Financial intermediary

A financial intermediary is an institution or individual that serves as a middleman for different parties in a financial transaction.[1] According to classical and neoclassical economics, as well as most mainstream economics, a financial intermediary is typically a bank that consolidates deposits and uses the funds to transform them into loans.[2] According to some heterodox economists[3][4] and others,[5][6] financial intermediaries simply do not exist.

Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities.[2] As such, financial intermediaries channel funds from people who have extra money or surplus savings (savers) to those who do not have enough money to carry out a desired activity (borrowers).[7]

A financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly.[8] That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages.[9] Alternatively, they may lend the money directly via the financial markets, and eliminate the financial intermediary, which is known as financial disintermediation.

In the context of climate finance and development, financial intermediaries generally refer to private sector intermediaries, such as banks, private equity, venture capital funds, leasing companies, insurance and pension funds, and micro-credit providers.[10] Increasingly, international financial institutions provide funding via companies in the financial sector, rather than directly financing projects.[11]

Functions performed by financial intermediaries

The hypothesis of financial intermediaries adopted by mainstream economics offers the following three major functions they are meant to perform:

  1. Creditors provide a line of credit to qualified clients and collect the premiums of debt instruments such as loans for financing homes, education, auto, credit cards, small businesses, and personal needs.
    Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs)
  2. Risk transformation
    Converting risky investments into relatively risk-free ones. (lending to multiple borrowers to spread the risk)
  3. Convenience denomination
    Matching small deposits with large loans and large deposits with small loans

Advantages and disadvantages of financial intermediaries

There are two essential advantages from using financial intermediaries:

  1. Cost advantage over direct lending/borrowing
  2. Market failure protection; The conflicting needs of lenders and borrowers are reconciled, preventing market failure

The cost advantages of using financial intermediaries include:

  1. Reconciling conflicting preferences of lenders and borrowers
  2. Risk aversion intermediaries help spread out and decrease the risks
  3. Economies of scale - using financial intermediaries reduces the costs of lending and borrowing
  4. Economies of scope - intermediaries concentrate on the demands of the lenders and borrowers and are able to enhance their products and services (use same inputs to produce different outputs)

Various disadvantages have also been noted in the context of climate finance and development finance institutions.[10] These include a lack of transparency, inadequate attention to social and environmental concerns, and a failure to link directly to proven developmental impacts.[12]

Types of financial intermediaries

According to the dominant economic view of monetary operations,[6] the following institutions are or can act as financial intermediaries:

According to the alternative view of monetary and banking operations, banks are not intermediaries but "fundamentally money creation" institutions,[6] while the other institutions in the category of supposed "intermediaries" are simply investment funds.[6]

Summary

Financial intermediaries are meant to bring together those economic agents with surplus funds who want to lend (invest) to those with a shortage of funds who want to borrow.[13] In doing this, they offer the benefits of maturity and risk transformation. Specialist financial intermediaries are ostensibly enjoying a related (cost) advantage in offering financial services, which not only enables them to make profit, but also raises the overall efficiency of the economy. Their existence and services are explained by the "information problems" associated with financial markets.[14]

See also

References

  1. ↑ Infinite Financial Intermediation, 50 Wake Forest Law Review 643 (2015), available at: http://ssrn.com/abstract=2711379
  2. 1 2 Siklos, Pierre (2001). Money, Banking, and Financial Institutions: Canada in the Global Environment. Toronto: McGraw-Hill Ryerson. p. 35. ISBN 0-07-087158-2.
  3. ↑ Wray, L. Randall."Functional finance and U.S- government budget surpluses in the new millennium"
  4. ↑ Mitchell, Bill. "The IMF fall into a loanable funds black hole again", 22 September 2009
  5. ↑ "Repeat After Me: Banks Cannot And Do Not "Lend Out" Reserves" by Paul Sheard, Chief Global Economist and Head of Global Economics and Research, Standard & Poor's Ratings Direct newsletter, 13 August 2013
  6. 1 2 3 4 "The currently dominant intermediation of loanable funds (ILF) model views banks as barter institutions that intermediate deposits of pre-existing, real, loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds; and ILF-type institutions do not exist. Instead, banks create new funds in the act of lending, through matching loan and deposit entries, both in the name of the same customer, on their balance sheets. The financing-through-money-creation (FMC) model reflects this, and therefore views banks as fundamentally monetary institutions. The FMC model also recognises that, in the real world, there is no deposit multiplier mechanism." From "Banks are not intermediaries of loanable funds — and why this matters", by Zoltan Jakab and Michael Kumhof, Bank of England Working Paper No 529, May 2015
  7. ↑ O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 272. ISBN 0-13-063085-3.
  8. ↑ Global Shadow Banking Monitoring Report 2013 (PDF). Financial Stability Board. 2013. p. 12. ISBN 0-07-087158-2.
  9. ↑ Robert E. Wright and Vincenzo Quadrini. Money and Banking: Chapter 2 Section 5: Financial Intermediaries. Accessed June 28, 2012
  10. 1 2 Institute for Policy Studies(2013), "Financial Intermediaries", A Glossary of Climate Finance Terms, IPS, Washington DC
  11. ↑ Eurodad (2012), "Investing in financial intermediaries: a way to fill the gaps in public climate finance?", Eurodad, Brussels
  12. ↑ Bretton Woods Project (2010)"Out of sight, out of mind? IFC investment through banks, private equity firms and other financial intermediaries", Bretton Woods Project, London
  13. ↑ "The Role Of Financial Intermediaries", Finance Informer website, Australia (accessed 10 June 2015)
  14. ↑ Gahir, Bruce (2009). "Financial Intermediation". Prague, Czech Republic.

Bibliography

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