Intermediatry functions

Introduction

A financial intermediary (such as a bank) simultaneously interacts with savers (or lenders) and borrowers and produces a set of services which facilitate the transformation of its liabilities (such as deposits) into assets (such as loans). The function of facilitating liabilities (or assets) into assets (or liabilities) is called intermediation. Through intermediation financial intermediaries allow indirect lending (and borrowing) between savers and borrowers. 

Direct lending between savers and borrowers is, like barter, inefficient. In order for financial transactions to be completed there must be a double coincidence of wants. People with savings will have a given amount of funds that they will want to lend for a particular time period. They will need to find someone to lend to with matching circumstances, the same approximate amount of funds and the same time period. Direct lending will necessitate a contract of some sort which will have to be negotiated. Subsequent transactions involving repayments of interest and principle will have to be accounted for. 

Most people do not enter financial markets directly but use intermediaries or middlemen. Commercial banks are the financial intermediary we meet most often in macroeconomics, but mutual funds, pension funds, credit unions, savings and loan associations, and to some extent insurance companies are also important financial intermediaries.When people deposit money in a bank, the bank uses the funds to make loans to home buyers for mortgages, to students so they can pay for their education, to business to finance inventories, and to anyone else who needs to borrow. A person who has extra money could, of course, seek out borrowers himself and bypass the intermediary. By eliminating the middleman, the saver could get a higher return.

Financial intermediaries provide two important advantages to savers. First, lending through an intermediary is usually less risky than lending directly. The major reason for reduced risk is that a financial intermediary can diversify. It makes a great many loans, and even though some of those loans will be mistakes, the losses will be largely offset by loans that are sound. In contrast, an average saver could directly make only a few loans, and any bad loans would substantially affect his wealth. 

Another reason financial intermediaries reduce risk is that by making many loans, they learn how to better predict which of the people who want to borrow money will be able to repay. Someone who does not specialize in this lending may be a poor judge of which loans are worth making and which are not, though even a specialist will make some mistakes.

A second advantage financial intermediaries give savers is liquidity. Liquidity is the ability to convert assets into a spendable form--money--quickly. A house is an illiquid asset; selling one can take a great deal of time. If an individual saver has lent money directly to another person, the loan can also be an illiquid asset. If the lender suddenly needs cash, he must either persuade the borrower to repay quickly, which may not be possible, or he must find someone else who will buy the loan from him, which may be very difficult. Although the intermediary may use its funds to make illiquid loans, its size allows it to hold some funds idle as cash to provide liquidity to individual depositors. Only when a great many depositors want to withdraw deposits at the same time, which happens when there is a "run" on the institution, will the financial intermediary be unable to provide liquidity. Unless it can obtain help from the government or other institutions, it will be forced to suspend payments to depositors.

In addition to lending money to individuals and groups, there are other ways in which banks are part of financial markets. Banks borrow and lend funds among themselves in the federal-funds market. They buy and sell foreign exchange. They buy and sell government and commercial debt. And finally, one form of bank debt serves as money in modern economies, and banks create this debt as a result of their financial transactions.

Intermediaries in a distribution channel provide services that enable manufacturers to reach different types of customers. A channel might include a number of intermediaries, such as agents, wholesalers, distributors and retailers. Intermediaries act as middlemen between different members of the distribution chain, buying from one party and selling to another. They also may hold stock and carry out logistical and marketing functions on behalf of manufacturers.

·         Examples of Financial Intermediaries

1) Direct and Indirect Channels

Manufacturers sell products and services to their customers through direct and indirect channels. Where manufacturers sell direct to customers through their own salesforce or website, they do not require intermediaries. If they wish to sell to customers and prospects their sales teams cannot reach, they appoint intermediaries to act on their behalf. Intermediaries may have additional resources and relationships to supplement to a manufacturer’s own sales and marketing resources, enabling it to reach a wider customer base.

2) Selling Through Agents

Agents act as independent representatives for manufacturers, selling to other intermediaries such as wholesalers or retailers. These agents can be individuals or companies. Agents earn commission or fees for the sales they make or the services they provide. They form a valuable extension to a manufacturer’s internal sales resources.

3) Reaching More Customers Through Retailers

Independent stores and retail chains sell products to consumers and business customers. By appointing retailers, manufacturers can reach different areas of the country and target smaller customers they could not afford to serve directly. Retailers buy products for resale direct from manufacturers or from wholesalers. They generally stock goods from many different suppliers, including competitive offerings in the same product category, so manufacturers must use incentives and discounts to encourage retailers to push their products in order to achieve strong sales.

By holding stock, wholesalers enable manufacturers to supply customers in different regions without investing in their own warehousing facilities. Wholesalers also help manufacturers reduce their logistics costs by delivering stock to retailers or offering stores a collection service.

Distributors carry out similar functions to wholesalers, but generally have closer working relationships with manufacturers. Distributors may have exclusive arrangements with manufacturers and do not carry competing products. They may be part of a franchise, only offering the products of one manufacturer. Like wholesalers, they provide valuable warehousing and logistical functions for manufacturers. They may also participate in cooperative marketing programs with suppliers, improving sales for manufacturers.

5) 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.

6) 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.

7) Credit Union.

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

8) 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.

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)

Benefits of intermediatry

A financial intermediary helps lenders meet borrowers and buyers meet sellers. In fact, thanks to the financial intermediary, the parties on either side of the transaction do not actually have to meet.
For instance, in the case of a commercial bank, the ultimate lenders are the people who deposit money into accounts at the bank.  The bank pays the depositors interest, and then loans the money to borrowers. The bank charges more interest on the loans it makes to borrowers than it pays to depositors. The excess interest on the loans can be thought of as payment for going out and finding people who want to borrow the depositors’ money. It saves time and lowers lending transaction costs by creating economies of scale.
Financial intermediaries also spread risk. If the depositors did not have the bank, they would have to make one-to-one individual loans to borrowers. If one of those borrowers defaulted, the particular individual depositor/lender would be the only one who suffered the loss. But by pooling their deposits in the bank/financial intermediary, losses on loan defaults are spread among all the depositors. 
Lower search costs.
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.
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.
Convenience of Amounts.