A financial intermediary is an entity that facilitates a financial transaction between two parties. Such an intermediary or a middleman could be a firm or an institution. Some examples of financial intermediaries are banks, insurance companies, pension funds, investment banks and more.
One can also say that the primary objective of the financial intermediaries is to channel savings into investments. These intermediaries charge a fee for their services.
Financial intermediaries have emerged as a useful tool for the efficient market system as they help channelize savings into investment. However, they can also be a cause of concern, as the sub-prime crisis shows. Often, there is a need to regulate the activities of these intermediaries.
Examples of Financial Intermediaries
Bank: These intermediaries are licensed to accept deposits, give loans and offer many other financial services to the public. They play a major role in the economic stability of a country, and thus, face heavy regulations.
Mutual Funds: They help pool savings of individual investors into financial markets. A fund manager oversees a mutual fund and allocates the funds to different investment products.
Financial advisors: Such intermediaries may or not offer a financial product, but advises investors to help them achieve their financial objectives. These advisors usually undergo special training.
Credit Union: It is also a type of bank, but works to serve its members and not public. They may or may not operate for profit purposes.
Other financial intermediaries are pension funds, insurance companies, investment banks and more.
Functions of Financial Intermediaries
A financial intermediary performs the following functions:
- As said before, the biggest function of these intermediaries is to convert savings into investments.
- Intermediaries like commercial banks provide storage facilities for cash and other liquid assets, like precious metals.
- Giving short and long term loans is a primary function of the financial intermediaries. These intermediaries accept deposits from the entities with surplus cash and then loan them to entities in need of funds. Intermediaries give the loan at interest, part of which is given to the depositors, while the balance is retained as profits.
- Another major function of these intermediaries is to assist clients to grow their money via investment. Intermediaries like mutual funds and investment banks use their experience to offer investment products to help their clients maximize returns and reduce risks.
Advantages of Financial Intermediaries
- They help in lowering the risk of an individual with surplus cash by spreading the risk via lending to several people. Also, they thoroughly screen the borrower, thus, lowering the default risk.
- They help in saving time and cost. Since these intermediaries deal with a large number of customers, they enjoy economies of scale.
- Since they offer a large number of services, it helps them customize services for their client. For instance, banks can customize the loans for small and long term borrowers or as per their specific needs. Similarly, insurance companies customize plans for all age groups.
- They accumulate and process information, thus lowering the problem of asymmetric information.
Let us consider a simple example that will help us understand these advantages better. Suppose you need some loan, but you don’t know who has enough money to give you. So, you contact a middleman, who in turn is in contact with those with surplus money.
A Potential Issue with Intermediaries
It is possible that a financial intermediary may not spread risk. They may channel depositor’s funds to schemes that earn them (intermediaries) more profits. Or, due to poor management, they may invest money in schemes, which may not be so attractive now.
Such issue (or issues) with the intermediaries, however, are avoidable. Moreover, after the 2008 crisis, financial intermediaries are facing increased regulations to ensure that they don’t overreach their limits.
Reading the above points, it is clear that financial intermediaries play a very important role in the economic development of the country. 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.