WHAT IS A FINANCIAL INTERMEDIARY?

A financial intermediary is an entity that acts as the middleman between two parties in a
financial transaction, such as a commercial bank, investment banks, mutual funds and pension
funds. Financial intermediaries offer a number of benefits to the average consumer, including
safety, liquidity, and economies of scale involved in commercial banking, investment
banking and asset management. Although in certain areas, such as investing, advances in
technology threaten to eliminate the financial intermediary, disintermediation is much less of a
threat in other areas of finance, including banking and insurance.

Financial 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.

BREAKING DOWN Financial Intermediary

A non-bank financial intermediary does not accept deposits from the general public. The
intermediary may provide factoring, leasing, insurance plans or other financial services. Many
intermediaries take part in securities exchanges and utilize long-term plans for managing and
growing their funds. The overall economic stability of a country may be shown through the
activities of financial intermediaries and growth of the financial services industry.

Mutual Funds as Financial Intermediaries

Mutual funds provide active management of capital pooled by shareholders. The fund
manager connects with shareholders through purchasing stock in companies he anticipates may
outperform the market. By doing so, the manager provides shareholders with assets, companies
with capital and the market with liquidity.
Example of a Financial Intermediary

In July 2016, the European Commission took on two new financial instruments for
European Structural and Investment (ESI) fund investments. The goal was creating easier access
to funding for startups and urban development project promoters. Loans, equity, guarantees and
other financial instruments attract greater public and private funding sources that may be
reinvested over many cycles as compared to receiving grants.

One of the instruments, a co-investment facility, was to provide funding for startups to
develop their business models and attract additional financial support through a collective
investment plan managed by one main financial intermediary. The European Commission
projected the total public and private resource investment at approximately $16.5 million per
small- and medium-sized enterprise.

Functions of Financial Intermediaries

Financial intermediaries move funds from parties with excess capital to parties needing
funds. The process creates efficient markets and lowers the cost of conducting business. For
example, a financial advisor connects with clients through purchasing insurance, stocks, bonds,
real estate and other assets. Banks connect borrowers and lenders by providing capital from other
financial institutions and from the Federal Reserve. Insurance companies collect premiums for
policies and provide policy benefits. A pension fund collects funds on behalf of members and
distributes payments to pensioners.

• 5 Types of Financial Intermediaries:

When it comes to financial intermediaries, there is a long list of those who qualify. Often
times, people may not even realize that they are interacting with a middleman who is just
overseeing the transaction in question. Nevertheless, without these entities, the investment
markets would be crippled and unable to operate.
1. Banks

Undoubtedly, banks are the most popular financial intermediaries in the world.
They come in multiple specialties that include saving, investing, lending, and many other
sub-categories to fit specific criteria. The most ancient way in which these institutions act
as middlemen is by connecting lenders and borrowers. For instance, when someone raises
a mortgage from a bank, they will be given the money that another person deposited into
that bank for saving. Similarly, large companies also use banks to help find investors. Not
to mention their role as the entities that people use to receive paychecks via direct
deposits.

2. Credit Unions

Similar to the aforementioned, credit unions also bring together people who need
money and those who have it. For instance, they are known to offer credit terms to people
by using the money that other individuals deposited into savings accounts. So, when
somebody needs a loan from a credit union, they will receive it because there are funds at
credit union’s disposal that someone else contributed. The main difference between these
entities and typical banks, however, is their role with consumer credit. Besides lending,
they also oversee many credit-related inquiries.

3. Pension Funds

Full-time employees often meet another popular financial intermediary known as

a pension fund. It is what millions of workers use to save for their retirement by
investing. The way it works is based on a risk factor, matching contribution, and long-
term investing. For instance, when somebody signs up for a pension fund, they choose
how much of their salary will be put away. Often, their employer matches that
contribution to a certain extent. Then, all of that money is used to purchase assets that
will grow and have a good yield. Once the employee retires, they get all the contributions
alongside any interest and realized gains
 4. Insurance Companies

Although there are several different types of insurance organizations, almost all of
them operate in the exact same way. First, they find a large number of customers who
need to obtain coverage. Whether it is a car, home, or health policy does not matter. Once
those customers purchase their insurance coverage, all of the funds are added to a large
pool of money. Later on, whenever somebody needs to make a claim and use the
insurance company to request a payout, the insurance provider will access that pool of
money. This means that there is no net inflow of cash to the market, per se.

