Role of Financial Intermediaries in a Developed Economy
Financial intermediaries, also known as financial institutions, are organizations that issue financial claims against themselves and use the proceeds from the issuance to purchase primarily the financial assets issued by individuals, corporations, government entities as well as other financial intermediaries. Financial claims against themselves means that the financial institutions sell financial assets representing claims, or dues, from themselves, in exchange for cash. What differentiates a financial intermediary from other institutions is what lies in the left-hand side of the balance sheet; the asset side.
Most corporations issue financial claims against themselves in form of debt and equity. When it comes to assets, however, financial intermediaries such as a commercial bank will invest in financial assets such as loans to individuals, corporations and government securities while other firms will have most of their investments in real assets such as land, buildings, equipment and inventory. Other examples of financial intermediaries include mutual funds, pension funds, investment dealers and life insurance companies (Shim and Siegel 2008).
Financial intermediaries provide an indirect method through which borrowers in an economy can access funds from lenders. Corporations can acquire funds directly from the general public by the use of the primary market, or alternatively, can source these funds from the financial institutions. Through the direct method, corporations issues securities to the general public in form of equity or long term debt instruments such as bonds and debentures in exchange for funds. In the indirect method, financial intermediaries offer accounts to the general public in exchange for funds, and offer these funds to investors in exchange for securities.
Financial intermediaries have several roles in a developed economy. The most noticeable role of financial institutions is the linkage of borrowers and lenders. Financial institutions accept cash from economic units that have a surplus in form of checking and savings accounts, and transfer such funds to economic units that are in need of money. In so doing, financial intermediaries transfer money into the formal system. Currently, financial intermediaries operate beyond borders, whereby they can access funds from one location and loan such funds to a corporation in another geographically located region. Therefore, financial institutions help the economy in generation of income as surplus money is allocated efficiently to areas where it can be more productive.
Without financial intermediaries, lenders and borrowers of funds would encounter problems in trying to locate each other, which would ultimately result into higher transaction costs. Financial intermediaries pool together funds from numerous investors and provide these resources to borrowers in form of loans. By linking borrowers and lenders, financial institutions are able to lower transaction costs by taking advantage of economies of scale. The financial institutions will therefore be in a better position to offer a more favorable transaction that will benefit all parties, as opposed to costs that would have been experienced had lenders and borrowers decided to transact directly.
Financial intermediaries assist in maturity intermediation (Brigham E.F. and Ehrhardt 2010). Most small scale investors operate checking accounts that bear short term interest rates. Corporate borrowers in turn prefer long term debts. Financial institutions help in providing liquidity for individuals and corporations by giving them the chance to withdraw their money whenever they want, and on the other hand ensuring that investors get access to long term basis with minimal interruptions.
Maturity intermediation can be described as the process of converting short term deposits into long term loans. In a direct system, lenders would have to convince borrowers to refund their money prematurely when they are in need of liquidity, which can prove to be difficult. Alternatively, lenders may decide to sell of those loans to another party, and may experience a loss in the process. Financial intermediaries solve this problem by converting short term source of financing into long term loans that benefit borrowers (Brigham and Houston 2007), whereby lenders are can still continue operating demand accounts. This is possible if a certain level of depositors withdraw their money at the same time. A bank run happens when too many depositors withdraw their money at the same time, whereby the bank may be forced to freeze the accounts.
A major advantage of financial intermediaries is risk transformation. The major difficulties that investors face include moral hazard and adverse selection. Moral hazard is a problem that arises where the likelihood of a borrower engaging in risky activities that promise higher returns increases once debt has been acquired. Such borrowers would want to profit from the use of leverage but stand to lose the lenders funds if the risk event occurs. Adverse selection problem arises due to the asymmetry of information in the market. Borrowers will usually have more information on their credit worthiness and there is always a risk that an investor may choose to lend bad credit borrowers due to asymmetric information.
Financial institutions help lenders reduce the risks of moral hazard and adverse selection through diversification. A lender could suffer great losses in case a borrower defaults in paying back the loan. Financial intermediaries pool together funds from multiple investors and lend such funds to numerous borrowers, thereby spreading the risk. In their scope and scale, financial institutions are able to employ several measures that weed out the problems of moral hazard and adverse selection through credit history checks, monitoring and enforcement processes, activities which may be beyond single lenders because of the significant transaction costs involved.
Financial intermediaries are taking more roles in the developed world, especially advisory services. Investment banks carry out underwriting services for firms willing to go public. Brokerage firms and other financial institutions may offer portfolio management and stock broking services. Other firms have specialized in mergers and acquisitions, enabling firms to carry out such activities as smoothly as possible. Financial consulting companies may exercise corporate counseling and capital restructuring services. Asset based financial institutions finance the acquisitions of assets by their clientele (Johnson 2000), for instance mortgage companies help finance homeowners when they are in the process of buying their houses.
Financial Assets and their Role in the Economy
Financial assets, also known as financial investments, involve contracts written on pieces of paper, for example common stocks and bonds. Financial assets help an economy in two broad categories. The first function is through providing liquidity in the economy by transferring funds from economic units that have surplus reserves to economic units that are in need of funds to invest in tangible assets. In the process, investors are able to invest in their projects while the providers of the funds gain from the interest charges, thereby helping grow the economy. The second function of financial assets involves the transfer of such funds while reducing the risk component associated with both lenders and borrowers, as carried out by financial intermediaries.
Risk, Return and Diversification
Risk is inherent in most investments since it is difficult to accurately predict the return on such projects. For such investments, variability in the past may provide a fairly good measure of the uncertainty surrounding the future return, which can be termed as the risk for the investment. Therefore, risk is the uncertainty associated with the return value of an investment. The return is what the investor stands to gain, or profit, from an investment. Investors will want to invest in projects that offer high return at reasonable risk levels. The total risk of a security consists of two parts; market risk and unique risk.
The unique risk, or unsystematic risk, is the portion of a security’s total risk that is not related to the market, and is company specific. Market risk, also known as systematic risk, is the part of a security’s total risk that is influenced by the market or industry, and is therefore not company specific. What differentiates unique risk from market risk is that while the unique risk can be diversified away, the market risk cannot. Diversification is the process of adding securities to a portfolio in order to reduce the portfolio’s unique risk and thereby, the portfolio’s total risk. When securities are combined into a portfolio, the resulting portfolio will have a lower level of risk than a simple average of risks of the securities. This is because while some securities may doing poorly, others in the portfolio may be performing well.
Brigham E.F. and Ehrhardt M.C. (2010). Financial Management: Theory and Practice, 13th ed. New York: Cengage Learning.
Brigham, E.F. and Houston, J.F. (2007). Fundamentals of financial management, 5th ed. New York: Cengage Learning.
Johnson, H.J. (2000). Global financial institutions and markets. Malden, MA: Wiley-Blackwell.
Shim, J.K. and Siegel J.G. (2008). Financial Management, 3rd ed. New York: Barron’s Educational Series.