Functions of Financial Intermediaries

Functions of Financial Intermediaries

Funds are transferred from the saving units of the economy to the deficit units. Saving units in the economy lend the funds and deficit units borrow the funds. In other words, saving units sell the funds, and deficit units buy the funds. Buying and selling of funds in the financial markets take place directly and indirectly. Borrowers may borrow the funds directly from the lenders. Borrowing by deficit units directly from surplus units is known as direct finance. In direct finance, surplus units directly lend funds to deficit units. But lending and borrowing directly are not possible in all situations.

Funds from saving units are channeled to deficit units in different ways through different financial institutions in the financial system. Saving units lend the financial institutions by buying debt instruments from the financial markets and they deposit their saving in banks. Similarly, they may buy a life insurance policy from an insurance company and contribute to the pension funds. In the same manner, deficit units may borrow funds from banks, insurance companies, and other financial institutions. Thus, financial institutions borrow the funds from saving units and lend the funds to the deficit units in the economy. Here, financial institutions function as intermediaries for channeling the funds from surplus units to deficit units of the economy. Financial intermediaries are the financial institutions that channel the funds from surplus units to deficit units of the economy.

Financial intermediation is the process of channeling the funds from surplus units (lenders) to deficit units (borrowers) in the economy. In the presence of financial intermediaries, lenders lend the funds to the financial intermediaries and borrowers borrow from financial intermediaries. So, we call lending and borrowing through financial intermediaries – indirect finance. The financial intermediation is the primary route for moving funds from lenders to borrowers.

Financial intermediaries and indirect finance are so important because of their roles in transaction costs, risk sharing, and information costs in financial markets. We discuss these functions of financial intermediaries in the financial markets.

Reducing Transaction Costs

Investor needs the skill to evaluate an investment. It takes more time to develop the required skills. Developing the skill required for evaluation of an investment has high opportunity costs. After acquiring the skill for evaluation, investors have to apply to evaluate the specific financial assets that are candidates for purchase or subsequent sales. Investors who want to lend the money need to draw up the loan contract. They have to hire a lawyer to write the loan contract.

Investors need information about the issuers and investing their funds. Lenders need information about the borrowers. Obtaining financial assets before the information on issuers, financial assets, and borrowers takes time and costs

There is a high opportunity cost of time taken to obtain and process the required data for investment decisions for individual investors. We call all these information processing costs. We have to pay fees to lawyers for writing the loan agreement and making the contract with the borrowers in the case of a loan. In addition to the cost of a lawyer, investors have to incur the costs of enforcing the terms of the contract. All these costs are called contracting costs.

Financial intermediaries have professional staff to evaluate the target financial securities and evaluate the financial condition of borrowers. They have the professional staff to obtain and process the information on specific securities and loan applicants. They process information at a large scale and gain the benefits of economies of scale. In the case of loan agreements, financial intermediaries have their own legal department and set format for loan contracts. Investment professional staff monitor the terms of the loan agreement. So, they can gain the benefits of the economies of scale and professional staff and reduce the contracting costs. Thus, intermediaries have a key role in reducing information processing and contracting costs. A sum of information processing costs and contracting costs is the transaction costs of the funds. Thus, the function of the financial intermediaries is to reduce the transaction costs of funds.

Reducing Risk through Diversification

Diversification is a process of transforming more risky assets into less risky assets by investing in many more financial assets. Individual investors have a small amount of funds for investment. They cannot invest their funds in many securities and diversify the risk in investment. So, it is almost impossible for small investors to diversify and reduce the risk. But, for financial institutions, it is easy to reduce risk via diversification.

Take the example of investors who invest their money in the stock of investment companies. An investment company invests the funds received in the stock from a large number of individual investors in the securities of a large number of companies. Thus, they reduce the risk via diversification. Individual investors with small amounts of savings can achieve the same by investing in investment companies. So, this is the second basic function of intermediaries. For individual investors with substantial large amounts of funds for investment is possible to reduce the risk via diversification. However, this is not as cost-effective for individual investors as for financial institutions.

