5. How finical intermediaries mange their risk and return?

A financial intermediary is an entity that acts as the middleman between two parties in a financial
transaction, such as a commercial bank, investment banks, mutual funds and pension funds.
Financial intermediaries offer a number of benefits to the average consumer, including safety,
liquidity, and economies of scale involved in commercial banking, investment banking and asset
management. Although in certain areas, such as investing, advances in technology threaten to
eliminate the financial intermediary, disintermediation is much less of a threat in other areas of
finance, including banking and insurance.

BREAKING DOWN Financial Intermediary

A non-bank financial intermediary does not accept deposits from the general public. The
intermediary may provide factoring, leasing, insurance plans or other financial services. Many
intermediaries take part in securities exchanges and utilize long-term plans for managing and
growing their funds. The overall economic stability of a country may be shown through the
activities of financial intermediaries and growth of the financial services industry.

Functions of Financial Intermediaries

Financial intermediaries move funds from parties with excess capital to parties needing funds. The
process creates efficient markets and lowers the cost of conducting business. For example, a
financial advisor connects with clients through purchasing insurance, stocks, bonds, real estate, and
other assets. Banks connect borrowers and lenders by providing capital from other financial
institutions and from the Federal Reserve. Insurance companies collect premiums for policies and
provide policy benefits. A pension fund collects funds on behalf of members and distributes
payments to pensioners.

Mutual Funds as Financial Intermediaries

Mutual funds provide active management of capital pooled by shareholders. The fund manager
connects with shareholders through purchasing stock in companies he anticipates may outperform
the market. By doing so, the manager provides shareholders with assets, companies with capital
and the market with liquidity.

Benefits of Financial Intermediaries

Through a financial intermediary, savers can pool their funds, enabling them to make large
investments, which in turn benefits the entity in which they are investing. At the same time,
financial intermediaries pool risk by spreading funds across a diverse range of investments and
loans. Loans benefit households and countries by enabling them to spend more money than they
have at the current time.

Financial intermediaries also provide the benefit of reducing costs on several fronts. For instance,
they have access to economies of scale to expertly evaluate the credit profile of potential borrowers
and keep records and profiles cost-effectively. Last, they reduce the costs of the many financial
transactions an individual investor would otherwise have to make if the financial intermediary did
not exist.
How to Manage Risk in the Financial Sector

Financial establishments, such as banks, routinely face different types of risks in the course of their
operations. Risk stems from uncertainty of financial loss and can potentially cripple the business if
not managed in time. This demands that mechanisms to manage risk be created via a risk
management philosophy, with the objective of minimizing negative effects risks can have on the
financial health of the institution. This involves identifying potential risks in advance, analyzing
them and taking steps to diminish or eliminate them.

Market Risk
Financial institutions face the possibility of loss caused by changes in market variables, including
interest rate and exchange rate fluctuations, as well as movements in market prices of commodities,
securities and financial derivatives. These constitute risks that can negatively impact the financial
capital of the institution. Market risk management involves developing a comprehensive and
dynamic framework for monitoring, measuring and managing liquidity, interest rate, foreign
exchange and commodity price risks. This should be integrated with the institution’s business
strategy. In addition, stress testing can assess potential problem areas in a given portfolio.

Credit Risk
Credit risk is the potential that an entity that borrowed money will default on that obligation to the
financial institution. It may be because of the inability or unwillingness of the client to honor their
part of the bargain in relation to the financial transaction. To manage credit risk, the institution has
to maintain credit exposure within the acceptable parameters. One effective way is via a risk rating
model that gauges how much a bank stands to lose on credit portfolio. Further, lending decisions
are routinely based on the credit score and report of the prospective borrower.

Operational Risk
Operational risk is associated with the potential negative consequences of the operations of the
financial institution, such as those caused by inadequate or failed internal processes, people and
systems, or unforeseeable external events. Internal operational risks include omissions in the work
of employees, inadequate information management and losses arising from fraud, trading errors or
system failures. External events such as floods, fire and natural disasters also pose risks.
Operational risk management involves establishing internal audit systems, assessing and
eliminating weak control procedures, familiarizing all levels of staff with the complex operations
and having appropriate insurance cover.

Regulatory Risk
All financial institutions face regulatory risk, since the U.S. has several financial regulations
implemented at federal and state levels that have to be complied with. This is to enhance
governance and safeguard the public against loss. Banks and other financial establishments that
have gone for public issue face a multiplicity of regulatory controls in order to ensure greater
responsibility and accountability. These regulations can inhibit free growth of business as
institutions focus on compliance, leaving little energy and time for developing new business. To
manage regulatory risk, institutions should conduct their business activities within the regulatory
framework.