Financial intermediary

A financial intermediary is an institution or individual that serves as a "middleman" among diverse parties in order to facilitate financial transactions. Common types include commercial banks, investment banks, stockbrokers, insurance and pension funds, pooled investment funds, leasing companies, and stock exchanges.

The financial intermediary thus facilitates the indirect channeling of funds between, generically, lenders and borrowers.^[1] That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). When the money is lent directly - via the financial markets - eliminating the financial intermediary, this is known as financial disintermediation.

Economic function

Main article: Financial system

See also: Financial services, financial market, Circular flow of income, and Finance § The financial system

Financial intermediaries, as outlined, essentially, channel funds from those who have surplus capital (savers) to those who require liquid funds to carry out a desired activity (investors).^{[2] [3]} Financial intermediaries thus reallocate otherwise uninvested capital to productive enterprises. ^[4][5]

In doing so, they offer the benefits of maturity and risk transformation. In other words, through the process of financial intermediation, assets or liabilities may be transformed into assets or liabilities with (very) different risk and payment profiles.^[5]

• In the personal finance context, the instrument in question will be in the form of a loan or a mortgage.^[6]
• In the corporate context, the form may be take any variety of debt, equity, or hybrid stakeholding structures, extending to private equity and venture capital investments.
• Even in the non-commercial context of project finance, climate finance and development finance, financial intermediaries generally will be from the private sector.^[7][8]

The prevalence of these intermediaries, relative to disintermediated transactions, is explained in that specialist financial intermediaries ostensibly enjoy a cost advantage in offering financial services; this not only enables them to make profit, but also raises the overall efficiency of the economy. Their existence and services are then explained by the "information problems" associated with financial markets.^[9]

Functions performed by financial intermediaries

The hypothesis of financial intermediaries adopted by mainstream economics offers the following three major functions they are meant to perform:

1. Creditors provide a line of credit to qualified clients and collect the premiums of debt instruments such as loans for financing homes, education, auto, credit cards, small businesses, and personal needs.
2. Risk transformation^{[citation needed]}
3. Convenience denomination

Advantages and disadvantages of financial intermediaries

There are two essential advantages from using financial intermediaries:

1. Cost advantage over direct lending/borrowing ^{[citation needed]}
2. Market failure protection; The conflicting needs of lenders and borrowers are reconciled, preventing^{[citation needed]} market failure

The cost advantages of using financial intermediaries include:

1. Reconciling conflicting preferences of lenders and borrowers
2. Risk aversion intermediaries help spread out and decrease the risks
3. Economies of scale - using financial intermediaries reduces the costs of lending and borrowing
4. 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)

Various disadvantages have also been noted in the context of climate finance and development finance institutions.^[7] These include a lack of transparency, inadequate attention to social and environmental concerns, and a failure to link directly to proven developmental impacts.^[10]

Types of financial intermediaries

According to the dominant economic view of monetary operations,^[11] the following institutions are or can act as financial intermediaries:

• Banks
• Mutual savings banks
• Savings banks
• Building societies
• Credit unions
• Financial advisers or brokers
• Insurance companies
• Collective investment schemes
• Pension funds
• Cooperative societies
• Stock exchanges

 

Money Creation Balance Sheets (stylized) by commercial banks (see Bank of England 2014).

According to the alternative view of monetary and banking operations, banks are not intermediaries but "fundamentally money creation" institutions,^[11] while the other institutions in the category of supposed "intermediaries" are simply investment funds.^[11]

See also

• Debt
• Financial economics
• Investment
• Saving
• Financial market efficiency
• Pass-through security

References

1. Global Shadow Banking Monitoring Report 2013 (PDF). Financial Stability Board. 2013. p. 12. ISBN 978-0-07-087158-8.
2. "The Role Of Financial Intermediaries" Archived 2015-04-16 at archive.today, Finance Informer website, Australia (accessed 10 June 2015)
3. O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 272. ISBN 0-13-063085-3.{{cite book}}: CS1 maint: location (link)
4. Infinite Financial Intermediation, 50 Wake Forest Law Review 643 (2015), available at: http://ssrn.com/abstract=2711379
5. Siklos, Pierre (2001). Money, Banking, and Financial Institutions: Canada in the Global Environment. Toronto: McGraw-Hill Ryerson. p. 35. ISBN 0-07-087158-2.
6. Robert E. Wright and Vincenzo Quadrini. Money and Banking: Chapter 2 Section 5: Financial Intermediaries.[1] Accessed June 28, 2012
7. Institute for Policy Studies(2013), "Financial Intermediaries", A Glossary of Climate Finance Terms, IPS, Washington DC
8. Eurodad (2012), "Investing in financial intermediaries: a way to fill the gaps in public climate finance?", Eurodad, Brussels
9. Gahir, Bruce (2009). "Financial Intermediation". Prague, Czech Republic. {{cite journal}}: Cite journal requires |journal= (help)
10. Bretton Woods Project (2010)"Out of sight, out of mind? IFC investment through banks, private equity firms and other financial intermediaries", Bretton Woods Project, London
11. "The currently dominant intermediation of loanable funds (ILF) model views banks as barter institutions that intermediate deposits of pre-existing, real, loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds; and ILF-type institutions do not exist. Instead, banks create new funds in the act of lending, through matching loan and deposit entries, both in the name of the same customer, on their balance sheets. The financing-through-money-creation (FMC) model reflects this, and therefore views banks as fundamentally monetary institutions. The FMC model also recognises that, in the real world, there is no deposit multiplier mechanism." From "Banks are not intermediaries of loanable funds — and why this matters", by Zoltan Jakab and Michael Kumhof, Bank of England Working Paper No 529, May 2015

Bibliography

• Pilbeam, Keith. Finance and Financial Markets. New York: PALGRAVE MACMILLAN, 2005.
• Valdez, Steven. An Introduction To Global Financial Markets. Macmillan Press, 2007.