Financial Intermediaries: Linking Savers And Investors

Financial intermediaries are institutions or individuals that act as middlemen between two parties in a financial transaction, such as banks, investment banks, mutual funds, and pension funds. They facilitate the flow of funds from those with surplus capital (savers) to those who need liquid funds for investments or other economic activities (borrowers). By doing so, financial intermediaries create efficient markets and reduce the cost of doing business. They also provide benefits such as safety, liquidity, and economies of scale. In addition, financial intermediaries help spread and reduce risk by pooling funds from multiple sources and investing them in a diverse range of assets. This allows individuals with surplus cash to lend to multiple borrowers, reducing the risk of loss through default.

Banks as financial intermediaries

Banks are financial intermediaries that act as middlemen between savers and borrowers. They facilitate the flow of funds from those with surplus capital (savers) to those who need liquid funds to carry out a desired activity (borrowers/investors). Banks, therefore, play a critical role in linking saving and investment.

Banks make it easier for individuals and businesses to store their money in accounts, such as checking or savings accounts, and then withdraw it as needed. This is far more convenient than having to rely on cash for transactions, which would require carrying large sums of money for purchases or payments. Banks also provide a safe place to store money, rather than keeping it at home, where it is more vulnerable to theft or loss.

As financial intermediaries, banks bring savers and borrowers together. They accept deposits from savers and then lend this money out to borrowers. All the deposited funds are mingled into one large pool, which is then loaned out. Banks provide capital to borrowers from other financial institutions and the Federal Reserve. This capital enables borrowers to make purchases that require significant funds, such as business premises, automobiles, or factory equipment.

Banks also play a crucial role in the payment system, helping an economy exchange goods and services for money or other financial assets. They facilitate the numerous transactions that occur in goods, labour, and financial capital markets, making the economy more efficient.

Additionally, banks offer various benefits to their customers. They provide safety for deposited funds, liquidity, and economies of scale. Banks also help evaluate the creditworthiness of borrowers, reducing the risk of default for lenders. They also offer specialized services, such as customized loan packages, to cater to the diverse needs of their customers.

Non-banking financial intermediaries

Non-Bank Financial Intermediaries (NBFI) are financial institutions that do not have a full banking license and are not supervised by national or international banking regulatory agencies. They are not allowed to take traditional demand deposits from the public and are outside the scope of conventional oversight from federal and state financial regulators. However, they provide bank-related financial services such as investment, risk pooling, contractual savings, and market brokering.

The non-bank financial intermediation ecosystem comprises a diverse set of financial activities, entities, and infrastructures. Non-bank financial institutions include investment funds, insurance companies, pension funds, and other financial intermediaries. They have different business models, balance sheets, and governance structures and are subject to distinct regulatory frameworks within and across jurisdictions. These institutions play an important role in financing the real economy and managing the savings of households and corporates. They are a valuable alternative to bank financing and help support real economic activity.

The financial assets of the NBFI sector accounted for 47.2% of the global financial system in 2022, compared to 42% in 2008. Examples of NBFI include insurance firms, venture capitalists, currency exchanges, microloan organizations, and pawn shops. These non-bank financial institutions provide services that are not typically offered by banks, serve as competition to banks, and specialize in specific sectors or groups.

One of the key benefits of non-banking financial intermediaries is their ability to provide alternative sources of funding and credit. They offer services such as loans, credit facilities, currency exchange, retirement planning, money markets, underwriting, and merger activities. By cutting out the intermediary role that banks often play, non-banking financial intermediaries allow clients to deal with them directly, resulting in lower costs, fees, and rates. This process, known as disintermediation, is important for maintaining a liquid money supply and a well-functioning economy.

However, critics argue that the lack of accountability to regulators and their ability to operate outside customary banking rules and regulations can pose a systemic risk to the financial system and the economy. While some non-banking financial intermediaries may be subject to oversight by authorities such as the Federal Trade Commission (FTC) or the Securities and Exchange Commission (SEC), there are concerns about their lack of transparency and potential impact on the financial system.

Investment funds

How Investment Funds Work

Benefits of Investment Funds

• Diversification and Risk Reduction: Investment funds allow individuals to diversify their investments across a wide range of assets and sectors, reducing the risk associated with investing in a single asset or industry.
• Access to Expertise: Fund managers are experts in the field of investing. They have access to industry knowledge, research, and tools that individual investors may not have. This expertise helps them make more informed investment decisions and maximise returns.
• Economies of Scale: By pooling funds from many investors, investment funds can invest in larger assets and take advantage of economies of scale. This allows individual investors to access investment opportunities that may not have been available to them if they were investing alone.
• Convenience and Time Savings: Investing through investment funds saves individuals time and effort in researching and managing their own investments. Fund managers handle the day-to-day investment decisions and portfolio management, providing convenience to investors.
• Better Negotiating Power: Investment funds, due to their large asset size, often have better negotiating power when it comes to fees and transaction costs. This can result in lower overall costs for investors.

