Question

01. There are many different types of financial intermediaries. Outline the role of financial intermediaries, their functions in financial markets and explain how they differ and what they have in common. Justify how the financial intermediaries provides a drive for the economic system of a country.

Answer 1

Role of Financial Intermediaries:

(i) Reduce Hoarding:

By bringing the ultimate lenders (or savers) and ultimate borrowers together, FIs reduce hoarding of cash by the people under the “mattress”, as is commonly said.

(ii) Help the Household Sector:

The household sector relies on FIs for making profitable use of its surplus funds and also to provide consumer credit loans, mortgage loans, etc. Thus they promote saving and investment habits among the ordinary people.

(iii) Help the Business Sector:

FIs also help the non-financial business sector by financing it through loan’s, mortgages, purchase of bonds, shares, etc. Thus they facilitate investment in plant, equipment and inventories.

(iv) Help the State and Local Government:

FIs help the state and local bodies financially by purchasing their bonds.

(v) Help the Central Government:

Similarly, they buy and sell central government securities and thus they help the central government.

(vi) Lenders and FIs both Earn:

When savers deposit their funds with FIs, they earn interest. When FIs lend to ultimate borrowers, they earn profits. In fact, the’ reward of intermediation arises from the difference between the rate of return on primary securities held by FIs and the interest or dividend rate they pay on their indirect debt.

(vii) Spread of Risks:

FIs possess greater resources than individuals to bear and spread risks among different borrowers. This is because of their large size, diversification of their portfolios and economies of scale in portfolio management. They can employ skilled portfolio managers and other financial experts.

FUNCTIONS OF FINANCIAL INTERMEDIARIES:

A financial intermediary performs the following functions:

• As said before, the biggest function of these intermediaries is to convert savings into investments.
• Intermediaries like commercial banks provide storage facilities for cash and other liquid assets, like precious metals.
• Giving short and long term loans is a primary function of the financial intermediaries. These intermediaries accept deposits from the entities with surplus cash and then loan them to entities in need of funds. Intermediaries give the loan at interest, part of which is given to the depositors, while the balance is retained as profits.
• Another major function of these intermediaries is to assist clients to grow their money via investment. Intermediaries like mutual funds and investment banks use their experience to offer investment products to help their clients maximize returns and reduce risks.

How Financial Intermediaries differ from others:

They accept deposits from the public and pay deposit rates to it. The financial intermediaries obtain funds from the public and lend these funds to investors. The difference between the lending and the borrowing rates are the profits of the financial intermediaries.

Common things with others:

A financial intermediary is an entity that acts as the middleman between two parties in a financial transaction, such as a commercial bank, investment banks, mutual funds and pension funds. Financial intermediaries offer a number of benefits to the average consumer, including safety, liquidity, and economies of scale involved in commercial banking, investment banking and asset management. Although in certain areas, such as investing, advances in technology threaten to eliminate the financial intermediary, disintermediation is much less of a threat in other areas of finance, including banking and insurance like others.

Financial Intermediaries provide drive for economic growth:

• Financial intermediaries which consist of commercial banks, cooperative credit societies, mutual savings funds, mutual funds, saving and loan associations, insurance companies, and other financial institutions, help in the growth process of the economy. They intermediate between ultimate lenders who are savers and ultimate borrowers who are investors. By performing this function they discourage hoarding by the people, mobilise their savings and lend them to investors.
• Investors can borrow funds internally by using their own savings or/and externally by using the savings of others. FIs provide external finance. Savers who are ultimate lenders deposit their savings with FIs, and FIs, in turn, lend these funds to ultimate borrowers. The difference between lending and borrowing rates are the profits of FIs. FIs lend to borrowers by purchasing primary securities issued by the latter. These are bonds, equities, mortgages, bills, etc. FIs buy them with the funds kept by the savers with them.
• They are, therefore, able to profit by this transformation process by exploiting the economies of scale in lending and borrowing. On the lending side, the intermediaries can invest and manage investments in primary securities at unit cost far below the experience of most individual lenders. The large size of their portfolios permits a significant reduction in risks through diversification.
• They can schedule maturities of primary securities in such a manner that chances of liquidity crises are minimised. They are favoured with tax benefits that are not available to individual savers. On the borrowing side, with a large number of depositors they can normally rely on a predictable schedule of claims for repayment. Thus FIs encourage saving and investment which are essential for promoting economic growth.
• Among other factors, investment depends upon the rate of interest. The lower the interest rate, the higher is the investment. Competition among FIs for primary securities raises their prices and lowers the interest rate. Moreover, when savers keep their cash holdings with FIs which involve less risk, and are safe and liquid, the demand for money falls which further lowers the interest rate.
• The fall in interest rate encourages investment which increase the rate of capital formation and hence promotes economic growth