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.

Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. 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).

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.

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.

See also

• Debt
• Financial economics
• Investment
• Saving
• Financial market efficiency

Bibliography

• Pilbeam, Keith. Finance and Financial Markets. New York: PALGRAVE MACMILLAN, 2005.
• Valdez, Steven. An Introduction To Global Financial Markets. Macmillan Press, 2007.