Financial Intermediaries

Do you have savings in the bank? Do you have a car loan? Is that at a different financial institution? And what about your car insurance? I bet that's at a different company yet. Perhaps you have relatives with retirement accounts, or your parents may have a life insurance policy to keep you safe in case anything happens to them. You and your family may be interacting with more financial intermediaries than they realize! So just what is a financial intermediary, which types exist, and what are its functions? Read on to find out!

Financial Intermediaries Definition

It is important for a country to have an efficient financial system that enables individuals to have a return on their investments while providing that investment money to companies that need to borrow money in order to grow. That's how the economy and household wealth both grow over time.

Imagine how would saving for retirement be if the financial sector was prone to extreme volatility, and you could wake up the next day finding out that all your money is lost! A very important part of any financial system is the financial intermediaries.

These intermediaries serve as middlemen for certain kinds of financial transactions. When two parties in a financial transaction engage in business, a financial intermediary may serve as a go-between for them, such as if two companies are merging. If a private company decides to go public and make an initial public offering of stock shares, an investment bank serves as the intermediary in that process.

Financial intermediaries facilitate money transfers from parties with surplus capital to parties in need of capital. They promote efficient marketplaces and liquidity while decreasing the cost of doing business for everyone involved.

Fig. 1 - Wall Street

Examples of financial intermediaries include:

• Commercial banks and investment banks
• Mutual funds and pension funds
• Insurance companies

Financial intermediaries provide a variety of advantages to individuals in an economy, such as safety, liquidity, and economies of scale, since they are able to aggregate financial assets from a lot of different contributors.

Some financial intermediaries take deposits from clients, such as banks, whereas others have a different business model. A financial intermediary that is not a bank does not take deposits from the general public but may instead provide financial services such as leasing, insurance, and other types of financing and asset management.

Other services by financial intermediaries that are non-bank related include participation in the stock exchanges and the use of investment strategies to manage and develop clients' money to maximize their returns.

Types of Financial Intermediaries

There are many types of financial intermediaries. The most important types of financial intermediaries include: mutual funds, pension funds, life insurance companies and banks. Each type is described here.

Mutual Funds

Owning some stocks in a company comes with some risk associated as the return on your stocks is conditional on the company's performance. Investors can lower their risk by investing in a diverse portfolio of stocks--a collection of stocks whose risks are uncorrelated with each other), rather than focusing their investment on the shares of a single firm or a group of related companies.

Financial advisors encourage their clients to diversify their stock portfolios by purchasing mutual funds. The same goes for overall wealth by owning other assets in addition to stocks, such as bonds, real estate, and cash. Diversification helps minimize risk and hedge against losses.

Individuals who do not have a large sum of money to invest may find that building a diversified stock portfolio incurs high transaction costs (particularly brokerage fees) because they are purchasing a small number of shares in many companies, resulting in increased transaction costs. That's when mutual funds come in. Mutual funds, or open-end funds, allow investors to have diversified portfolios without incurring high transaction costs.

Any individual, regardless of whether they are rich or not, can indirectly hold shares of stock in a large number of companies--a diversified portfolio--by owning some shares in a mutual fund that owns the diversified portfolio of company stock. As intermediaries, mutual funds make the purchase of financial assets more efficient in terms of transaction costs.

Pension funds

Pension funds are another type of financial intermediary that are very similar to mutual funds.

Pension funds are not as common as they once were in the U.S. Today, most employees in the U.S. must save for their own retirement, although many employers hire a financial intermediary to provide this service to the employees. The employees make contributions as they choose, they direct the investments, and they choose when and how their money is returned to them as income in retirement.

These types of financial intermediaries are one of the most important as they directly impact an individual's retirement account, which funds them after they retire. The function of pension funds is similar to that of mutual funds; however, one difference between them is that they have different rules and regulations from mutual funds in the U.S., particularly regarding favorable tax status for qualified retirement accounts like pensions.

Life Insurances

Life insurance companies are another type of financial intermediary. The primary purpose of life insurance is to guarantee the delivery of funds to the beneficiaries in the unlikely event of the untimely death of the insurance policy holder. This can be beneficial for parents whose children depend on the parents' income, although any beneficiary can be chosen by the life insurance policy holder.

Banks

Banks are types of financial intermediaries that facilitate the transaction between lenders who want to save and borrowers who need financing for their projects. Banks are a very commonly used type of financial intermediary.

