What are Financial Intermediaries - A Detailed Explanation (2024)

Have you had any savings in a bank? Do you owe money on a loan? Does that happen at a different bank? How about your automobile insurance? That must be at a different organization still. It’s possible that you have family members who have retirement funds or that your parents have life insurance to protect you in the event that something were to happen to them. More financial intermediaries may be involved in your family’s interactions than they realize! So exactly what are financial intermediaries, what varieties are there, and what do they do? Find out by reading on!

What are Financial Intermediaries: Understand

A third party that creates a setting for performing financial transactions between several parties is referred to as a financial intermediary. The fundamental process of financial intermediation is demonstrated, for instance, by banks collecting deposits from consumers and granting them to those customers who need money.

In the procedure of financial intermediation, there are numerous methods to link lenders and borrowers. To avoid financial catastrophes, they carefully manage financial assets and obligations. Additionally, they are responsible for rigorously following any regulations or recommendations put forth by recognized organizations.

A commercial bank, investment bank, a mutual fund, or pension fund are examples of organizations that serve as intermediaries involving the two parties in a financial transaction. Consumers as a whole gain from financial intermediaries’ reliability, liquidity, and efficiencies of scale in the banking and asset management industries. Disintermediation is significantly less of a concern in other sectors of finance, such as banking and insurance, even though it does threaten to abolish the financial middleman in other areas, such as investing.

Financial Intermediaries Examples Include:

Investment banks and commercial banks
Mutual Funds
Pension Funds
Stock Exchange
Credit Unions

Due to their ability to combine financial assets from many different sources, financial intermediaries benefit people in an economy in many ways, including security, liquidity, and efficiencies of scale.

While some financial intermediaries, like banks, accept deposits from customers, others operate according to a different business model. Instead of accepting funds from the general public, a financial intermediary which is not a bank may offer financial services including leasing, insurance, and other forms of finance as well as asset management.

Involvement in stock exchanges and the employment of investment methods to manage and develop customers’ money to maximize returns are two additional non-bank services provided by financial intermediaries.

Now that we understood what are financial intermediaries let’s move forward and understand how it operates.

How Financial Intermediaries Operate

Funds from the general public are not accepted by a non-bank financial intermediary. The middleman may offer leasing, factoring, coverage for insurance, or other types of financial services. In order to manage and increase their money, many intermediaries participate in securities trading platforms and use long-term strategies. The actions of financial intermediaries and the growing popularity of the financial services sector can both reveal a nation’s overall economic soundness.

Financial middlemen transfer money from those with extra capital to others that need it. The method minimizes the cost of doing business and produces effective marketplaces. An investment in insurance policies, real estate, bonds, stocks, and other assets, for instance, might help a financial adviser establish a connection with a client.

Banks function as the intermediaries between borrowers and lenders by supplying funds from the Federal Reserve and other financial institutions. Insurance businesses take premium payments, offer insurance benefits and issue policies. On behalf of its members, a pension fund raises money and disburses benefits to retirees.

Let’s go on and learn what are financial intermediaries purpose now that we have a better understanding of what they are and how they operate.

Professional Courses from IIM SKILLS

Digital Marketing Course
SEO Course
Technical Writing Course
GST Course
Content Writing Course
Financial Modeling Course
Business Accounting And Taxation Course
CAT Coaching
Investment Banking Course

The Purpose of Financial Intermediaries

Financial middlemen essentially connect a party with surplus money to a party with a deficit fund. They promote economic expansion and facilitate the movement of money throughout the economy. The intricacy of the intermediaries’ duties varies depending on the services and goods they provide. They manifest themselves as channels that offer mortgages, financing, instruments for investment, leases, insurance, etc.

Asset Protection:

One of the most crucial roles played by financial intermediaries may be asset storage. Commercial banking institutions provide the safekeeping of currency, whether it be in the manner of coins or paper money, as well as other valuables like gold or silver.

A range of instruments is made available to people who make deposits to assist them in both securing their money and facilitating 24/7 access to it. These consist of credit cards, cheques, debit cards, and ATM cards. Additionally, depositors have access to information about the deposits, withdrawals, and direct payments they have authorized through the bank.

Loans:

Loans are another crucial role that financial intermediaries play. The majority of the work that financial intermediaries do is to advance both immediate and long-term loan transactions. They serve as a go-between for customers wishing to borrow money from depositors who have extra funds and the depositors themselves. Loans are typically obtained by borrowers to buy capital-intensive items like commercial real estate, cars, and manufacturing equipment.

