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Financial intermediation - Essay Example

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What is Financial Intermediation - In its simplest definition, it means acting as sort of a bridge between people who have excess funds (savers, depositors and lenders) and those who do not have funds but need the funds (borrowers or debtors). …
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Financial intermediation
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Download file to see previous pages Being an intermediary also means acting as the middleman or go-between among lenders and borrowers; a good example of a financial intermediary are the banks and other financial institutions which accept deposits from people who have extra monies and lend these out to those who need them and willing to pay interest for the use of the money. Financial intermediation is the crucial process in any of free capitalist markets or economies because it allows for capital-raising activities and helps to promote economic growth. This is achieved through a dual savings – investment process. Financial intermediation accomplishes three general objectives which are: convert a short-term liability into a long-term asset (banks do this by reconciling different maturities), a way to mitigate market risks (such as by lending to several borrowers instead of just one) and to re-denominate fund amounts (like bundling several small investors together and lend their monies to one big borrower; conversely, one big deposit can be lent out to many borrowers). When financial regulation is performed by the concerned government authorities/agency in a prudential manner, it will safeguard the economy from excessive risks and abuses. The primary beneficiaries of financial intermediation are the borrowers who will be able to keep their borrowing costs down as opposed to borrowing directly on the markets and other primary beneficiaries are the lenders who will be insulated from any of probable market failures if done properly, as stated earlier, in a prudent way. The entire nation will benefit if it is well-managed, in the sense that intermediation increases financial efficiency. Using Financial Intermediation to Trade Risks – a good example to trade risks is the insurance industry. What insurance firms do is spread the risks by issuing several life policies, for example, because not all people die at the same time. In other words, only a few people do die in a certain year based on statistics (or probabilities) and so the insurance people can make money based on these probabilities. For example, they issue a thousand life insurance policies and accept premium payments on these policies; however, maybe only 10 people die within a single year and so they are able to earn profits because their payout is much less than revenues from the premium payments they receive. There are also many other ways by which risks can be traded, such as through esoteric investment instruments like credit default sways (CDS) or by selling collateralized debt obligations (CDO) like the sub-prime mortgage markets. The net effect of these opaque and poorly-understood instruments is to transfer the risks to the buyers. Banks, insurance firms and investment companies are example of financial intermediaries that trade risks in the open market and make money by their arbitrage activities. Intermediaries are necessary to mediate or mitigate the risks by credit rationing or diversification (Benner 90). Components of Good Financial Management – the collapse of the sub-prime market in the United States of America brought to the fore the issue of unregulated and opaque types of investment instruments such as derivatives (the CDO and CDS are two examples of these). Other examples of derivative investment instruments are options, futures, swaps and forwards in which the derivatives' values are based on another underlying commodity, hence its name. Its ultimate value is derived from other variables and derivatives are supposed to work by the process in which excessive swings or fluctuations in prices are avoided. A derivative in any of tradeable commodities is simply a contract in which the payoff is dependent on the ...Download file to see next pagesRead More
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