Financial Intermediary

An institution that acts as a middleman between two parties to facilitate a financial

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What is a Financial Intermediary?

A financial intermediary refers to an institution that acts as a middleman between two parties in
order to facilitate a financial transaction. The institutions that are commonly referred to as
financial intermediaries include commercial banks, investment banks, mutual funds, and pension
funds. They reallocate uninvested capital to productive sectors of the economy through debts
and equity.

In simple terms, financial intermediaries channel funds from individuals or corporations with
surplus capital to other individuals or corporations that require cash to carry out certain
economic activities.

Functions of Financial Intermediaries

A financial intermediary performs the following functions:

Asset storage

Commercial banks provide safe storage for both cash (notes and coins), as well as precious
metals such as gold and silver. Depositors are issued deposit cards, deposit slips, checks, and
credit cards that they can use to access their funds. The bank also provides depositors with
records of withdrawals, deposits, and direct payments they have authorized. To ensure the
depositors’ funds are safe, the Federal Deposit Insurance Corporation (FDIC) requires deposit-
taking financial intermediaries to insure the funds deposited with them.

Providing loans
Advancing short-term and long-term loans is the core business of financial intermediaries. They
channel funds from depositors with surplus cash to individuals who are looking to borrow
money. Borrowers typically take out loans to purchase capital-intensive assets such as business
premises, automobiles, and factory equipment.

Intermediaries advance the loans at interest, some of which they pay the depositors whose
funds have been used. The remaining amount of interest is retained as profits. Borrowers
undergo screening to determine their creditworthiness and their ability to repay the loan.

Investments

Some financial intermediaries, such as mutual funds and investment banks, employ in-house
investment specialists who help clients grow their investments. The firms leverage their industry
experience and dozens of investment portfolios to find the right investments that maximize
returns and reduce risk.

The types of investments range from stocks to real estate, Treasury bills, and financial
derivatives. Sometimes, intermediaries invest their clients’ funds and pay them an annual interest
for a pre-agreed period of time. Apart from managing client funds, they also provide investment
and financial advice to help them choose ideal investments.

Benefits of Financial Intermediaries

Financial intermediaries offer the following advantages:

Spreading risk

Financial intermediaries provide a platform where individuals with surplus cash can spread their
risk by lending to several people rather than to only one individual. Lending to just one person
comes with a higher level of risk. Depositing surplus funds with a financial intermediary allows
institutions to lend to various screened borrowers. This reduces the risk of loss through default.
The same risk reduction model applies to insurance companies. They collect premiums from
clients and provide policy benefits if clients are affected by unforeseeable events like accidents,
death, and disease.

Economies of scale

Financial intermediaries enjoy economies of scale since they can take deposits from a large
number of customers and lend money to multiple borrowers. The practice helps to reduce the
overall operating costs that they incur in their normal business routines. Unlike borrowing from
individuals with inadequate funds to loan the requested amount, financial institutions can often
access large amounts of liquid cash that they can loan to individuals with a strong credit rating.
Economies of scope

Intermediaries often offer a range of specialized services to clients. This enables them to
enhance their products to cater to the requirements of different types of clients. For example,
when commercial banks are lending out money, they can customize the loan packages to suit
small and large borrowers. Small and medium enterprises often make up the bulk of borrowers.
Preparing packages that suit their needs can help banks grow their customer base.

Similarly, insurance companies enjoy economies of scope in offering insurance packages. It

Examples of Financial Intermediaries

Bank

A bank is a financial intermediary that is licensed to accept deposits from the public and create
credit products for borrowers. Banks are highly regulated by governments, due to the role they
play in economic stability. They are also subject to minimum capital requirements based on a set
of international standards known as the Basel Accords.

Credit union

A credit union is a type of bank that is member-owned. It operates on the principle of helping
members access credit at competitive rates. Unlike banks, credit unions are established to serve
their members and not necessarily for profit purposes. Credit unions claim to provide a wide
variety of loan and saving products at a relatively lower price than other financial institutions
offer. They are governed by a board of directors, who are elected by the members.

Mutual funds

Mutual funds pool savings from individual investors. They are managed by fund managers who
identify investments with the potential of earning a high rate of return and who allocate the
shareholders’ funds to the various investments. This enables individual investors to benefit from
returns that they would not have earned had they invested independently.

Mutual funds let you pool your money with other investors to "mutually" buy stocks, bonds, and
other investments. They're run by professional money managers who decide which securities to
buy (stocks, bonds, etc.) and when to sell them. You get exposure to all the investments in the
fund and any income they generate.

Financial advisors
A financial advisor is an intermediary who provides financial services to clients. In most
countries, financial advisors must undergo special training and obtain licenses before they can
offer consultancy services. In the U.S., the Financial Industry Regulatory Authority provides the
series 65 or 66 licenses for investment professionals, including financial advisors.