Why Financial Intermediaries Are Needed if Financial Markets Bring Together Borrowers and Lenders - Essay Example

FINANCIAL MARKETS BRING TOGETHER BORROWERS AND LENDERS; WHY THEN ARE FINANCIAL INTERMEDIARIES NEEDED Table of Contents Introduction 4 Requirement of financial intermediary 4 Types of financial intermediaries 5 Fee based or advisory financial intermediaries 5 Asset based financial intermediaries 6 Role of financial intermediaries 6 Poverty reduction 6 Market for firm’s assets 7 Pension funds as financial intermediaries 8 Clearing and settling payments 8 Mechanism of pooling of funds and subdivision of shares 8 Transfer economic resources 9 Managing uncertainty and controlling risk 9 Price information 9 Intermediaries reducing transaction costs 9 Forms of financial intermediaries 10 Depository institutions 10 Investment intermediaries 11 Advantages of financial intermediation 11 Conclusion 12 Reference 14 Introduction Financial intermediaries bring together borrowers and lenders in financial markets. It does so by interacting with savers and borrowers simultaneously and by producing a set of services facilitating the transformation of liabilities into assets like transforming deposits into loans. This function of transformation is termed as intermediation. Through this process, financial intermediaries facilitate savers and borrowers to have indirect lending and borrowing. Financial intermediaries can be banks, building societies, financial advisor or broker, insurance companies, life insurance companies, mutual fund and pension fund. Firstly, national bank served as a financial intermediary by accepting deposits and placing in various securities and mortgage loans. By doing this, individual investors are linked by banks with financial markets and demanders of credit. The intermediaries actually act as a middleman between firm raising funds and investors (Rampini & Viswanathan, 2012, pp.1-2). Requirement of financial intermediary Though financial markets can also bring together lenders and borrowers directly, still the existence of financial intermediaries is of utmost importance. This is because the direct lending approach between savers and borrowers has proved inefficient as this process can be directly traced to the barter system where there is always a need for double coincidence of wants. People with savings will want to lend the amount available with him for a particular time period. For this, he will have to find a person who needs approximately the same amount of fund for the same time period. Searching of such person is a difficult task. Again, direct lending necessitates a negotiable contract. Transactions of repayments of principle and interest are required to account for. Direct lenders will have limited ability to diversify and minimum exposure to default risk by lending small amounts to many borrowers but the transaction costs would be relatively higher. Here plays the role of financial intermediaries who reduces the transaction costs and minimises risks. It thus improves the economic efficiency. Generally, the financial intermediaries perform the following functions:- i. It facilitates transactions. ii. It creates a portfolio. iii. It spreads risks over time. iv. It eases household liquidity constraints. v. It reduces the problem of asymmetric information. In addition to intermediation, sometimes brokerage function also takes place by financial institutions in bringing together buyers and sellers to complete financial transactions. Stockbrokers specialize in brokerage to perform such task. Types of financial intermediaries Fee based or advisory financial intermediaries These financial intermediaries charge a fee for rendering advisory financial services. Their services include- i. Issue management ii. Underwriting iii. Portfolio management iv. Corporate counselling v. Stock broking vi. Credit syndication vii. Mergers and acquisitions viii. Debenture trusteeship ix. Capital restructuring Asset based financial intermediaries The specific requirements of customers are met by these financial intermediaries. They provide the required asset or finance for rent or interest respectively. The income is earned by them from interest spread which is the difference between interest paid and interest earned. Role of financial intermediaries Poverty reduction Providing financial services to poor to improve their productive capacity and quality of life is the role of financial intermediary. Most of the poor living in rural areas and engaged in agricultural activities have little access to institutional financial services. They are more prone to risk due to their vulnerability to income fluctuations. Their inability to access conventional credit and insurance markets does not offset this risk. So, efficient micro finance to the poor in poverty alleviation is required. Efficient provision of savings, credit and insurance facilities enables poor to smoothen their consumption, better management of risk, building of assets gradually, development of micro enterprises, and enhancement of income earning capacity ultimately leading to improved quality of life. Efficient micro finance services improves resource allocation, develops financial markets and system which contribute towards growth and development of economy. Having improved access to institutional micro finance, poor can have active participation in development opportunities and can benefit from it. Micro financial services can contribute to development of rural financial markets and it strengthens the social and human capital of poor. Availability of small scale loans can encourage the poor for entrepreneurship which will make them more self-reliant. It will create employment opportunities and women can be engaged in economically productive activities. The scope and outreach of services by micro finance institutions should be expanded to potential clients on a sustainable basis. Market for firm’s assets Financial intermediaries plays vital role in restructuring and liquidation of firm in distress. It plays actively in the piece-meal reallocation of assets and sale of entire bankrupt corporations to healthy ones. Emerging of financial intermediaries as internal, centralized markets providing ready information on the availability of machines and buyers allows displaced capital to migrate towards its most productive uses. Intermediaries create wealthy buyer without assets by increasing the number of highly productive matches in credit market. It decreases the thickness of decentralized resale market. This leads to less appealing of decentralized market increasing the incentive of firms to use intermediaries as resale markets. Pension funds as financial intermediaries Pension fund is a form of institutional investor which collects funds from sponsors and beneficiaries and invests them to provide future pension entitlement of beneficiaries. Thus, it accumulates savings of individuals over their working life to finance their consumption needs in retirement by way of lump sum or by provision of annuity. Pension funds play the following financial functions- Clearing and settling payments Pension funds boost the efficiency of financial systems by influencing the structure of securities markets. Pension funds generate liquidity by its activity in arbitrage, trading