Functions and Examples of Financial Intermediaries

Definition of financial intermediaries

A financial intermediary is a financial institution such as bank, building society, insurance company, investment bank or pension fund.

A financial intermediary offers a service to help an individual/ firm to save or borrow money. A financial intermediary helps to facilitate the different needs of lenders and borrowers.

For example, if you need to borrow £1,000 – you could try to find an individual who wants to lend £1,000. But, this would be very time consuming and you would find it difficult to know how reliable the lender was.

Therefore, rather than look for individuals to borrow a sum, it is more efficient to go to a bank (a financial intermediary) to borrow money. The bank raises funds from people looking to deposit money, and so can afford to lend out to those individuals who need it.

Examples of Financial Intermediaries

1. Insurance Companies

If you have a risky investment. You might wish to insure, against the risk of default. Rather than trying to find a particular individual to insure you, it is easier to go to an insurance company who can offer insurance and help spread the risk of default.

2. Financial Advisers

A financial adviser doesn’t directly lend or borrow for you. They can offer specialist advice on your behalf. It saves you understanding all the intricacies of the financial markets and spending time looking for best investment.

3. Credit Union

Credit unions are informal types of banks which provide facilities for lending and depositing within a particular community.

4. Mutual funds/Investment trusts

These are mutual investment schemes. These pool the small savings of individual investors and enable a bigger investment fund. Therefore, small investors can benefit from being part of a larger investment trust. This enables small investors to benefit from smaller commission rates available to big purchases.

Benefits of Financial Intermediaries

  1. Lower search costs. You don’t have to find the right lenders, you leave that to a specialist.
  2. Spreading risk. Rather than lending to just one individual, you can deposit money with a financial intermediary who lends to a variety of borrowers – if one fails, you won’t lose all your funds.
  3. Economies of scale. A bank can become efficient in collecting deposits, and lending. This enables economies of scale – lower average costs. If you had to sought out your own saving, you might have to spend a lot of time and effort to investigate best ways to save and borrow.
  4. Convenience of Amounts. If you want to borrow £10,000 – it would be difficult to find someone who wanted to lend exactly £10,000. But, a bank may have 1,000 people depositing £10 each. Therefore, the bank can lend you the aggregate deposits from the bank and save you finding someone with the exact right sum.

Potential Problems of Financial Intermediaries

  • There is no guarantee they will spread the risk. Due to poor management, they may risk depositors money on ill-judged investment schemes.
  • Poor information. A financial intermediary may become complacent about spreading the risk and invest in schemes which lose their depositors money (for example, banks buying US mortgage debt bundles, which proved to be nearly worthless – precipitating the global credit crunch.)
  • They rely on liquidity and confidence. To be profitable, they may only keep reserves of 1% of their total deposits. If people lose confidence in the banking system, there may be a run on the bank as depositors ask for their money bank. But the bank won’t have sufficient liquidity because they can’t recall all their long-term loans. (This can be overcome to some extent by a lender of last resort, such as the Central Bank and / or government)