A financial intermediary, by definition, is responsible for the process of transferring money from economic agents with a surplus of funds to economic agents with a deficit of funds, and is known as financial intermediation. This is achieved by means of a financial security, such as stocks and bonds. The mechanism that allows the trade of such financial securities is known as a financial market. Financial markets aim to facilitate the raising of capital, as well as the transfer of risk between economic agents and also international trade.
Typically, the borrower will issue a receipt, or financial security, to the lender that promises to pay back the capital gained. Securities such as these can be freely bought or sold within financial markets. The lender should expect some sort of capital gains from these securities in the form of dividends or interest on the amount invested initially. As previously mentioned, financial intermediaries exist primarily to transfer funds from economic agents with a surplus of funds, i. e. those with incomes greater than expenditure, to those agents that have a deficit of funds, or those with incomes less than their expenditure.
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Banks, insurance companies and pension funds are examples of financial intermediaries. An example of an economic agent could be an individual willing to invest, or a company, institution or even the government. The transfer of funds between these economic agents occurs in one of two ways. The first process is known as direct finance. This means that the transfer of funds from economic agents with surplus funds, such as savers and lenders, to those with a deficit, or borrowers, occurs via financial markets such as the stock exchange.
The second process is known as indirect finance, which means that the transfer of funds between economic agents does not occur directly from lenders to borrows, but via a financial intermediary or “middle-man”. Borrowers and lenders tend not to engage in financial transactions by themselves typically, however. This is because financial markets are able to provide economic agents with a fair price mechanism and evaluation of the asset to be traded. This characteristic of financial markets is referred to as the pricing function.
Also, financial markets are thoroughly regulated. Economic agents with a surplus of funds, or issuers of financial securities, are therefore able to assess whether or not engaging in particular activities within the marketplace is putting the value of their assets at risk. This is known as the discipline function. Financial intermediaries exist because financial markets alone cannot ensure the transfer of funds between economic agents easily. There are two main barriers that can be identified with the direct finance process.
The first is that it is difficult, time-consuming (and therefore expensive) to match the complex needs of both the economic agents with surplus funds and those with a deficit of funds. The other barrier is dissimilar financial intentions of the borrowers and lenders. In order to be willing to trade, lenders insist on the minimisation of risk and overall costs incurred, as well as requiring the maximum returns on investment possible and to be able to convert a financial security into cash easily, which is known as liquidity. Minimisation of risk is achieved via what is known as asset securitisation.
Similarly the borrower has a typical set of requirements when trading on the financial market. The borrower will want the funds at a specified date, for an agreed period of time, which is usually long term. Also, the borrower requires the investment lowest possible cost, such as having the lowest interest rate, or giving away the least amount of equity possible. Financial intermediaries have advantages over direct finance, but inevitably there are additional costs to the borrowers and lenders that are not associated with direct finance as previously mentioned.
These costs can be anything from commission and fees charged by the financial intermediary, to interest rate spreads. For intermediated finance to be more beneficial than direct finance, the benefits associated with trading via financial intermediaries should outweigh the costs of such method. Financial intermediaries provide a number of functions. The first of which is known as size transformation. A financial intermediary is able to borrow to an economic agent with a deficit of funds the amount they require without the need to find a lender that is willing to invest the exact amount required by the borrower.
Without financial intermediaries, it would be extremely difficult for a borrower to raise capital as lenders would have to pool their funds together in order to lend the borrower the amount they require. Another function of financial intermediaries is maturity transformation. Economic agents with surplus funds usually prefer investing their money in short-term projects, whereas borrowers require more long-term financing. Financial intermediaries offer an optimal solution, without which borrowers and lenders would be in disagreement over the terms of the transfer of funds.
Financial intermediaries also provide risk transformation. Economic agents with surplus funds are usually very risk conscious when it comes to investment, but borrowers however may require the finance for a more risky project, that may be more profitable. Financial intermediaries are willing to take risks that borrowers usually would not. However, there is usually a compensation agreement so as to avoid direct loss for taking such risks. Economic agents with a surplus of funds are favorable to the idea that assets invested in are easily convertible into cash.
Financial intermediaries are able to provide liquidity by having a large number of economic agents willing to invest, and insure that investments are covered by cash added to new accounts. Another characteristic of a financial intermediary is that they are able to reduce overall costs associated with the trading of a financial security. A financial intermediary is able to benefit from economies of scale. They are therefore able to pass on this reduction of costs in the form of a lower interest rate to the economic agents requiring investment.
