Table of Contents Hide
- What are Financial Intermediaries?
- Importance of Financial Intermediaries
- Benefits of Financial Intermediaries
- Classification of Financial Intermediaries
- Types of Financial Intermediaries
- Advantages and Disadvantages of Financial Intermediaries
- Financial Intermediaries FAQ’s
- What are the three major groups of financial intermediaries?
- Why is a bank called a financial intermediary?
- What is the difference between financial market and financial intermediary?
Have you ever heard of the word middlemen? That’s basically the role of a financial intermediary.
While many individuals just think the bank saves their money, their main business is that of a middleman, same as your stockbroker and insurance agent.
You will get to understand this concept better after reading this article on financial intermediaries comprising of its classifications, importance, advantages, disadvantages, types, and lots more.
Stay with us as we discuss this interesting topic.
What are Financial Intermediaries?
A financial intermediary is a person or an entity that acts as a middleman between two parties in a financial transaction. They can be a commercial bank, investment bank, stockbroker, mutual fund, or pension fund.
The role of FIs in a financial transaction is to ensure safety, liquidity, and economies of scale in banking and asset management.
There are bank and non-bank financial intermediaries.
Generally, since they are middlemen that link two parties, they do not accept deposits from the public. They just create an efficient market and reduce the cost of business. They can be likened to a negotiator in a financial transaction.
In other words, the bank as a financial intermediary between two individuals in a financial transaction guards the safety of funds and their availability between parties
Importance of Financial Intermediaries
Essentially, the greatest importance of financial intermediaries is that it decreases transaction costs for accumulating capital and encourage savings.
It also increases productivity since it directs investments to profitable projects and helps monitor them.
Summarily, the importance/roles of financial intermediaries are taking deposits from savers and lending them money to borrowers; pooling the savings of many, and investing in a variety of stocks, bonds, and other financial assets; and making loans available to small businesses and consumers.
Benefits of Financial Intermediaries
The benefits you can get from FIs are:
#1 Access to a pool of funds
You know that the primary aid of Fis is to save funds, right? Following this benefit of financial intermediaries is one that allows savers access to a pool of funds that can enable them to make large investments. This also benefits the entity in which they are investing.
If you want to borrow $10,000, it would be difficult to find someone who wants to lend exactly $10,000. But, an FI will have this from a pool of users who deposit funds.
Therefore, the bank can lend you the aggregate deposits from the bank and save you from finding someone with the exact right sum.
#2 Cost Reduction
This is another crucial benefit-reducing cost. FIs have the economies of scale to evaluate the credit profile of potential borrowers and keep records and profiles cost-effectively. Again, they reduce the costs of the many financial transactions an individual investor would have made if the financial intermediary did not exist.
#3 Risk Hedging
The risk both the lender and borrower are willing to bear differ although they want maximum returns.
Therefore, financial intermediaries share this risk with them in return for profits. They do this by providing a medium for collateral which ensures the lender gets his full capital even if the borrower defaults in payments. That profit is what you call interest on loans.
Classification of Financial Intermediaries
There are different types of financial houses and they serve different purposes.
On a broad scale, they are classified as Mainstream financial intermediaries and Quasi Financial intermediaries.
#1. Mainstream Financial Intermediaries
Under this category, we have a deposit and non-deposit FIs.
Deposit financial intermediaries include Central banks and private banks. Non-deposits FIs are Long-term and short-term Insurers, Retirement/pension funds, Mutual funds, Exchange-traded funds, Hegde funds, etc.
#2. Quasi Financial Intermediaries
These include Development financial institutions, Special purpose vehicles, Investment trusts, Finance companies, Credit Unions/savings, and credit cooperatives, micro-lenders, etc.
Having explained these classifications of financial intermediaries, we will list some of the types of FIs.
Types of Financial Intermediaries
There are numerous types of FI that come as a result of the broader classification of Quasi and mainstream financial intermediaries. They are the following.
The central bank and commercial banks are the most popular FIs. They basically create a reliable and simple service for their customers.
The Central bank acts as a financial intermediary between the customer and the commercial bank. While the commercial bank between two customers in a financial transaction.
#2 Pension funds:
These are companies that provide plans for retirement income.
They generally provide risk control directly to households through retirement income. Also, they link pension funds to employers.
#3 Insurance Companies
This is a means of protection from financial loss. They hedge against loss.
The company that provides the insurance is the insurer or underwriter, while the individual who buys the insurance is the insured or policyholder.
Lastly, it is worthy of mention that the term of insurance can either be long-term or short-term.
#4 Credit Unions
They are cooperative financial units that encourage and grant lending and borrowing of funds amongst their members.
Advantages and Disadvantages of Financial Intermediaries
There are many advantages one can get from using the services of financial intermediaries.
Financial intermediaries hedge risks by spreading funds across a diverse range of investments and loans. Let us use the bank as an example. Lenders save their funds with the bank and borrowers come up to bid for the loans. Scrutinizing the business ideas and making a pick of the feasible projects that require a loan, the bank helps the lenders diversify investments on their money.
Basically, these loans benefit households, businesses, and countries by enabling them to spend more money than they have at the current time.
Additionally, FIs provide an avenue for small savers to pull their resources.
They get a safekeeping and accounting service as well as access to payment systems. Lastly, there is access to information on how the funds were deposited and withdrawn. Even information of borrowers and disbursed funds.
These are some of the advantages of financial intermediaries to the individuals and economy.
Disadvantages of Financial Intermediaries
It is a known fact that everything that has an advantage will have some disadvantages, including financial intermediaries.
Starting from the less obvious one, a drawback of FI is that they may impose fees or charge commissions for their services. For instance, a stock brokerage firm might charge you a flat $20 to place buy and sell orders for stocks. This will either reduce the amount of money you can actually invest.
Another drawback is that the services of FIs reduce your returns on investment ROI. Financial intermediaries are in business to make a profit, therefore, their services reduce the interest you would have emersed if the investment was done elsewhere.
Let me explain. When you save money at a bank, they pay interest on the money you save and then lend those funds to other consumers or companies at a higher interest rate to make a profit. If you lent to those companies directly, the ROI would be higher.
Lastly, FIs like stockbrokers and personal financial advisers might provide helpful advice about investments and savings opportunities, but their overall goals may be counter to the goals of their clients.
For instance, as an investor, your goal might be to make as much money as possible to grow your net worth, however, the stockbroker wants your investment in addition to a higher commission charge and this will reduce the returns. This difference in goal could potentially result in intermediaries giving sub-optimal advice and taking advantage of clients.
As a piece of advice, it is important to consider the cost of fees, commissions, interest rates, and potential alternatives before making any sort of financial transaction with any intermediary.
The services of financial intermediaries are one we cannot do without. You cannot outsmart the services of online or offline FIs.
Use this article as a beginner guide to understand the classification, importance, types, advantages and disadvantages types of financial intermediaries.
Financial Intermediaries FAQ’s
What are the three major groups of financial intermediaries?
These are commercial banks, savings and loan associations, mutual savings banks, and credit unions.
Why is a bank called a financial intermediary?
Banks serve as financial intermediaries by acting as a bridge between savers and borrowers. Savers make bank deposits, then receive interest payments and withdraw funds. Borrowers obtain bank loans and repay them with interest.
What is the difference between financial market and financial intermediary?
Financial markets, which usually have a physical location, are places where investors can purchase and sell assets such as stocks or bonds. Financial intermediaries, on the other hand, are institutions or individuals who bridge the gap between savers and spenders.