2. Market failure protection
the conflicting needs of lenders and borrowers are reconciled,
preventing[citation needed] market failure
The cost advantages of using financial intermediaries include:
1. Reconciling conflicting preferences of lenders and borrowers
2. Risk aversion
intermediaries help spread out and decrease the risks
3. Economies of scale
using financial intermediaries reduces the costs of lending and borrowing
4. Economies of scope
Intermediaries concentrate on the demands of the lenders and borrowers and
are able to enhance their products and services (use same inputs to produce
different outputs)
Types of financial intermediaries
Financial intermediaries include:
Banks
Building societies
Credit unions
Financial advisers or brokers
Insurance companies
Collective investment schemes
Pension funds
Summary & conclusion
Financial institutions (intermediaries) perform the vital role of bringing together
those economic agents with surplus funds who want to lend, with those with a
shortage of funds who want to borrow.
In doing this they offer the major benefits of maturity and risk transformation. It is
possible for this to be done by direct contact between the ultimate borrowers, but
there are major cost disadvantages of direct finance.
Indeed, one explanation of the existence of specialist financial intermediaries is
that they have a related (cost) advantage in offering financial services, which not
only enables them to make profit, but also raises the overall efficiency of the
economy. The other main explanation draws on the analysis of information
problems associated with financial markets.[3]
