Definition: Financial intermediaries are the individuals or institutions which discursively connects the depositors with the borrowers. It acts as a medium between both by using the depositors’ funds for offering a loan to the borrowers. While these financial intermediaries make income from the interest rate spread.
Interest rate spread can be explained as the earnings made by a financial intermediary as the surplus of interest received from borrowers over the interest paid to the depositors. Some of the most common financial intermediaries are banks, insurance companies, NBFCs, financial brokers and credit unions.
Content: Financial Intermediaries
Financial Intermediation Process
A financial intermediary is a substantial part of any country’s economic system. It efficiently regulates money to fulfil the financial purpose of individuals, organizations and the government.
As we know that an intermediary acts as an emissary between two parties i.e., the depositor and the borrower, we must first understand its functioning.
The financial intermediation process begins when a client (depositor) deposits money into the bank or other financial intermediary. Then this financial intermediary further grants this sum as loans to another client (borrower). Now, the borrower has to repay this sum in multiple instalments payable at regular intervals.
The rate of interest charged by the financial intermediary from the borrower is usually high. After receiving this interest, the financial intermediary pays off the interest promised to the depositor which is comparatively lesser. Thus, the difference between these two interest rates i.e., the interest rate spread is retained by the financial intermediary as its earnings.
Mr X sells a property and deposits the fund as a fixed deposit with ABC bank. While Mr Y who holds a small shop approaches ABC bank to take a loan for business expansion.
Now, ABC bank acts as a medium for fulfilling the requirements of both these parties. It takes the deposited fund of Mr X and issues it as a loan to Mr Y. When Mr Y was charged high interest, Mr X was paid at a lower rate by the bank to make income from this interest rate spread.
Functions of Financial Intermediaries
A financial intermediary is the backbone of any country and its economic system. Let us find out its various operations:
- Offering Loans: The financial intermediaries issues short-term and long-term loans to the eligible borrowers payable in instalments with a certain interest amount.
- Asset Storage Facility: It provides an asset storage system for the clients where they can safely keep their cash, valuables, jewellery and other assets
- Converting Savings into Investments: A financial intermediary transforms the deposits, savings and other financial inflow from one client to loans and advances given to the other client.
- Maximizing Returns for Clients: These intermediaries allocate the depositor’s or investor’s money to highly rewarding opportunities with a low-risk involvement.
- Reducing Risk: Being more experienced and professional entities, the financial intermediaries help their client mitigate risk and utilize their funds sensibly.
- Other Services: The financial intermediaries also provide a range of different services like debit cards, credit cards, line of credit, demand draft, etc.
Types of Financial Intermediaries
Many of us are only aware of banks being the financial intermediaries, however, several other organizations are equally essential to run an economy. These are unfolded below:
A bank as we know is a registered and authorized financial institution of a country. The central and commercial banks serve the various purposes of individuals, organizations and the government. These include deposit facility, wealth management, loans and advances, locker facility, currency exchange and many more.
Non-Banking Financial Companies
The non-banking finance companies work in a similar way like banks do, however they don’t hold a banking license. While NBFCs can provide microcredit i.e., lend funds to individuals and organizations (at a higher interest rate), they aren’t allowed to accept any kind of deposits or savings from the public.
An insurance company provides a shield from uncertainties to their clients. It acquires a regular premium from the clients and promises to bear the expense up to an agreed sum in case the insured event or loss occurs. While the probability of such an occurrence is extremely low, the company can still make profits.
A credit union is a form of cooperative society that offers limited financial services to its members. These form of financial intermediaries are formed, owned and run by the members and therefore the rate of interest charged from them is quite low. Also, such organizations are exempt from taxes.
A market place where the securities can be openly traded and shares are offered as IPOs by the listed companies is known as a stock exchange. The listed companies get additional capital while the investors generate income from stock appreciation. The stock exchange charges different fees such as trading and listing fees from the registered companies; and data fees from the informative websites or news agencies.
Mutual Fund Companies
These financial intermediaries mostly fulfil the long-term goals of the investors. A mutual fund company acquires funds from investors and put them into the bonds, shares and debt instruments of high-yielding companies to generate income.
Collective Investment Providers
The collective investment trust formed by a financial institution pools the assets of its clients to create a single massive portfolio termed as a collective investment fund. These groups work under the norms of the OCC (Office of the Comptroller of Currency).
Financial Brokers or Advisers
While the financial brokers guide the clients to trade in the stock markets and make earnings from the brokerage; financial advisers show the direction to their clients for selecting a suitable investment product and make money from the commission.
Pension Fund Organizations
It is usually a government-held financial intermediary that accepts employer and employee contributions at regular intervals to ensure retirement benefits to the latter.
When it comes to huge financial investments, individuals, government, institutions and corporations rely upon the expert advice of investment bankers. However, they function as a part of any financial institution like a bank.
This form of a financial intermediary is a mutual organization possessed by its members. The function of a building society is to provide mortgage loans, savings, banking services and other facilities to its members.
When it comes to property dealing, an escrow company or agent acts as a third-party responsible for keeping the charge of the property till the dispute between the dealing parties resolve or until the transaction is successful.
Advantages of Financial Intermediaries
Have you ever imagined, how difficult it would be for a company to avail funds from individuals all by itself?
So arises a need for financial intermediaries. Discussed below are multiple benefits offered by these mediators:
- Accessibility: A financial intermediary is easily approachable by a depositor as well as a borrower. Neither of these parties needs to search for one another to initiate the exchange of funds.
- Cost Efficient: A financial intermediary benefit from economies of scale, thus reducing its operational overheads and the borrowing cost for its clients.
- Provides Real-Time Information: As we know that the financial market is highly volatile, a financial intermediary not only provides but also functions on real-time data.
- Higher Liquidity: The financial intermediaries provide the flexibility of fund withdrawal to its depositors and early repayment of loans to its borrowers.
- Spread Risk: Since the financial intermediaries hold expertise in market analysis, there are minimal chances of failure, fraud and loss.
- Facilitates Customization: The clients can get tailor-made services from financial intermediaries. Whether it is an insurance plan, investment portfolio, a loan or other financial services, everything can be customized.
- Avoids Deception: When lending personally to an individual involves great risk of non-payment, a financial intermediary hedge this risk and thus becomes a safer option for the investors.
- Specialized Services: Financial intermediaries work more professionally and therefore provides a variety of high-end services to their clients with better returns and less risk involvement.
Disadvantages of Financial Intermediaries
Not everyone prefers access to the facilities of financial intermediaries. The reason behind it is its various drawbacks mentioned below:
- Fake Promises: Even after strict government regulations, sometimes a financial intermediary trick the customers into high-risk investments where they end up losing their sum instead of earning high returns.
- Poor ROI: The depositors are disheartened at times because of low returns on their investment especially the current or savings account holders.
- Transaction Costs: The clients have to bear the expenses of availing the financial intermediary services in the form of commission, fees, brokerage, etc.
- High Interest on Borrowings: The rate of interest charged from the borrowers is somewhat high, making the loans and advances expensive for the common man.
- Differing Goals: When it comes to investors, their goals are contrasting to that of the financial intermediaries due to which it becomes difficult to fulfil the motives of both.
- Secondary Market Risk: The security markets are extremely volatile and risk-prone, while the financial intermediaries are involved in maximum exchange in these secondary markets.
A financial intermediary is a lifeline rather than just a part of the system. When money is considered to be the blood for any economic system, financial intermediaries make this blood flow to the different sections of an economy.