The final main function of a financial intermediary is that they are able to facilitate payments not just via cash, but via cheques, credit and debit cards, and digital payments. A financial intermediary is also beneficial in the way that, sometimes, not all economic agents within a transaction have access to the same information, meaning each economic agent has less than perfect information, and each economic agent’s information may be slightly dissimilar. Also, some parties have access to secret “inside” information which is not made available to all economic agents.
This results in asymmetry in the quality and amount of information between economic agents. This can generate adverse selection and moral hazard. Adverse selection occurs before the financial transaction. It consists of risky borrowers being most likely to seek, and be selected for finance. It also occurs if it is difficult to determine the riskiness of each individual economic agent requiring investment, and therefore a universal interest rate is set. Risky borrowers will actively look to raise funds at that universal interest rate.
Similarly, a moral hazard occurs after the financial transaction has taken place. The economic agent that was granted investment uses the funds raised for activities dissimilar to the ones outlined to the economic agent willing to invest. This in turn decreases the likeliness of the loan being paid back. Financial intermediaries aid this situation by regulating how the investment is used, enabling them to maximize profits for the economic agents with a surplus of funds that have invested. However, monitoring borrowers can come at a high cost to the investor.
It is therefore more efficient for the economic agents with a surplus of funds to hand over the task of regulating the borrower to a financial intermediary, which are able to monitor the economic agents seeking investment by financing a large number of them and spreading funds over various investment projects. There are five main types of financial intermediaries, one of which is deposit institutions. As discussed previously, deposit institutions take funds from economic agents that have surplus funds, such as savers, and lend the money to economic agents, who have a deficit of funds, in order to satisfy their need for consumption.
Examples of deposit institutions are banks, building societies and savings institutions. Deposit institutions make a profit via net interest income. Banks can be referred to as monetary financial institutions. MFIs play a vital role in the country’s economy. This is because cash deposits within a bank form a large part of the country’s money supply, making them relevant to the Central Banks and monetary policy. Also, deposits within a monetary financial institution functions as money, so an increase in bank deposits would result in more money circulating the economy.
There are however risks attached to deposit institutions, such as the borrower going bankrupt, risk of liquidity due to large number of withdrawals by depositors, and funding risk, by where fluctuations in the interest rates could reduce or wipe out net interest income. Another type of financial intermediaries is insurance companies. These are non-deposit institutions and do not participate in the payment system. Instead, insurance companies carry out its intermediary function by collecting funds from the policies they sell, and invest these funds in the apital market. The premiums are pooled by the insurance company and they then use this money to invest in the capital market. The third main type of financial intermediary is mutual funds or unit trusts as they are referred to in the UK. These are also non-deposit institutions, and carry out their intermediary function by gathering funds from the general public and investing them in the equity and bond markets. Unit trusts should in theory be able to offer its investors with low-risk returns on amounts invested.
This is achieved by using professional expertise and economies of scale that would be unreachable to the individual investor. The fourth type of financial intermediary is investment trusts. These are publically quoted companies that invest in financial securities. They differ from unit trusts in the way that you can only invest in investment trusts if you buy shares off current shareholders, whereas anybody can invest in unit trusts. Finally, the fifth type of financial intermediary is pension funds.
A pension fund is one that is collected by an employer on behalf of the pension fund over an employee’s working years and pays benefits during retirement. The pension fund uses funds invested within the stock markets in order to guarantee that the value of the amount saved increases by at least the inflation rate. Also, in order to ensure security of money invested within these funds, the pension fund is legally separated from the company that manages it, in case the company goes bankrupt, so that creditors cannot make a claim on the actual pension fund.
As well as these main types of financial intermediary, there are also other less common types of intermediaries, such as hedge funds, finance companies, factory agencies and venture capital companies. To conclude, both financial markets and financial intermediaries allow economic agents with a surplus of funds, where their income is greater than expenditure (I > E) to transfer funds to economic agents with a deficit in funds, meaning their income is less than their expenditure or consumption needs (I < E).
Financial intermediaries facilitate this transfer of funds by eliminating the necessity that the requirements of economic agents with surplus funds match those absolutely of agents with a deficit of funds, and also by reducing transaction costs. Different financial intermediaries deal with different surplus and deficit agents, and aim to maximize the risk dependant return of their investment by using different strategies and different risk return preferences. This improves allocative efficiency within an economy, meaning the funds are transferred to the most reliable borrowers.
Financial markets can be classified according to several features they present, including whether or not the assets traded are newly or previously issued, the maturity of the assets, the type of asset being traded, and the means of settlement. Deposit institutions are especially vital for any economy, as they handle the payments system within a country. References: Pilbeam, K. (2005). Finance and Financial Markets, 2nd ed. Palgrave Macmillan. Casu, B. , Girardone, C. and Molyneux, P. (2006). Introduction to banking. FT Prentice Hall.