Types of Investment Funds

There are various types of investment funds, including:

• Mutual Funds: These funds pool money from multiple investors and invest in a diversified portfolio of assets, such as stocks, bonds, and other securities. Mutual funds are managed by professional fund managers who allocate the pooled funds to various investments.
• Hedge Funds: Hedge funds are similar to mutual funds but often employ more complex investment strategies, including leveraging and derivative investments. They typically require a higher minimum investment and are less regulated than mutual funds.
• Index Funds: These funds aim to replicate the performance of a specific stock market index, such as the S&P 500. Index funds are passively managed, meaning they aim to mirror the index rather than outperform it.
• Private Equity Funds: Private equity funds invest in private companies, often with a focus on improving and growing the value of these companies before selling them for a profit.

Risk protection

Financial intermediaries, such as banks, investment banks, stockbrokers, insurance companies, and pension funds, play a crucial role in risk protection for both individuals and businesses. They achieve this through various mechanisms, including risk pooling, risk transformation, and risk reduction.

Risk pooling is a key advantage offered by financial intermediaries. By collecting funds from numerous savers and lenders, they can diversify risk across a wide range of investments and loans. This diversification ensures that the risk is spread out, reducing the potential for significant losses. For example, an individual lending their surplus funds to a financial intermediary benefits from the institution's ability to lend to multiple screened borrowers, lowering the risk of default. Similarly, insurance companies, as financial intermediaries, collect premiums from a large number of clients and can then provide policy benefits to those affected by unforeseen events.

Financial intermediaries also facilitate risk transformation. Through financial intermediation, assets and liabilities undergo a change in their risk profiles. This means that the original savers and lenders are no longer directly exposed to the risks associated with the investments or loans their funds are channelled into. Instead, the financial intermediary assumes this risk, transforming it into different risk and payment structures.

Additionally, financial intermediaries contribute to risk reduction by providing safety and security to their clients. They achieve this through various means, including insurance plans, credit risk evaluation, and record-keeping. For instance, commercial banks, as intermediaries, offer safe storage for cash and precious metals, while also insuring deposits to safeguard their clients' funds. Furthermore, financial intermediaries often have the expertise to evaluate the creditworthiness of borrowers, reducing the risk of default for lenders.

The services provided by financial intermediaries also enable individuals and businesses to protect themselves from financial risks. For example, individuals can purchase insurance to safeguard against specific risks, such as accidents, death, or illness. Similarly, businesses can utilise financial intermediaries to access specialised services, such as customised loan packages, that help mitigate financial risks associated with their operations.

In summary, financial intermediaries are vital for risk protection as they pool risk across diverse investments, transform risk profiles, and provide safety measures that reduce potential financial losses for individuals and institutions alike.

Investing and saving

Financial intermediaries are institutions or individuals that act as middlemen between two parties in a financial transaction. They facilitate the flow of funds from those with surplus capital (savers) to those who need liquid funds to carry out a desired activity (investors). By doing so, they create efficient markets and lower the cost of doing business.

Types of Financial Intermediaries

There are several types of financial intermediaries, including:

• Commercial banks
• Investment banks
• Mutual funds
• Pension funds
• Stock exchanges
• Insurance companies
• Credit unions
• Financial advisors

Functions of Financial Intermediaries

Financial intermediaries perform various functions, including:

• Advancing short-term and long-term loans: They channel funds from depositors with surplus cash to individuals or businesses looking to borrow money.
• Providing safe storage: Commercial banks provide safe storage for cash, precious metals, and other valuable assets.
• Investment advice: Some intermediaries, such as mutual funds and investment banks, employ investment specialists who help clients grow their investments and provide financial advice.
• Risk management: Financial intermediaries distribute risk across various investments by pooling them, reducing the risk of loss through default.
• Payment simplification: They simplify the payment process, making transactions faster and smoother.

Benefits of Financial Intermediaries

Financial intermediaries offer several advantages, such as:

• Reduced costs: They lower the cost of financial transactions by creating economies of scale.
• Reduced risk: By pooling funds from multiple investors, financial intermediaries enable individuals to spread their risk across a diverse range of investments.
• Liquidity: Financial intermediaries provide liquidity to the market, making it easier for borrowers to access funds.
• Convenience: They provide a platform that connects savers and investors, saving time and effort for both parties.

Drawbacks of Financial Intermediaries

While financial intermediaries offer numerous benefits, there are also some potential drawbacks, including:

• Lower investment returns: Intermediaries may charge fees or expenses, resulting in lower returns for investors.
• Mismatched goals: There may be a conflict of interest between the intermediary's profit-maximizing goals and the investor's best interests.
• Credit risk: The risk of clients defaulting on their loans, which can impact both the intermediary and the investor.

Frequently asked questions