Financial intermediaries are the actors that characterize indirect finance, a way to move funds from lenders to borrowers characterized by the involvement of a third party, the financial intermediary. It stands between the savers and spenders and, by borrowing funds from the former and then using these funds to make loans to the latter helps with the transfer of funds from one to the other.
Financial intermediation, which is the process of indirect financing using intermediaries, is a far more important source of financing for corporations than securities markets, even though they generally do not receive as much attention from the media.
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Why are financial intermediaries so important?
Financial intermediaries and indirect finance in general, are a fundamental component of financial markets and are vital to allow them to work properly and to sustain the economy. To better understand why they are so important we need to understand the determinant effects that they have on information costs, transaction costs, and risk sharing.
Information costs are caused by the fact that in financial markets, one party often does not know enough about the other party to make accurate decisions.
Adverse selection, which is a problem that appears before the transaction occurs, derives from the fact that potential borrowers, who are the most likely to produce an undesirable outcome (the bad credit risks), are the ones who most actively seek out a loan and thus most likely to be selected.
On the other hand, moral hazard, which is created after the transaction occurs, is the risk that the borrower might decide to engage in activities that make it less likely that the loan will be paid back, and that is therefore undesirable, from the point of view of the lender.
As you can imagine, the problems created by adverse selection and moral hazard are a major impediment to well-functioning financial markets, but luckily financial intermediaries can contribute to alleviate these problems.
In fact, they can solve information problems because they are better equipped than individuals to screen out bad credit risks from good ones, and moreover they are experts in monitoring the parties they lend to, which helps them to have greater returns, and therefore to increase their profits so that they are able to give decent returns to individuals that have entrusted their savings to them as intermediaries.
Transaction costs are the costs related to the time and money spent on carrying financial transactions. These costs can damage the entire economy, but mainly small savers and borrowers. In fact, if transaction costs are too high, it becomes almost impossible for them to have access to financial markets.
Indeed, assuming that you want to loan $5,000 to another person that will pay you a 3% interest in a year, you will earn $150. But, if the transaction costs that you have to pay in order to settle this transaction are $500, you realize that you can’t earn enough from the deal (you spend $500 to make $100), and therefore you will not make the loan.
Financial intermediaries, thanks to their large size that allows them to take advantage of economies of scale, can substantially reduce transaction costs.
Risk, in financial markets can be considered as uncertainty about the returns that investors will earn on their assets.
Financial intermediaries can help reduce the exposure of investors to risk through the process of risk sharing, which is made possible by the low transaction costs.
The process of risk sharing is sometimes referred to as asset transformation, where risky assets are turned into safer assets for investors.
In fact, it consists of financial intermediaries creating and selling assets with risk characteristics that people are comfortable with. Then, intermediaries use the funds they acquire by selling these safer assets to individuals in order to purchase other assets that may have more risk so that they can earn a profit on the spread between the returns they can earn on risky assets and the payments they make on the assets they have sold to individuals.
Moreover, they help investors to reduce their exposure to risk by helping them to diversify, which means investing in a portfolio of assets whose returns do not always move together. This means that while some assets have a bad performance, other assets can balance the overall result by showing higher returns, with the result that overall risk is lower than for individual assets.
Types of Financial Intermediaries
Now that we have seen why financial intermediaries are so relevant in the functioning of the economy, it is important to take a look at the principal financial intermediaries and how they perform their functions.
The different types of financial intermediaries that exist can be divided into depository institutions, investment intermediaries, and contractual savings institutions.
Depository institutions (banks) are financial intermediaries that make loans and accept deposits from individuals and institutions, therefore they are a fundamental group of financial institutions because they are actively involved in the process of money supply, through the creation of deposits.
The group of depository institutions is composed of commercial banks, credit unions, and savings and loan associations (S&L) and mutual savings banks.
Commercial banks are intermediaries that raise funds in order to buy financial assets like U.S. government securities and municipal bonds, primarily by issuing checkable deposits, savings deposits, and time deposits.
Credit unions, carry out an activity focused on acquiring funds from deposits and make consumer loans. They are financial institutions usually organized as small cooperative lending institutions, organized around a particular group, like union members, employees of a firm, etc.
Savings and loan associations (S&L) and mutual savings banks are depository institutions that obtain funds primarily through savings deposits and time and checkable deposits. Even though in the past their activity was mostly focused on making mortgage loans for residential housing, which was differentiating their activity from that of commercial banks, nowadays most of those old restrictions have been loosened, and therefore these intermediaries have become much more alike.
This category of intermediaries includes:
- Finance companies are intermediaries that lend funds mostly to consumers who use them to purchase items such as furniture, automobiles, and home improvements. Some of them are organized by a parent company to help sell its product.
- Mutual funds are financial intermediaries that use the funds that they have acquired through the sale of shares to individuals, to purchase diversified portfolios of stocks and bonds. Shareholders of mutual funds can redeem shares at any time, but the value at which they will sell them will be determined by the value of the total holdings of the mutual fund. Given that the value of mutual fund’s holdings fluctuates greatly, investments in mutual funds can be risky, but however, they allow shareholders to take advantage of lower transaction costs, and also to hold a more diversified portfolio.
- Money market mutual funds are very similar to mutual funds, but they also function to some extent as depository institutions, because they offer deposit-type accounts. In fact, a key feature of money market mutual funds is that shareholders can write checks against the value of their shareholding because in these funds shares function like checking account deposits that pay interest.
- Investment banks are a type of intermediary that helps corporations to issue securities, in detail it advises the corporation on which type of securities to issue (stocks or bonds), and then it helps to sell the securities by purchasing them from the corporation at a determined price and reselling them in the market.
- Hedge funds are a type of mutual fund with special characteristics, in fact, they are organized as limited partnerships. However, given that the amount of money necessary in order to invest in hedge funds is higher than normal mutual funds, it means that they are subject to weaker regulation.
Contractual savings institutions
Contractual savings institutions are financial intermediaries that acquire funds at periodic intervals on a contractual basis, such as insurance companies and pension funds.
To them, the liquidity of assets is not as important as it is for depository institutions, because they can predict with reasonable accuracy how much they will have to pay out in benefits in the coming years.
An example of contractual savings institutions can be life insurance companies. They insure people against financial hazards following a death and sell annuities, which are annual income payments upon retirement.
They are among the largest of the contractual savings institutions, and they tend to invest their funds, that they acquire from the premiums that people pay to keep their policies in force, primarily in long-term securities such as corporate bonds, stocks, and mortgages.