Financial intermediation

It works as follows:

Savers (lenders) give funds to
An intermediary institution (such as a bank), who then gives those funds to
Spenders (borrowers)

This may be in the form of loans or mortgages.

The Roles include

Aggregating investments to meet needs of borrowers

To provide a link between many investors who may have small amounts of surplus cash and fewer borrowers who may need large amounts of cash

Risk transformation

Intermediaries offer low-risk securities to primary investors to attract funds, which are then used to purchase higher-risk securities issued by the ultimate borrowers

Maturity transformation

Investors can deposit funds for a long period of time while borrowers may require funds on a short-term basis only, and vice versa. In this way the needs of both borrowers and lenders can be satisfied

Benefits of financial intermediation

These are:

Value transformation

Borrowers may require large sums of money.

Financial intermediaries can pool together many smaller deposits and lend a smaller number of large amounts of money to borrowers.

Maturity transformation

Depositors may only want to deposit money in the short term, or retain a level of liquidity.

Borrowers may want to borrow money over a long period of time.

By dealing with many customers over a long period of time, financial intermediaries can provide long-term funds to borrowers, whilst ensuring that depositors retain the level of liquidity they require.

Reduction in transaction costs

Financial intermediaries can reduce the transaction costs associated with, for example, writing contracts for borrowers and lenders.

Risk diversification for savers

If a borrower defaults on a loan, the savers should not be directly affected as the cost will be charged to the financial intermediary, not the depositors.

The return on an individual’s savings are not reliant on the performance of one borrower.

Expertise

Financial intermediaries have the specialist knowledge and resources to assess the risk and anticipated profitability of proposed projects, so reducing the risk to the lenders.