Financial intermediation consists of channeling funds between surplus and deficit agents A financial intermediary is an entity that connects

surplus and deficit agents. The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money (savers) to those who do not have enough money to carry out a desired activity (borrowers). Functions performed by financial intermediaries 1. Maturity transformation Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs) 2. Risk transformation Converting risky investments into relatively riskfree ones. (lending to multiple borrowers to spread the risk) 3. Convenience denomination Matching small deposits with large loans and large deposits with small loans Advantages of financial intermediaries 1. Cost advantage over direct lending/borrowing 2. Market failure protection the conflicting needs of lenders and borrowers are reconciled, preventing market failure Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. The financial system is complex in structure and function. A healthy economy requires a financial system that moves funds from people who save to people who have productive investment opportunities. A financial intermediary provides the essential link between depositors and investors in financial markets. Funds move from lenders to borrowers by a second route, called indirect finance. This involves a financial intermediary that stands between the lender (saver) and the borrower (spender) and helps in the transfer of funds from one to another. A financial intermediary does this by borrowing funds from the saver and uses the same to give out as loans to the spender. This process of indirect finance is called financial Intermediation. The existence of financial intermediation is proven to be beneficial for both depositors and investors in the following ways: Expertise - Financial intermediaries are also beneficial as they are able to provide essential information about reduction in costs and other queries to individuals. Their understanding and experience in computer technology help in the provision of essential services to individuals by means of toll free numbers that allows one to check on investment progress and the ability to write cheques etc.

Reduction in transaction costs Transaction costs is a major problem in financial markets. High transaction costs often curb investments, if one has a small sum of money which one wants to invest in the stock market the brokerage costs involved are so high that they cut into the investment and one is left with almost nothing. This problem has been reduced to a great extent due to the existence of financial intermediaries. These intermediaries facilitate transactions of all amounts small and big at a low transaction cost, thereby allowing small savers and borrowers to benefit from the existence of financial markets. Liquidity services- Financial intermediaries also offer their customers with liquidity services. These services are another outcome of the low transaction costs to intermediaries. These liquidity services enable its customers to conduct transactions in an easier manner. Money market mutual funds for example, allow shareholders to write cheques that allow facilitate their payment of bills while at the same time paying them high interests. Adverse selection and asymmetric information- An intermediary like a bank can produce information about firms so as to sort the good credit ones from the bad. It can then acquire funds from the savers or depositors and lend them to good firms. The money earned allows it to engage in information acquiring activities. The information acquiring activity also helps eradicate the free rider problem by making private loans over trading/purchasing securities in the open market. Principle-agent problem- Equity contracts are subject to a particular type of moral hazard called the Principle-agent problem. The separation of ownership and control i.e. the managers in control (agents) may own only a fraction of the firm they work for , as a result they may act in their own interest rather than that of the stockholder owners (the principles). This is mainly because they lack incentive to maximize profits. This problem is addressed by the venture capital firm. Moral hazard in the debt contracts- As seen before , financial intermediaries like banks have the capability of avoiding the free rider problem by making private loans. The intermediary thus gets the advantage of monitoring and enforcing restrictive covenants, thereby shrinking the moral hazard problem in debt contracts. Financial institutions (intermediaries) therefore perform the vital role of bringing together those economic agents with surplus funds who want to lend, with those with a shortage of funds who want to borrow. In doing this they offer the major benefits of maturity and risk transformation. It is possible for this to be done by direct contact between the ultimate borrowers, but there are major cost disadvantages of direct finance. Indeed, one explanation of the existence of specialist financial intermediaries is that they have a related (cost) advantage in offering financial services,

which not only enables them to make profit, but also raises the overall efficiency of the economy. Financial intermediaries perform the vital role of bringing together those economic agents with surplus funds who want to lend, with those with a shortage of funds who want to borrow. In doing this they offer the major benefits of maturity and risk transformation. It is possible for this to be done by direct contact between the ultimate borrowers, but there are major cost disadvantages of direct finance. Indeed, one explanation of the existence of specialist financial intermediaries is that they have a related (cost) advantage in offering financial services, which not only enables them to make profit, but also raises the overall efficiency of the economy. The other main explanation draws on the analysis of information problems associated with financial markets.