Banks work by accepting checking or savings deposits from clients, which is money individuals are looking forward to saving and having for future consumption. The bank pays a certain amount of interest on savings deposits to these individuals. That interest can be considered their modest investment return for the use of these funds--typically just for overnight transactions.

The bank then uses these funds to offer loans for borrowers. The bank charges higher interest than what it gives on a savings account, and this is how the bank profits.

Functions of Financial Intermediaries

There are many functions (roles of financial intermediaries. The three main functions of financial intermediaries include asset storage, loans, and investments.

Asset Storage

Asset storage is perhaps one of the most critical functions of financial intermediaries. Commercial banks provide safety and security by ensuring storage of cash--either in the form of paper money or coins--and other precious materials such as gold or silver.

Individuals who make deposits are offered a variety of tools to help them secure their cash and also to help them access it at any time. These include ATM cards, debit cards, checks, and credit cards. Depositors may also see records of withdrawals, deposits, and direct payments that they have approved via the bank.

Loans

Another important function of financial intermediaries is loans. Financial intermediaries are primarily engaged in advancing short- and long-term loan transactions. They act as a middleman between depositors who have excess cash and those looking to borrow money from them. Borrowers generally take out loans to acquire capital-intensive assets such as commercial real estate, vehicles, and manufacturing equipment.

Intermediaries advance the loans at interest, with a portion of the money going to the depositors whose funds have been utilized to make the loans. Interest on the remaining amount of principal is kept as a profit. Borrowers are subjected to a credit check to establish their creditworthiness and capacity to repay the loan.

Investments

Investment is another important function of financial intermediaries. Clients of financial intermediaries such as mutual funds and investment banks may benefit from the expertise of in-house investment professionals who assist them in growing their investments. The businesses use their extensive industry knowledge and hundreds of investment portfolios to identify the most appropriate assets that optimize profits while minimizing risk.

Stocks, real estate, treasury notes, and financial derivatives are among several forms of assets available to you as an individual investor. In some instances, like certificates of deposit, intermediaries invest their customers' cash and pay them an annual interest rate for a length of time that has been previously agreed upon. In addition to managing client assets, some intermediaries may also give investment and financial advice to assist clients in making the best investment decisions.

Disadvantages of Financial Intermediaries

While there are benefits of financial intermediaries, there are also some disadvantages to these institutions. The main disadvantages of financial intermediaries can include the possibility of lower investment returns, mismatched goals, credit risk, and market risk. For all of these reasons, individual investors should always be cautious and understand all of their alternatives before investing their money, with or without an intermediary.

Lower Investment Returns

Keep in mind that financial intermediaries also want to make a profit. In the process of facilitating these investments, the institutions will require some kind of compensation for their service, which could mean that in investment returns are lower than if the investor had gone directly to the source instead of through the intermediary. However, in some cases, the investment opportunity is not possible without the presence of the intermediary.

Mismatched Goals

It is possible that a financial intermediary is not acting as an unbiased third party. The institution's profit-maximizing incentive could directly conflict with certain choices that would otherwise increase the investor's return. They may promote investment possibilities fraught with hidden dangers or that may not serve the investor's best interests.

Furthermore, there is also some indirect conflict of interest where financial intermediaries have different clients who manage their money and invest in them. They could have an incentive to invest in companies that benefit them rather than their investors.

Credit Risk

Credit risk is also another disadvantage of financial intermediaries. This involves the risk of clients defaulting on their loans. This is dangerous as the intermediary uses these funds to pay back the investors, or bank depositers, so it has to raise fees to compensate for the possibility of some default. Thus, defaults negatively impact both parties. If many loans were to default at once, it could trigger a financial crisis.

Market Risk

The performance of financial intermediaries is significantly correlated with the performance of the overall market. If external shocks negatively impact the performance of the market, it will also cause trouble for financial intermediaries. This is the risk that is inherent in investing.

Examples of Financial Intermediaries

If you have savings in an account at your local bank or credit union, or an online institution, that is a financial intermediary. Some of the largest institutions that help make investing accessible to individuals are household names in the U.S. like Fidelity, Vanguard, State Farm, and E-Trade. Fidelity and Vanguard provide low-cost mutual funds and bond funds, where many people keep their retirement savings. State Farm sells life insurance and term life insurance, for people who have dependents relying on their income. E-trade provides access to individuals wanting to purchase individual stocks, rather than diversified mutual funds.