In addition to charging interest on the loans, intermediaries often distribute a percentage of the proceeds to the depositors whose funding was used to fund the loans. The interest earned on the remaining principle is retained as a profit. A credit check is performed on borrowers to determine their creditworthiness and ability to repay the loan.

Investments:

Financial intermediaries also perform essential investment-related tasks. The knowledge of in-house investment specialists who help customers of financial intermediaries like mutual funds and investment banks increase their investments may be advantageous. The companies discover the most suitable assets that maximize returns while lowering risk using their substantial industry expertise and countless of investment portfolios.

As an individual investor, you have access to a variety of assets, including securities, real estate, treasury notes, and derivatives of financial markets. In certain circ*mstances, such as with certificates of deposit, intermediaries make an investment of the money of their clients and pay them an annual interest rate over a certain period of time. Some intermediaries may offer financial and investment advice alongside or in addition to managing the assets of clients to help customers make the best investment choices.

Advantages of Financial Intermediaries

Savings can be pooled using a financial intermediary, allowing investors to make sizable contributions that benefit the company they are investing in. Financial intermediaries spread money over a variety of loans and assets to diversify risk at the same time. By allowing people to make the most of more money compared to what they currently have, loans help families and nations.

Financial intermediaries also have the advantage of lowering costs across the board. For instance, they may make use of economies of magnitude to cost-effectively maintain data and profiles and properly assess the credit profiles of potential borrowers. Finally, they lower the expenses of the numerous financial transactions that a particular investor would otherwise need to conduct.

Also, Check,

Online Financial Modeling Courses
Financial Modeling Courses With Placements
Financial Modeling Software

Types of Financial Intermediaries

Financial intermediaries come in a wide variety of types. Banks, life insurance firms, pension funds, and mutual funds are among the most significant categories of financial intermediaries. Here, each kind is discussed.

Banks:

When borrowers need finance for their initiatives and lenders want to save, banks operate as mediators to make the transaction possible. A fairly popular kind of financial intermediary is a bank.

Customers deposit their money into banks’ checking or savings accounts, which is money they intend to save and have on hand for future purchases. These people receive interest on their savings accounts from the bank in a predetermined amount. Their meager investment return for using this money, which is often only used for overnight transactions, might be deemed to constitute interest.

Mutual Funds:

Owning shares in a firm carries some risk since the return that you receive on your investment is based on how well the company performs. Instead of concentrating on making investments in the shares of a single company or a group of linked firms, investors can reduce their risk by investing in a broad portfolio of stocks—a collection of equities with risks that have no relationship with one another.

Financial advisers advise their customers to purchase mutual funds to diversify their stock holdings. The same is true for accumulating wealth overall by owning assets besides stocks, such as securities, real estate, and savings. Diversification reduces risk and provides insurance against losses.

Building a diverse stock portfolio may result in high transaction costs (especially transaction fees) for investors who do not have a sizable quantity of money to invest since they are buying just a handful of shares in several firms, which raises transaction costs. Mutual funds step in at this point. Investors can diversify their portfolios with mutual funds or open-end funds without paying exorbitant transaction fees.

By holding a few shares in a mutual fund that holds a varied portfolio of firm stock, any person, wealthy or not, can indirectly possess holdings of stock in an extensive range of companies in a diversified portfolio. Mutual funds serve as mediators, reducing the expenses associated with the acquisition of financial assets.

Pension Funds:

Identical to mutual funds, pension funds are a different kind of financial intermediary.

A pension fund is an organization with no profit that invests money, typically given by an employer, in stocks, bonds, properties, and other assets with the objective to pay out income to employees beginning with their retirement. An annuity paid by one’s employer that offers a set amount of revenue upon retirement throughout the remainder of one’s life is known as a pension.

Pension plans are less prevalent than they formerly were. Although many businesses now engage a financial intermediary in order to give their workers this service, most employees nowadays are required to save for their own retirement. The workers control the investments, when and how they invest, and how much they contribute.

These kinds of financial intermediaries are among the most crucial since they have a direct influence on a person’s retirement account, which provides them with funding after they retire. Pension funds serve a similar purpose as mutual funds, but one distinction between them is that they are subject to different laws and regulations than mutual funds in the United States, notably in relation to qualified retirement accounts with favorable tax status, such as pensions.

