Financial intermediation

2. Financial intermediation.

Financial intermediation is an activity of financial intermediaries. A

financial intermediary is an institution that links lenders with borrowers,

by obtaining deposits from lenders and then re-lending them to borrowers.

The role of financial intermediaries in an economy, such as banks and

building societies, is to provide means by which funds can be transferred

from surplus units in the economy to deficit units. Surplus units are those

economical agents, which have more money, than they need for their

immediate needs. Deficit units are those, which have less money, than they

need in order to fund their current activity.

Financial intermediaries help to reconcile different requirements of

borrowers and lenders.

They provide obvious and convenient ways in which a lender can save

money. Instead of having to find a suitable borrower for his money, the

lender can deposit his money with a bank etc. All the lender has to do is

decide for how long he might want to lend money, and what sort of return he

requires, and choose a financial intermediary, that offers a financial

instrument of the fitting conditions.

They can package up the amounts lent by savers and lend on to borrowers

in bigger amounts.

They provide for a risk reduction. Provided that the financial

intermediary is itself financially sound, the lender would not run any risk

of losing his investment. Bad debts would be borne by the financial

intermediary in its re-lending operations.

They provide a ready source of funds for borrowers. Even when money is

in short supply, a borrower will usually find a financial intermediary

prepared to lend some.

Most importantly they provide maturity transformation, i.e. they bridge

up the gap between the wish of most lenders for liquidity and the desire of

most borrowers for loan over longer periods. They do this by providing

investors with financial instruments, which are liquid enough for the

investors’ needs, and by providing funds to borrowers in a different longer-

term form.