Financial intermediary
Encyclopedia
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 loan
s or mortgage
s. Alternatively, they may lend the money directly via the financial market
s, which is known as financial disintermediation
.
The cost advantages of using financial intermediaries include:
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.
(1) they facilitate the acquisition of payment
for goods and services, e.g. through the use of cheques;
(2) the financial system provides economies of scale
and economies of scope
that allow an individual to invest in a portfolio
of assets, which would be much more difficult in the absence of financial intermediaries;
(3) they ease the liquidity constraint
on households and firms which arises when the liquidity available for certain purchases is at variance with the immediate flow of income available; e.g. the use of mortgages allows households to purchase homes today instead of thirty years from now when they have saved up enough money to pay for it;
(4) they allow for the spreading of risk
e.g. bank loans spread the costs over all customers in the event of default
;
(5) they can reduce the risk of moral hazard
and adverse selection
created by the information asymmetry
that exists between lender and borrower (the lender usually has incomplete information about how the borrower will use the money loaned) because financial intermediaries can develop expertise in things like monitoring borrowers' activities and market conditions.
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Financial institution
In financial economics, a financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries...
that connects surplus and deficit agents. The classic example of a financial intermediary is a bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
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.
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
, a financial intermediary is typically an institution that facilitates the channeling of funds
Funding
Funding is the act of providing resources, usually in form of money , or other values such as effort or time , for a project, a person, a business or any other private or public institutions...
between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
), and that institution gives those funds to spenders (borrowers). This may be in the form of loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
s or mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
s. Alternatively, they may lend the money directly via the financial market
Financial market
In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
s, which is known as financial disintermediation
Disintermediation
In economics, disintermediation is the removal of intermediaries in a supply chain: "cutting out the middleman". Instead of going through traditional distribution channels, which had some type of intermediate , companies may now deal with every customer directly, for example via the Internet...
.
Functions performed by financial intermediaries
Financial intermediaries provide 3 major functions:- Maturity transformation
- Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs)
- Risk transformation
- Converting risky investments into relatively risk-free ones. (lending to multiple borrowers to spread the risk)
- 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:- Cost advantage
- over direct lending/borrowing
- Market failure protection
- the conflicting needs of lenders and borrowers are reconciled, preventing market failure
The cost advantages of using financial intermediaries include:
- Reconciling conflicting preferences of lenders and borrowers
- Risk aversion
- intermediaries help spread out and decrease the risks
- Economies of scaleEconomies of scaleEconomies of scale, in microeconomics, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit...
- using financial intermediaries reduces the costs of lending and borrowing
- Economies of scopeEconomies of scopeEconomies of scope are conceptually similar to economies of scale. Whereas 'economies of scale' for a firm primarily refers to reductions in average cost associated with increasing the scale of production for a single product type, 'economies of scope' refers to lowering average cost for a firm in...
- 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:- BankBankA bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s - Building societiesBuilding societyA building society is a financial institution owned by its members as a mutual organization. Building societies offer banking and related financial services, especially mortgage lending. These institutions are found in the United Kingdom and several other countries.The term "building society"...
- Credit unionCredit unionA credit union is a cooperative financial institution that is owned and controlled by its members and operated for the purpose of promoting thrift, providing credit at competitive rates, and providing other financial services to its members...
s - Financial adviserFinancial adviserA financial adviser, is a professional who renders financial services to individuals, businesses and governments. This can involve investment advice, which may include pension planning, and/or advice on life insurance and other insurances such as income protection insurance, critical illness...
s or brokerBrokerA broker is a party that arranges transactions between a buyer and a seller, and gets a commission when the deal is executed. A broker who also acts as a seller or as a buyer becomes a principal party to the deal...
s - InsuranceInsuranceIn law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...
companies - Collective investment schemeCollective investment schemeA collective investment scheme is a way of investing money alongside other investors in order to benefit from the inherent advantages of working as part of a group...
s - Pension fundPension fundA pension fund is any plan, fund, or scheme which provides retirement income.Pension funds are important shareholders of listed and private companies. They are especially important to the stock market where large institutional investors dominate. The largest 300 pension funds collectively hold...
s
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
- DebtDebtA debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
- Financial economicsFinancial economicsFinancial Economics is the branch of economics concerned with "the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment"....
- InvestmentInvestmentInvestment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
- SavingSaving (money)Saving is income not spent, or deferred consumption. Methods of saving include putting money aside in a bank or pension plan. Saving also includes reducing expenditures, such as recurring costs...
- Financial market efficiencyFinancial market efficiencyIn the 1970s Eugene Fama defined an efficient financial market as "one in which prices always fully reflect available information”.The most common type of efficiency referred to in financial markets is the allocative efficiency, or the efficiency of allocating resources.This includes producing the...
Functions of financial intermediaries
Financial intermediaries perform five major functions:(1) they facilitate the acquisition of payment
Payment
A payment is the transfer of wealth from one party to another. A payment is usually made in exchange for the provision of goods, services or both, or to fulfill a legal obligation....
for goods and services, e.g. through the use of cheques;
(2) the financial system provides economies of scale
Economies of scale
Economies of scale, in microeconomics, refers to the cost advantages that an enterprise obtains due to expansion. There are factors that cause a producer’s average cost per unit to fall as the scale of output is increased. "Economies of scale" is a long run concept and refers to reductions in unit...
and economies of scope
Economies of scope
Economies of scope are conceptually similar to economies of scale. Whereas 'economies of scale' for a firm primarily refers to reductions in average cost associated with increasing the scale of production for a single product type, 'economies of scope' refers to lowering average cost for a firm in...
that allow an individual to invest in a portfolio
Portfolio (finance)
Portfolio is a financial term denoting a collection of investments held by an investment company, hedge fund, financial institution or individual.-Definition:The term portfolio refers to any collection of financial assets such as stocks, bonds and cash...
of assets, which would be much more difficult in the absence of financial intermediaries;
(3) they ease the liquidity constraint
Liquidity constraint
A liquidity constraint in economic theory is a form of imperfection in the capital market. It causes difficulties for models based on intertemporal consumption.Many economic models require individuals to save or borrow money from time to time....
on households and firms which arises when the liquidity available for certain purchases is at variance with the immediate flow of income available; e.g. the use of mortgages allows households to purchase homes today instead of thirty years from now when they have saved up enough money to pay for it;
(4) they allow for the spreading of risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
e.g. bank loans spread the costs over all customers in the event of default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...
;
(5) they can reduce the risk of moral hazard
Moral hazard
In economic theory, moral hazard refers to a situation in which a party makes a decision about how much risk to take, while another party bears the costs if things go badly, and the party insulated from risk behaves differently from how it would if it were fully exposed to the risk.Moral hazard...
and adverse selection
Adverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...
created by the information asymmetry
Information asymmetry
In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other. This creates an imbalance of power in transactions which can sometimes cause the transactions to go awry, a kind of market failure...
that exists between lender and borrower (the lender usually has incomplete information about how the borrower will use the money loaned) because financial intermediaries can develop expertise in things like monitoring borrowers' activities and market conditions.
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