Financial intermediaries

Learning objectives

After studying this text the learner should / should be able to:

1. Explain the concepts of direct and indirect financing.

2. Distinguish between primary and indirect securities.

3. Examine the concept of financial intermediation.

4. Offer an opinion on why financial intermediaries exist.

5. Elucidate the economic functions of financial intermediaries.

6. Examine the logical categorization of financial intermediaries.

7. Describe the relationship of financial intermediaries to one another.

8. List the financial intermediaries that populate most countries.

Introduction

Financial intermediaries evolved over many years to perform the financial-related functions desired by the four sectors of the economy: household, corporate, government and foreign sectors. However, some of them have been legislated into being, such as the central bank. We cover the various aspects of financial intermediaries in the following sections:

• Financial intermediation.

• Economic functions of financial intermediaries.

• Financial intermediaries.

• Intermediation functions.

Financial intermediation

Income does not usually match expenditure; therefore surplus and deficit economic (budget) units exist. Given their existence, which amounts to a supply of and a demand for loanable funds, some financial conduit is necessary if the excess funds of surplus units are to be transferred to deficit units. The needs of these units may be reconciled either through direct financing or indirect financing, i.e. through the interposition of financial intermediaries.

Direct financing involves the bringing together of lenders and borrowers (and often entails the interposition of a broker who would act as a go-between in return for a commission, i.e. s/he distributes the claims on borrowers - debt and equity - among the lenders). However, a clash of interests exists between borrowers and lenders, and it is therefore rare that the ultimate lenders and borrowers are able to meet in order consummate a deal.

This is so because lenders tend to require investments (buy financial instruments / securities) that differ from those that borrowers prefer to issue, and the differences involve characteristics such as size, term to maturity, quality, liquidity, etc. Put another way, borrowers generally require accommodation (i.e. issue financial instruments / securities) on terms differing from those which lenders are willing or able to grant (i.e. buy financial instruments / securities).

Figure 1: direct & indirect financing

Financial intermediaries, performing so-called indirect financing, assist in resolving this conflict between lenders and borrowers by creating markets in two types of financial instruments, i.e. one type for borrowers and another for lenders. They offer claims against themselves, customized to satisfy the needs (in terms of the characteristics of instruments mentioned above) of the lenders, in turn acquiring claims on the borrowers. The former claims are usually referred to as indirect securities and the latter as primary securities. This is depicted in Figure 1.

The financial intermediaries, of course, receive a fee, represented by the difference between the cost of the indirect securities they issue (interest, dividends, capital gains paid) and the revenue (interest, dividends, capital gains) earned from the primary securities they purchase. In the case of banks this is called the margin. They of course also levy other fees as well.

Another way of seeing financial intermediaries is that they are financial instrument / security transformers. They transform various primary securities with particular features into others with different features, much like a securitization vehicle. In the process financial intermediaries bring about a number of economic benefits. These are covered next.