5. Stock Exchanges

Buying corporate stocks can be a long and tedious process. In order to simplify it,
stock exchanges were invented. They act as large platforms where people can make stock
orders. After paying for them, the stock exchange will use that money to buy the actual
stocks from corporations. Then, the customer gets their desired assets while the
corporations get funding. In the meantime, the stock exchanges facilitate the entire
process and every transaction. Hence why they are seen as the financial intermediary of
the investment world. As with most other similar institutions, these exchanges earn
revenues by adding transaction fees and interest rates.

Ultimately, absent financial middlemen, the entire investment and financial sector would
suffer. People would be unable to make daily transactions and large companies would find it
hard to get funding. Hence why it is important to understand how relevant the role of common
financial intermediaries is.

Benefits of Financial Intermediaries

Through a financial intermediary, savers can pool their funds, enabling them to make a
large investment which in turn benefits the entity in which they are investing. At the same time,
financial intermediaries pool risk by spreading funds across a diverse range of investments and
loans. Loans benefit households and countries by enabling them to spend more money than they
have at the current time.

Financial intermediaries also provide the benefit of reducing costs on several fronts. For
instance, they have access to economies of scale to expertly evaluate the credit profile of
potential borrowers and keep records and profiles cost-effectively. Last, they reduce the costs of
the many financial transactions an individual investor would otherwise have to make if the
financial intermediary did not exist.

These are:

1. Value transformation. Borrowers may require large sums of money. Financial

intermediaries can pool together many smaller deposits and lend a smaller number of
large amounts of money to borrowers.
2. Maturity transformation. Depositors may only want to deposit money in the short
term, or retain a level of liquidity. Borrowers may want to borrow money over a long
period of time. By dealing with many customers over a long period of time, financial
intermediaries can provide long-term funds to borrowers, whilst ensuring that
depositors retain the level of liquidity they require.
3. Reduction in transaction costs. Financial intermediaries can reduce the transaction
costs associated with, for example, writing contracts for borrowers and lenders.
4. Risk diversification for savers. If a borrower defaults on a loan, the savers should
not be directly affected as the cost will be charged to the financial intermediary, not
the depositors. The returns on an individual’s savings are not reliant on the
performance of one borrower.
5. Expertise. Financial intermediaries have the specialist knowledge and resources to
assess the risk and anticipated profitability of proposed projects, so reducing the risk
to the lenders.
6. Ease of borrowing. Borrowers do not need to visit many banks to secure funding, but
visit one financial intermediary.
Potential Problems of Financial Intermediaries

1. There is no guarantee they will spread the risk. Due to poor management, they
may risk depositors’ money on ill-judged investment schemes.
2. Poor information. A financial intermediary may become complacent about
spreading the risk and invest in schemes which lose their depositors money (for
example, banks buying US mortgage debt bundles, which proved to be nearly
worthless – precipitating the global credit crunch.)
3. They rely on liquidity and confidence. To be profitable, they may only keep
reserves of 1% of their total deposits. If people lose confidence in the banking system,
there may be a run on the bank as depositors ask for their money bank. But the bank
won’t have sufficient liquidity because they can’t recall all their long-term loans.
(This can be overcome to some extent by a lender of last resort, such as the Central
Bank and / or government)

CONCLUSION

Reading the above points, it is clear that financial intermediaries play a very important
role in the economic development of the country. They are the “lubricants” that keep the
economy going. They play even bigger role in the developing countries, including helping the
government to eliminate poverty and implement other social programs. However, given the
complexity of the financial system and the importance of intermediaries in affecting the lives of
the public, they are heavily regulated. Several past financial crises, like the sub-prime crisis, have
shown that loose or uneven regulations could put the economy at risk.

References:
• https://www.investopedia.com/terms/f/financialintermediary.asp
• https://www.economicshelp.org/blog/6318/economics/functions-and-examples-of-financial-
intermediaries/
• https://www.topaccountingdegrees.org/lists/5-types-of-financial-intermediaries/