Financial intermediaries are common in the entire financial world. A financial intermediary can be defined as an institution that borrows money from people who have saved and, in turn, offers loans to others, acting as a middleman between firms and investors raising money. Common institutions that conduct intermediary actions are credit unions, commercial banks, finance companies, mutual funds, and insurance companies. These financial institutions are an integral part of the entire health and functionality of the world financial market. Keep reading to learn more about the what, how, and why of financing intermediary.
What Is A Financial Intermediary?
A financial intermediary is an entity that serves as the middleman between two parties in a financial transaction, like a pension fund, mutual fund, investment bank, and a commercial bank. These financial intermediaries reallocate uninvested capital to productive sectors of the economy via equity and debts. In simple terms, financial intermediaries channel money from corporations and individuals with surplus capital to other corporations or individuals that need cash to carry out certain economic activities. Financial intermediaries provide several benefits to the average consumer, including liquidity, safety, and economies of scale involved in asset and banking management. Even though in certain areas, like investing, advances in technology threaten to get rid of the financial intermediary, the aftermarket is much less of a threat in other finance regions, including insurance and banking.
How does intermediary financial work?
Generally, a non-bank financial intermediary does not accept deposits from the general public. The intermediary might provide leasing, factoring, insurance plans, or other financial services. Most intermediaries participate in securities exchanges and use long-term plans for growing and managing their funds. The entire economic stability of a country might be shown through financial intermediaries’ activities and the growth of the financial services industry.
A financing intermediary moves funds from parties with excess capital to parties that need funds. The process develops efficient markets and lowers the cost of conducting business. For instance, a financial advisor connects with customers through purchasing real estate, bonds, stocks, insurance, and other assets. Banks connect lenders and borrowers by providing capital from the Federal Reserve and other financial institutions. Insurance companies collect premiums for policies and offer benefits. A pension fund distributes payments to pensioners and collects funds on behalf of members.
What are the Functions of Financial Intermediaries?
A financial intermediary performs the following functions
Advancing long-term and short-term loans is the core business of a financial intermediary. They channel funds from depositors with excess cash to individuals who are seeking to borrow money. Typically, borrowers take out loans to buy capital-intensive assets like factory equipment, automobiles, and business premises.
Financial intermediaries advance the loans at interest, some of which they pay the depositors whose funds have been utilized. The remaining amount of interest is maintained as profits. Typically, borrowers undergo screening to determine their ability to repay the debt and their creditworthiness.
Commercial banks offer safe storage for both cash (coins and notes) and precious metals like silver and gold. Depositors are issued credit cards, checks, deposit slips, and deposit cards that they can use to access their funds. The bank also offers depositors with records of withdrawals, direct payments, and deposits they have authorized. To make sure the depositors’ funds are safe, FDIC (the Federal Deposit Insurance Corporation) requires deposit-taking financial intermediaries to secure the funds deposited with them.
Like investment banks and mutual funds, some financial intermediaries employ in-house investment specialists who assist clients grow their investments. The firms leverage their industry experience and many investment portfolios to find the right investments that increase returns and lower risk.The types of investments range from real estate to stocks, financial derivatives, and treasury bills. Sometimes, intermediaries invest their customers’ funds and pay them an annual interest for a pre-agreed period. Apart from managing client funds, they also offer investment and financial advice to assist them in choosing ideal investments.
Benefits of Financial Intermediaries
Financial intermediaries provide the following advantages
Economies of scale
Financial intermediaries experience economies of scale since they take deposits from a large number of clients and lend money to many borrowers. The practice reduces the overall operating costs that they incur in their normal business routines. Contrary to borrowing from individuals with inadequate funds to loan the requested amount, financial institutions can frequently access large amounts of liquid cash to lend to individuals with a good credit ranking.
Financial intermediaries offer a platform where individuals with surplus money can spread their risk by lending to several people instead of only one individual. Lending to just an individual comes with a higher level of risk. Depositing surplus funds with a financial intermediary enables institutions to lend to various screened borrowers. This lowers the risk of loss via default. The same risk depletion model applies to insurance companies. They gather premiums from clients and offer policy benefits if clients are affected by unforeseeable events such as disease, death, and accidents.
Economies of scope
Financial intermediaries usually offer a range of specialized services to clients. This allows them to enhance their products to cater to the qualifications of different types of clients. For instance, when commercial banks are lending out money, they can customize the loan packages to suit large and small borrowers. Medium and small enterprises often make up the bulk of borrowers. Preparing packages that are ideal for their needs can assist the banks to grow their customer base. Likewise, insurance companies enjoy economies of scope in providing insurance packages. It enables them to promote their services and products to satisfy the needs of a specific category of customers like senior citizens or people suffering from chronic illnesses.
Depositors might only want to deposit money in the short-term or maintain a level of liquidity. Borrowers might want to borrow money over a long period. By dealing with many clients over a long time, financial intermediaries can offer long-term funds to borrowers while ensuring that depositors retain the liquidity level they need.
Potential Problems of a Financial Intermediary
Some of the potential shortcomings of financial intermediaries
- Inadequate information: A financial intermediary might become complacent about spreading risk and invest in schemes which lose their depositors’ money (for instance, banks purchasing US mortgage debt bundles, which proved to be almost worthless- precipitating the worldwide credit crunch.)
- There is no guarantee that the financial intermediaries will spread the risk: Because of poor management, they might risk depositing money on ill-judged investment schemes.
- Financial intermediaries depend on liquidity and confidence: To be profitable, financial intermediaries might only keep reserves of one-percent of their total deposits. If the society loses faith in the banking system, there might be a bank run since depositors ask for their money bank. However, the bank will not have sufficient liquidity since they can’t recall all their long term loans. Nevertheless, this can be controlled to some extent by a lender of last resort, like the government or the Central Bank.
Examples of Financial Intermediaries
A credit union is a kind of bank that is member-owned. It operates on the principle of assisting members access credit at competitive rates. Contrarily to banks, credit unions are established to serve their members and not necessarily for profit. Credit unions claim to offer a wide variety of loans and saving products at a comparatively lower price than other financial institutions provide. They are ruled by a board of directors who are elected by the members.
Banks are financial intermediaries that are licensed to accept deposits from the public and create products for borrowers. They are highly regulated by the government because of the role they play in economic stability. Banks are also susceptible to minimum capital requirements based on a set of international standards called the Basel Accords.
Generally, a financial advisor is a financial intermediary who offers financial services to customers. In many countries, financial advisors must undergo special training and get licenses before they can provide consultancy services. In the USA, the Financial Industry Regulatory Authority offers the series 66 or 65 licenses for investment professionals, including financial advisors.
If your investment is risky, you might want to insure it against the risk of default. Instead of finding a particular individual to insure you, it is simpler to go to an insurance company that can offer insurance and helps spread the default risk.
Mutual funds and investment trusts
Mutual funds pool savings from individual investors. They are controlled by fund managers who identify investments with the potential of earning a high rate of return and who allocate the shareholders’ funds to the various investments. This allows individual investors to benefit from returns that they would not have earned had they invested independently.