Life Insurances:

Financial intermediaries of a different kind include life insurance businesses. In the unusual event that the insurance policyholder passes away unexpectedly, the main goal of life insurance is to ensure the distribution of monies to the beneficiaries. Although any intended recipient can be selected by the owner of the life insurance policy, this might be advantageous for families who have kids who depend on their income.

Stock Exchanges:

The stock exchange represents a market where both buyers and sellers deal in financial products like derivatives and stocks. Through an intermediary, it links businesses in need of finance with investors who have extra money to invest. One can hold a stake in a blue-chip corporation even with a modest sum of money, which may not have been possible before.

Credit Unions:

Typically, credit unions are members-owned non-profit organizations. Although it performs comparable duties to banks, they provide more favorable savings rates and lower borrowing costs, i.e. lending at competitive rates.

In this blog, we are learning what are financial intermediaries but to understand the topic of what are financial intermediaries, we should also understand the drawbacks of financial intermediaries.

Financial Intermediaries’ Drawbacks

Financial intermediaries provide advantages, however, there are also some drawbacks to these organizations. The potential for reduced investment returns, the chance of misaligned aims, credit risk, and market risk are some of the key drawbacks of financial intermediaries. Due to all of these factors, whether an intermediary is used or not, private investors should always exercise caution and fully research all of their options before making an investment.

Lower Returns on Investment:

Remember that financial middlemen desire to generate a profit as well. The institutions that facilitate these transactions will need to be paid in some way for their services, which might result in lower investment returns compared to when the money invested had gone straight to the source rather than through the middleman. But occasionally, the availability of the middleman is necessary in order to take advantage of the investment opportunity.

Misaligned Objectives:

A financial intermediary could not be functioning as an objective third party. The institution’s motive to maximize profits may be directly at odds with decisions that might otherwise boost the investor’s return. They could advocate for investment opportunities that are loaded with unrecognized risks or that don’t necessarily suit the objectives of the investor.

Indirect conflicts of interest also exist when financial intermediaries manage and invest for a variety of customers. They could be motivated to invest in businesses that serve their interests rather than those of their investors.

Recommend Read,

Financial Modeling Best Practices
Financial Consultant Profile
Financial Modeling Terms
Financial Modeling Career Path

Credit Risk:

Another drawback of financial intermediaries is credit risk. Customers running the danger of loan default are involved here. This is risky because the intermediary must boost fees to account for the likelihood of any default since it utilizes these monies to reimburse the investors or bank depositors. Therefore, defaults have a bad effect on both parties. A financial crisis may start if a lot of loans were to fall behind all at once.

Marketplace Risk:

The success of financial intermediaries and the performance of the market as a whole are highly connected. Financial intermediaries will face problems if exogenous shocks have a detrimental effect on market performance. The risk associated with investing in this one.

Let’s move ahead to the conclusion for the blog what are financial intermediaries?

Conclusion:

We have reached the conclusion in the blog post about what are financial intermediaries. Hope the above blog has given clarity on the question that what are financial intermediaries, how they operate, what are financial intermediaries purpose and what types of financial intermediaries.

As we’ve seen, financial intermediaries are essential in today’s global economy. The economy depends on them for maintenance. Financial intermediaries must constantly reinvent themselves in order to meet the varied portfolios and want of investors as a result of the rising complexity of financial transactions.

The financial intermediaries are heavily obligated to both the lenders and the borrowers. By virtue of the name “intermediary,” it is implied that these organizations play a crucial role in the operation of the economy and that they, together with the monetary authorities, are responsible for ensuring that those in need of credit receive it without endangering investor interests. One of their biggest obstacles is this.

FAQs

Q. What are financial intermediaries and what do you mean by this?

A business or organization that works as a middleman between a service provider and a customer is known as a financial intermediary. In a financial setting, it is the organization or person positioned through two or more parties. A financial intermediary, in theory, converts savings into investments. In order for the financial system to function profitably, financial intermediaries must occasionally have their actions regulated. Recent developments also imply that financial intermediaries’ position in savings and investment activities can be employed for a market system that is efficient, or as the subprime crisis demonstrates, they could also cause you to worry.

Q. What function do financial intermediaries serve in the economy?

Financial intermediaries that act as a bridge between those who lend and those who borrow, such as conventional banks and other entities with banking functions, are crucial for the distribution of capital.

Q. What major categories of financial intermediaries exist in India?

Financial intermediaries come in many forms, including banks, credit unions, insurance firms, mutual fund firms, stock exchanges, credit unions, etc. Banks offer well-known financial services that make borrowing and investing money simple.