The ChoosaBroker Trading Academy

6.5. Financial Intermediaries

Suppose you are great cook and want to start a home-made food outlet. At around the same time that you are planning to step in to the food business, a woman named Vivian, who lives two states away, has saved considerable money and wants to invest in a start-up. If somehow you and Vivian could cross paths, she could invest in your outlet and you could fulfil your dream of entrepreneurship. But in reality, since you probably would never find Vivian on your own, there is a process called financial intermediation that can ensure both of your goals are met.

In this lesson, we will discuss what financial intermediation is; highlight the key players in the process; and dwell on their most notable advantages and disadvantages.

FINANCIAL INTERMEDIARIES DEFINED

Broadly speaking, a financial intermediary is an individual or an institution that facilitates the channelling of funds from people who have surplus capital to those who require funds to undertake a desired activity. Common examples of financial intermediaries include commercial banks, savings banks, investment banks, stock brokers, and stock exchanges.

The financial needs of the different participants in an economy are diverse. For example, households may need money to buy a car; companies may need money to buy new equipments; while the government may need money to construct new roads. This demand accrues because the need for money is higher than the available funds of the above economic subjects. On the other hand of the spectrum lay some economic subjects, whose earnings exceed their expenditures. The reasons underlying their savings can be manifold. For example, individuals may save for retirement, while companies may save to shield against business down turn. But whatever be the reasons for saving, this money typically gets hoarded for a certain period of time, remaining unproductive for the saver until it gets consumed.

The financial intermediary enters in to the scene here. Lenders (savers) transfer their excess funds to an intermediary institution (like a bank or a stock broker), and that institution forwards those funds to borrowers (spenders). This may be in the form of debt, equity or mortgage. Thus, economic subjects do not have to delay their investment decisions, while savers also receive a return on their idle savings. Such a system facilitated by the presence of financial intermediaries ensures that resources get used efficiently.

FUNCTIONS OF FINANCIAL INTERMEDIARIES

The role of financial intermediaries can be outlined under three major heads:

  1. Facilitating Flow of Funds – Financial intermediaries enable the flow of funds from surplus economic units to deficit economic units. Without robust financial intermediaries, savings of the ultimate lenders will not become available to the ultimate borrowers. In large number of underdeveloped countries, individuals still prefer to keep their savings in the form of notes and coins as opposed to deposits with financially unsound banks.
  2. Efficient Allocation of Funds – Financial intermediaries have the requisite expertise to ensure that the process of flow of funds remains efficient. Intermediaries, particularly commercial banks, are aware of the twin dangers of adverse selection and moral hazard. Adverse selection means that borrowers with higher risk profile are more likely to seek loans than good risk borrowers. Moral hazard refers to a situation whereby once a loan is granted; the borrower may become inclined to take risks with the money that were not disclosed in the loan application. Banks are keenly aware of these two real-life risks, and typically allocate funds to borrowers that are expected to utilize the funds prudently.
  3. Transformation of Risk – Financial intermediaries help to convert risky investments in to relatively risk-free ones by lending to multiple borrowers. From a savers point of view, rather than lending to just one individual, depositing money with a financial intermediary that lends to a variety of borrowers will lower the risk of the saver.

TYPES OF FINANCIAL INTERMEDIARIES

Based on the type of asset transformations they undertake, financial intermediaries can be classified in to four broad categories:

01. Depository Institutions

Depository institutions act as intermediaries between savers and users of funds. Commercial banks, savings banks, credit unions, and other such institutions raise funds from depositors and lend it to borrowers. Depositors earn interest on their funds, while the lenders obtain funds without having to search for external investors. Traditionally, commercial banks have specialized in issuing checking deposits and extending loans to businesses, while savings banks typically issue time and savings deposits, and offer mortgage loans to households and businesses. Credit unions issue time deposits and make consumer loans.

02. Insurance Companies

These are firms that help individuals and entities hedge their risks by underwriting contracts that payout in case of losses due to a wide variety of underlying reasons. Insurance providers basically transfer the risk from the buyers of the contracts to the insurance company’s shareholders and creditors. The insurers invest the premiums collected from policyholders in stocks, government and corporate bonds, and various money market instruments; the mix of which is determined by the nature of the contingencies they insure against.

03. Investment Banks

These are institutions that assist corporate clients in issuing diverse range of securities, including common stock, preferred stock, bonds, and notes, in addition to helping their clients with potential takeover targets. Another important function of investment banks involves providing personal wealth management services to high net worth individuals.

04. Brokers

These are agents who facilitate the exchange of both equity and debt securities by linking buyers and sellers, either through a regulated exchange, or through over-the-counter marketplaces, in return for a fee or commission. Advances in connectivity have given rise to discount brokers that allow small investors to buy and sell securities at fees that are much lower compared to a full-service broker. If you are just starting to look at trading, there are a number of brokers with excellent ongoing education projects making them ideal brokers for beginner trading.

BENEFITS AND DISADVANTAGES OF FINANCIAL INTERMEDIARIES

Financial intermediaries provide three key benefits:

  1. Reduction in Transaction Costs – When compared to direct lending/borrowing, a financial intermediary can reduce the transaction costs by reconciling the confliction preferences within its large pool of lenders and borrowers.
  2. Risk Diversification –If a borrower defaults on a loan, the individual saver is not directly affected as the loss on account of the default is charged to the financial intermediary, and not to its depositors, thereby reducing the risk of the saver.
  3. Economies of Scope – Due to their inherent financial expertise, intermediaries can better concentrate on the demands of the lenders and the borrowers. This enables them to design products and services that can cater to the diverse needs of the various economic groups.

As regards their disadvantages, academics have often criticized financial intermediaries for the below listed reasons:

  1. Lack of Transparency – The opacity of investments made through financial intermediaries remains an important concern.
  2. Reliance on Tax Havens – To reduce their tax liabilities, financial intermediaries often base themselves in countries where taxes are levied at a relatively lower rate. But these so called “tax havens” have often been at the centre of illicit fund flows that get easily disguised and hidden amongst legitimate transactions.
  3. Social and Environmental Concerns – Financial intermediaries can also pose social and environmental risks through the businesses and projects they choose to finance.

FINAL THOUGHTS

Since direct lending between savers and borrowers is inefficient, the process of financial intermediation has a very important role in any modern economy. The majority of economic agents are in need of resources which they can seldom generate on their own. Financial intermediaries keep the economic engine running by channelling resources from surplus to deficit units. 

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