Financial intermediation consists of “channeling funds between surplus and deficit agents”
A financial intermediary is an entity that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans.[1]
Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities.[2]
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).[3]
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.
Forms of intermediation
There are 2 forms of intermediation:
- Direct- lenders and borrowers make agreements and channel funds directly among them (fewer options)
- Indirect- funds are channeled by financial institutions (intermediaries)
Lenders and borrowers have conflicting needs
- Most lenders prefer lending short-term
That is why most intermediation is done indirectly, where intermediaries understand and reconcile the different needs of lenders and borrowers.
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
2. 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 scale- using financial intermediaries reduces the costs of lending and borrowing
- 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:
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. [4]
See also
References
- ^ Siklos, Pierre (2001). Money, Banking, and Financial Institutions: Canada in the Global Environment. Toronto: McGraw-Hill Ryerson. p. 35. ISBN 0-07-087158-2.
- ^ Siklos, Pierre (2001). Money, Banking, and Financial Institutions: Canada in the Global Environment. Toronto: McGraw-Hill Ryerson. p. 35. ISBN 0-07-087158-2.
- ^ Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 272. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4.
- ^ Gahir, Bruce (2009), Financial Intermediation, Prague, Czech Republic
Bibliography
- Pilbeam, Keith. Finance and Financial Markets. New York: PALGRAVE MACMILLAN, 2005.
- Valdez, Steven. An Introduction To Global Financial Markets. Macmillan Press, 2007.
References