and diversification. If pension funds are active in larger markets, it attracts more trading which reduces costs and improves liquidity further. Mechanism of pooling of funds and subdivision of shares Pension funds reduce the costs of transaction through negotiation of lower transaction costs and custodial fees. It offers large investment strategies and also indivisible assets like property unavailable with small investors. Thus, it encourages individuals to switch to pension funds from direct holdings of securities and bank deposits. Transfer economic resources Pension funds increases the volume of savings besides disposition of household funds. At micro level, through deferred wages and salaries, it encourages savings, reducing risk of low replacement ratio. At macro level, increased contractual saving from pension fund is duly offset by declining discretionary saving. Managing uncertainty and controlling risk Households get risk control from pension funds in the form of retirement income insurance. To provide risk control, assets are diversified and functions are performed in securities and derivatives market for hedging and controlling of risk. Price information Publication of information by pension funds are seemed from companies and press directly for accounting systems based on market value. It benefits all market users. It is a disadvantage to banks which relies on private information in making loans which is not available with other investors. Intermediaries reducing transaction costs Transaction costs causes huge problem in financial markets as it reduces profit of a person and interest in financial market. Its glaring example can be how people get affected out of stock trading. For example, with a fund of 10,000$, a set of amount of shares can be purchased of a particular stock. Using a cheap online broker because of small investment, extra commission and more fees can be charged by a broker. It will reduce certain percentage of share earnings. The amount of trades a person makes gets limited because of transaction costs. This discourages many people to take part in various financial markets and they actually lose money as they would earn less interest in savings account of bank than they would have earned in various financial markets. Here, financial intermediaries play an active role in reducing transaction costs. The first measure can be bundling of funds of many investors which will provide them the benefit of economies of scale. Sharing of investment with multiple people splits the cost of transaction by the amount of people investing. It leads to smaller costs of transaction to each person for the transaction. Moreover, increase in size of investment waives certain fees to a person for becoming a good customer to the broker. Another measure is that financial intermediaries try to develop enterprise with lower transaction costs. Settling up of toll free hotlines and websites for the customers allows them to check balances of their accounts, performing transactions online lowering brokerage fees. Overall transaction fees are sometimes high, but financial intermediaries provide ways to avoid these fees. Several fees are there which are unavoidable but it worth’s the costs for return from the asset in financial market. Forms of financial intermediaries Depository institutions These are financial intermediaries who accept deposits from institutions and individuals and use that money to make loans, for example, commercial banks. It accepts deposits for savings accounts, time deposits with fixed maturity date like certificate of deposit. Another example can be credit union which is smaller operations, specifically designed for people of particular membership or group like employees of a particular company. Primarily, credit unions make consumer loans whereas commercial banks make corporate and consumer loans. Investment intermediaries These are basically mutual fund companies, finance companies and money market accounts. Mutual fund companies sell shares to many individuals to acquire funds and utilises the funds in purchasing diversified portfolio of bonds and stocks. Its advantage is that professionals pick up the investments and make diversification lowering the risk and increasing potential for long term growth. Money market mutual funds are combination of mutual funds and depository institutions which offers deposit style accounts. Interest is paid by money market accounts which also functions as checking accounts enabling users to write checks or withdrawing money at any time from the account. Investment banks differ from other financial intermediaries as they do not provide loan out of the funds collected from people’s savings. It actually helps corporations to issue securities. It helps them to decide on the type of securities they are willing to release and then helps to sell them taking a significant percentage of transactions that it does for the corporations. Other financial intermediaries include pension funds, insurance companies, government retirement funds and other type of insurance funds. Advantages of financial intermediation A borrower in requirement of money has two choices – taking direct loan from relative or a loan shark. If the amount of money is small, it can be a workable loan. Another option available to the borrower is taking help of financial intermediary to seek capital from commercial bank or credit union. Comparative advantages of financial intermediaries over direct lenders are as follows– Firstly, financial intermediaries because of their specialization achieve economies of scale. This is because large number of transactions is handled by them. They spread out their overhead through fixed costs. Secondly, in searching for credit information, financial intermediaries reduce the transaction costs. But a consumer lending directly searches information usually at a higher cost. Finally, financial intermediaries obtain important and sensible information about the financial condition of borrowers. Moreover, they reduce the problem of unreliable information as it holds intimate knowledge regarding operation of borrower’s, their personal history and character. For example, maintains records of transactions for evaluation of risk of default for an applicant. Furthermore, financial intermediaries render financial services at lower costs as compared to individual lenders. For a direct lender, the small quantities of money with higher overhead make direct lending risky for him. Conclusion Finally, it can be concluded that the financial intermediary is perhaps a firm of special kind but nevertheless a firm. Through bank-like intermediation, securities which are issued by intermediaries are bought by household; the money is then invested as lending to borrowers. Its functioning of bringing together economic agents with shortage of funds, intending to borrow and with surplus of funds, intending to lend ensures direct contact with capital market between household and firms dominating one. With this, the importance of financial intermediary in financial market is quite justified. Reference Rampini, A. A. & Viswanathan, S. 2012. Financial Intermediary Capital. [Pdf]. Available at: https://faculty.fuqua.duke.edu/~rampini/papers/intermediarycapital.pdf. [Accessed on February 22, 2013]. Read More