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Financial Intermediaries
Financial intermediation consists of channeling funds between surplus and deficit agents. A financial
intermediary is a financial institution 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
Financial intermediaries provide 3 major functions:
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 risk-free 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
There are 2 essential advantages from using 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
The cost advantages of using financial intermediaries include:
1. Reconciling conflicting preferences of lenders and borrowers
2. Risk aversion intermediaries help spread out and decrease the risks
3. Economies of scale using financial intermediaries reduces the costs of lending and borrowing
4. Economies of scope intermediaries concentrate on the demands of the lenders and borrowers
and are able to enhance their products and services (use same inputs to produce different
outputs)




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Types of financial intermediaries
Financial intermediaries include:
Banks
Building societies
Credit unions
Financial advisers or brokers
Insurance companies
Collective investment schemes
Pension funds
1) A bank is a financial institution and a financial intermediary that accepts deposits and channels
those deposits into lending activities, either directly or through capital markets. A bank connects
customers that have capital deficits to customers with capital surpluses.
Due to their critical status within the financial system and the economy

generally, banks are highly
regulated in most countries. Most banks operate under a system known asfractional reserve
banking where they hold only a small reserve of the funds deposited and lend out the rest for
profit. They are generally subject to minimum capital requirements which are based on an
international set of capital standards, known as the Basel Accords.
2) A building society is a financial institution owned by its members as a mutual organization.
Building societies offer banking and related financial services, especially mortgage lending.
These institutions are found in the United Kingdom (UK) and several other countries.
The term "building society" first arose in the 18th century in Great Britain from cooperative
savings groups. In the UK today, building societies actively compete with banks for most
consumer banking services, especially mortgage lending and deposits.
3) A credit union is a member-owned financial cooperative, democratically controlled by its
members, and operated for the purpose of promoting thrift, providing credit at competitive rates,
and providing other financial services to its members.
Many credit unions also provide services intended to support community development

or
sustainable international development on a local level, and could be consideredcommunity
development financial institutions.
Worldwide, credit union systems vary significantly in terms of total system assets and average
institution asset size,ranging from volunteer operations with a handful of members to institutions
with several billion dollars in assets and hundreds of thousands of members.




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4) A financial adviser is a professional who helps clients to maintain the desired balance of investment
income, capital gains, and acceptable level of risk by using proper asset allocation. Financial advisers
use stock, bonds, mutual funds, real estate investment trusts (REITs), options, futures, notes,
andinsurance products to meet the needs of their clients. Many financial advisers receive
a commissionpayment for the various financial products that they broker, although "fee-based" planning is
becoming increasingly popular in the financial services industry.
A further distinction should be made between "fee-based" and "fee-only" advisers. Fee-based advisers
often charge asset based fees but may also collect commissions. Fee-only advisers do not collect
commissions or referral fees paid by other product or service providers.
Some investment advisers only charge a fee based on the assets managed for the client. Typically they
charge about 1.0 to 1.5% per year to make the investment decisions for the client. They do not collect
commissions.
5) A broker is an individual or party (brokerage firm) that arranges transactions between a buyer and
a seller, and gets a commissionwhen the deal is executed. A broker who also acts as a seller or as a
buyer becomes a principal party to the deal. Distinguish agent: one who acts on behalf of a principal.
In general a broker is an independent agent used extensively in some industries. The prime responsibility
of a broker is to bring sellers and buyers together. Therefore, a broker is the third -person facilitator
between a buyer and a seller. An example would be a real estate broker who facilitates the sale of a
property.
6) Insurance is a form of risk management primarily used to hedge against the risk of a
contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one
entity to another, in exchange for payment. An insurer is a company selling the insurance; the insured, or
policyholder, is the person or entity buying the insurance policy. The amount to be charged for a certain
amount of insurance coverage is called the premium. Risk management, the practice of appraising and
controlling risk, has evolved as a discrete field of study and practice.
The transaction involves the insured assuming a guaranteed and known relatively small loss in the form
of payment to the insurer in exchange for the insurer's promise to compensate (indemnify) the insured in
the case of a financial (personal) loss. The insured receives a contract, called the insurance policy, which
details the conditions and circumstances under which the insured will be financially compensated.
7) A pension fund is any plan, fund, or scheme which provides retirement income.
Pension funds are important shareholders of listed and private companies. They are especially important
to the stock market where large institutional investors dominate. The largest 300 pension funds
collectively hold about $6 trillion in assets. In January 2008, The Economist reported that Morgan
Stanley estimates that pension funds worldwide hold over US$20 trillion in assets, the largest for any
category of investor ahead of mutual funds,insurance companies, currency reserves, sovereign wealth
funds, hedge funds, or private equity. Although the (Japan) Government Pension Investment Fund (GPIF)
lost 0.25 percent, in the year ended March 31, 2011 GPIF was still the world's largest public pension fund
which oversees 114 trillion Yen ($1.5 trillion).