What is a Financial Intermediary?
A financial intermediary refers to an institution that acts as a middleman between two parties in order to facilitate a financial transaction. The institutions are commonly referred to as financial intermediaries, and they include commercial banks, investment banks, mutual funds and pension funds. They reallocate uninvested capital to productive sectors of the economy through debts and equity.
In simple terms, financial intermediaries channel funds from individuals or corporations with surplus capital to other individuals or corporations that require liquid cash to carry out certain economic activities.
Functions of Financial Intermediaries
A financial intermediary performs the following functions:
Commercial banks provide safe storage for both cash (notes and coins), as well as precious metals like gold and silver. The depositors are issued deposit cards, deposit slips, checks and credit cards that they can use to access their funds at any time. The bank also provides the depositors with records of withdrawals, deposits and direct payments they have authorized during a specific period. To ensure the depositors’ funds are safe, the Federal Deposit Insurance Corporation (FDIC) requires deposit-taking financial intermediaries to insure the funds with them.
Advancing short-term and long-term loans is one of the core businesses of financial intermediaries. They channel funds from depositors with surplus cash to individuals who are looking to borrow certain amounts of money to use in other activities. Borrowers typically borrow loans to purchase capital-intensive assets such as business premises, automobiles, factory equipment, and machinery, etc.
Intermediaries advance the loans at an interest, some of which they pay the depositors whose funds have been used and the other amount is retained as profits. However, before awarding loans to individuals and businesses, borrowers undergo screening to determine their creditworthiness and their ability to repay back the principal and interests accruing on the loans.
Some financial intermediaries such as mutual funds and investment banks employ in-house investment specialists that help clients grow their investments. The firms leverage their industry experience and dozens of investment portfolios to find the right investments that maximize returns and reduce risks.
The types of investment range from investing in the stock market, real estate, Treasury bills, financial derivatives, etc. Sometimes, these intermediaries invest their clients’ funds and pay them an annual interest for a particular pre-agreed period of time. Apart from managing their client’s funds, they also provide investment and financial advice to help them choose their ideal investments.
Benefits of Financial Intermediaries
Financial intermediaries offer the following advantages:
Financial intermediaries provide a platform where individuals with surplus cash can spread their risk by lending to several people rather than to only one individual. Lending to one person comes with a higher level of risk since the borrower can default on the loan. Depositing surplus funds with a financial intermediary allows the institutions to lend to various screened borrowers, and this reduces the risk of default. The same model applies to insurance companies that collect premiums from the clients and provide policy benefits if any the members are affected by unforeseeable events like accidents, death, and diseases.
Economies of scale
Financial intermediaries enjoy economies of scale since they can take deposits from a large number of customers and lend it out to multiple borrowers. The practice helps to reduce the overall operating costs that they incur in their normal business routines. Unlike borrowing from individuals with inadequate funds to loan the requested amount, financial institutions can often access large amounts of liquid cash that they can loan to individuals with a strong credit history.
Economies of scope
Intermediaries often offer a range of specialized services to clients, which allows them to enhance their products to favor the requirements of the different types of clients. For example, when commercial banks are lending out loans, they can customize the loan packages to suit small and large borrowers. Small and medium enterprises often make up the bulk of borrowers and preparing packages that suit their needs and repayment period can help banks grow their customer base.
Similarly, insurance companies enjoy economies of scope in offering insurance packages. It allows them to enhance their products and services to satisfy the needs of a specific category of customers such as people suffering from chronic illnesses, senior citizens over 65 years, etc.
Examples of Financial Intermediaries
A bank is a financial intermediary that is licensed to accept deposits from the public and create credit products for borrowers. Banks are highly regulated by governments or central banks of their respective countries due to the role they play in economic stability. They are also subject to minimum capital requirements that are based on a set of international standards known as Basel Accords.
A credit union is a type of bank that is member-owned, and it operates on the principle of helping members access credit at competitive rates. Unlike banks, credit unions are established to serve their members and not necessarily for profit purposes. Most credit unions claim to provide a wide variety of loan and saving products at a relatively lower price than other financial institutions. They are governed by a board of directors who are elected by the members in a one-person-one-vote voting system.
Mutual funds pool savings from individual investors. They are managed by fund managers who identify investments with the potential of earning a high rate of return and allocate the shareholder’s funds to the various investments. It allows individual investors to benefit from annual interest incomes that they would not have earned had they invested independently.
A financial advisor is an intermediary who provides financial services to clients based on their situation. In most countries around the world, financial advisors must undergo special training and obtain practicing licenses before they can start offering consultancy services. In the U.S., the Financial Industry Regulatory Authority provides the series 65 or 66 licenses for investment professionals, including financial advisors.
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