Transforming the Financial Assets

Financial institutions receive the funds from their customers and transform the funds into different assets. For example, depository institutions receive deposits from their customers and they transform deposits into different products and sell them in the markets. Non-depository institutions also receive funds from their customers and invest in different financial assets. For example, insurance companies collect the insurance premium from their policyholders and invest the money collected from their customers. Thus, financial institutions transform the financial assets from one form to another as per the needs of their markets. In transforming assets, individual savers and financial intermediaries
share the risk in the investment.

Alleviation of Adverse Selection and Moral Hazard

In financial markets, one party may have more information and another party may have less information about investment projects and about each other. For example, a borrower has more information about the investment project where the borrower is going to invest the borrowed funds but the lender does not have as much information about the investment project as the borrower does. We call this inequality in having the relevant information asymmetric information. Asymmetric information creates problems in the financial system before and after lending the funds.

The lender has less information about the borrower and investment where the borrower invests the borrowed funds but the borrower may have more information. There is a probability of lending money to the borrower who may produce an undesirable outcome. And lender may reject the lending to the borrower who may produce good results. We call such selection of borrower adverse selection. An adverse selection problem takes place before making the decision to lend. It results in the default in the payment of due interest and principal amount of the loan.

Moral hazard takes place after lending the money. Lenders may have less information about the borrower’s character and borrowers may misuse or invest the borrowed funds in highly risky investments. For example, borrowers may use a certain percentage of borrowed funds in bating. Similarly, s/he may invest in high-risk securities and may sustain a loss in her/his investment. In extreme cases, borrowers may not make repayment of loans even if they have the money. We call such types of tendency of borrower moral hazard.

Both moral hazard and adverse selection of borrowers increase the default risk and earning power of lenders. Borrowers can reduce the risk of adverse selection and moral hazard if they have more information about the borrowers. All these take place only because of asymmetric information about the borrowers and their investment projects and investment securities. Financial intermediaries have different mechanisms to get the correct information about the borrowers, relevant projects, and securities. They can alleviate the problem of adverse selection of borrowers and moral hazard.

Maturity Intermediation

The maturity period for the funds demanded by deficit units may not match the maturity period of funds supplied by surplus units. For example, a business firm needs Rs 3 million in loans for 3 years. In the absence of financial intermediaries, this firm has to seek investors who want to invest their money for three years. Investors may be interested in investing for less than 3 years or more than years. This firm may find it difficult to find out investors who want to invest their funds exactly for 3 years. But a commercial bank can solve the problem of this firm very easily by issuing claims against it and granting loans for the firm for 3 years. Banks may issue claims with different maturity periods. This type of role of financial intermediaries is known as maturity intermediation.

Maturity intermediation is the intermediation for matching the maturity period of financial assets and liabilities. Thus, financial intermediaries play roles in providing loans for a desired period of deficit units and investing the funds as per the desired investment horizon.

There are two implications of maturity intermediation for financial markets. First, maturity intermediation provides investors with more choices concerning their investments and borrowers have more choices for the maturity of their debt obligation. Second, investors want higher interest rates for longer-period investments than for short-term investments. This is because of the commitment of their funds for a longer period. However financial institutions can provide borrowers the longer-term loans at a lower cost than individual investors. Financial institutions can raise funds from successive deposits until the maturity of the long-term loan. So, the second implication of maturity intermediation is the likely reduction in the costs of longer-term borrowing.

Providing Payment Mechanism

The payment mechanism is the method of making payments. We always do not make payments in cash. In developed financial systems, payments in cash are not often made. We make payments using checks, credit cards, debit cards, and electronic transfers of funds. These methods of payment are cheap and safe. Financial intermediaries provide the mechanism for these methods of payment. In underdeveloped financial markets, modern methods of payment such as debit cards, credit cards, and electronic transfers are hardly used. Even checks are not easily accepted for payments in markets where payment mechanism is not well developed. We can take the example of our market. In most of the shops and shopping points, we cannot use credit cards, debit cards, and other electronic funds transfer methods. However financial intermediaries should have a key role in introducing the innovative mechanism of payment.

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