9/29/2020 Additional Notes | Chapter 4: Financial Intermediation - Google Docs

FINMAR: Financial Markets MW | 6:00-7:30pm

Mr. Airwin Serrano Ditianquin

Chapter 4: Financial Intermediation

Financial intermediation is a productive activity in which an institutional unit incurs liabilities on its
own account for the purpose of acquiring financial assets by engaging in financial transactions on
the market; the role of financial intermediaries is to channel funds from lenders to borrowers by
intermediating between them.

Benefits of financial intermediation

Value transformation. Borrowers may require large sums of money. Financial intermediaries can
pool together many smaller deposits and lend a smaller number of large amounts of money to
borrowers.

Maturity transformation. Depositors may only want to deposit money in the short term, or retain a
level of liquidity. Borrowers may want to borrow money over a long period of time. By dealing with
many customers over a long period of time, financial intermediaries can provide long-term funds to
borrowers, whilst ensuring that depositors retain the level of liquidity they require.

Reduction in transaction costs. Financial intermediaries can reduce the transaction costs
associated with, for example, writing contracts for borrowers and lenders.

Risk diversification for savers. If a borrower defaults on a loan, the savers should not be directly
affected as the cost will be charged to the financial intermediary, not the depositors. The returns on
an individual’s savings are not reliant on the performance of one borrower.

Expertise. Financial intermediaries have the specialist knowledge and resources to assess the risk
and anticipated profitability of proposed projects, so reducing the risk to the lenders.

Ease of borrowing. Borrowers do not need to visit many banks to secure funding, but visit one
financial intermediary.

Definition of financial intermediaries

Financial intermediaries are an important source of external funding for corporates. Unlike the
capital markets where investors contract directly with the corporates creating marketable
securities, financial intermediaries borrow from lenders or consumers and lend to the companies
that need investment.

● A financial intermediary is a financial institution such as bank, building society, insurance

company, investment bank or pension fund.
● A financial intermediary offers a service to help an individual/ firm to save or borrow money. A
financial intermediary helps to facilitate the different needs of lenders and borrowers.

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● For example, if you need to borrow £1,000 – you could try to find an individual who wants to
lend £1,000. But, this would be very time consuming and you would find it difficult to know how
reliable the lender was.
● Therefore, rather than look for individuals to borrow a sum, it is more efficient to go to a bank (a
financial intermediary) to borrow money. The bank raises funds from people looking to deposit
money, and so can afford to lend out to those individuals who need it.

Direct Finance and Indirect Finance

Indirect finance is where borrowers borrow funds from the financial market through indirect
means, such as through a financial intermediary. You engage in direct financing when you borrow
money from a friend, or when you purchase stocks or bonds directly from the corporate issuing
them.

Depository and Non-depository Financial Institutions

Those that accept deposits from customers—depository institutions—include commercial banks,

savings banks, and credit unions; those that don't—nondepository institutions—include finance
companies, insurance companies, and brokerage firms.

Benefits of Financial Intermediaries

1. Lower search costs. You don’t have to find the right lenders, you leave that to a specialist.
2. Spreading risk. Rather than lending to just one individual, you can deposit money with a
financial intermediary who lends to a variety of borrowers – if one fails, you won’t lose all your
funds.
3. Economies of scale. A bank can become efficient in collecting deposits, and lending. This
enables economies of scale – lower average costs. If you had to seek out your own savings,
you might have to spend a lot of time and effort investigating the best ways to save and borrow.
4. The convenience of Amounts. If you want to borrow £10,000 – it would be difficult to find
someone who wanted to lend exactly £10,000. But, a bank may have 1,000 people depositing
£10 each. Therefore, the bank can lend you the aggregate deposits from the bank and save
you finding someone with the exact right sum.

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.

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9/29/2020 Additional Notes | Chapter 4: Financial Intermediation - Google Docs

When financial intermediaries allocate funds, they assess the risks—credit risk, duration or
interest rate risk—and returns that come from various risky claims. They sell some of the risks to
investors and individuals who are willing to bear it. Intermediaries help allocate resources and risks
throughout the economy.

Potential Problems of Financial Intermediaries

● There is no guarantee they will spread the risk. Due to poor management, they may risk
depositors money on ill-judged investment schemes.
● Poor information. A financial intermediary may become complacent about spreading the risk
and invest in schemes which lose their depositors money (for example, banks buying US
mortgage debt bundles, which proved to be nearly worthless – precipitating the global credit
crunch.)
● They rely on liquidity and confidence. To be profitable, they may only keep reserves of 1% of
their total deposits. If people lose confidence in the banking system, there may be a run on the
bank as depositors ask for their money bank. But the bank won’t have sufficient liquidity
because they can’t recall all their long-term loans. (This can be overcome to some extent by a
lender of last resort, such as the Central Bank and / or government)

Drawbacks of Financial Intermediaries

False Opportunities: Sometimes, the financial intermediaries come up with the investment
opportunities which guarantee high potential returns with the hidden risk involved in it. Even some
of these may not yield the promised returns and turn out to be a failure for the investor.

Why does a currency lose value?

Currency depreciation can occur due to factors such as economic fundamentals, interest rate
differentials, political instability or risk aversion among investors. Countries with weak economic
fundamentals such as chronic current account deficits and high rates of inflation generally have
depreciating currencies.

Role of Financial Intermediaries in Socio-economic Development

Financial intermediaries perform two major economic functions in almost all economies. First, they
create money and administer the payments mechanism. In most economies today, a central bank
or monetary authority issues currency and depository institutions supply deposit money.

Without financial intermediaries lenders and borrowers would have to pay higher transactional
and information costs. Modern world would not have been so efficient, aggressive and progressive
without financial intermediation.

Financial intermediaries serve as middlemen for financial transactions, generally between banks or
funds. These intermediaries help create efficient markets and lower the cost of doing business.
Intermediaries can provide leasing or factoring services, but do not accept deposits from the public.

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9/29/2020 Additional Notes | Chapter 4: Financial Intermediation - Google Docs

Factoring is a financial transaction and a type of debtor finance in which a business sells its
accounts receivable (i.e., invoices) to a third party (called a factor) at a discount. A business will
sometimes factor its receivable assets to meet its present and immediate cash needs.

Economic Basis for Financial Intermediation

The true economic basis of financial intermediation lies in the economies of scale ( proportionate
saving in costs gained by an increased level of production) in portfolio management and in the
law of large numbers.

When more units of a good or service can be produced on a larger scale, yet with (on average)
fewer input costs, economies of scale are said to be achieved. Alternatively, this means that as a
company grows and production units increase, a company will have a better chance to decrease
its costs.

Portfolio management is the art and science of selecting and overseeing a group of investments
that meet the long-term financial objectives and risk tolerance of a client, a company, or an
institution.

The law of large numbers, in probability and statistics, states that as a sample size grows, its
mean gets closer to the average of the whole population. In a financial context, the law of large
numbers indicates that a large entity which is growing rapidly cannot maintain that growth pace
forever.

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