The Principle of The Principle of Intermediation and the Intermediation and the

Role of FinancialRole of FinancialInstitutionsInstitutions

The Principle of IntermediationThe Principle of Intermediation

Financial intermediation refers to borrowing by economic deficit units from financial institutions in preference to borrowing directly from economic surplus units.

Funds are transferred from economic surplus units (lenders) to economic deficit units (borrowers), termed indirect finance since it involves a financial intermediary that stands between savers and the borrowers and helps in the transfer of funds from one economic unit to the other.

The process of indirect finance using financial intermediaries,

termed financial intermediation, is the principle means for transferring funds from economic surplus units to economic deficit

units.

The Principle of IntermediationThe Principle of Intermediation

Role of Financial Intermediaries Role of Financial Intermediaries in Financial Markets in Financial Markets

Financial intermediaries are mainly concerned with recycling funds from economic surplus units to economic deficit units.

Like financial markets, financial intermediaries have two tasks:

Matching savers and borrowers. Providing risk-sharing, liquidity, and information services.

  In facilitating the process of intermediation

Financial intermediaries provide a number of economic functions:

1. Provision of a payment mechanism2. Size transformation3. Maturity transformation4. Risk transformation5. Liquidity provision6. Reduction of transaction, information and

search costs

Role of Deposit Institutions

Deposit institutions accept deposits from economic surplus agents which become their liabilities and provide credit to economic deficit agents, which

become their assets.

Deposit institutions are popular because:

Deposits are liquid They customize loans They accept the risk of loans They have expertise in evaluating creditworthinessThey diversify their loans

Savings institutions Include building societies and savings banks Are mostly owned by depositors y y p (mutual) Concentrates on residential mortgage loans  

Credit unions Are nonprofit institutions Restrict their business to credit union members Tend to be much smaller than other deposit institutions

Role of Nondepository financial institutions

Nondepository institutions generate funds from sources other than deposits

Finance companies

Obtain funds by issuing securities

Lend funds to individuals and small business firms

Mutual funds Sell shares to surplus units Use funds to purchase a portfolio of securities Some focus on capital markets securities (e.g., stocks or

bonds)

Money market mutual funds concentrate on money market securities

Hedge fundsUse funds to purchase a portfolio of securities (e.g., stocks, bonds,

options and futures contracts)

Securities firms Broker function Execute securities transactions between two parties Charge a fee in the form of a bid-ask spread Investment banking function  Underwrite newly issued securities Dealer function Securities firms make a market in specific securities by adjusting

their inventory

Insurance Companies 

Provide insurance policies to individuals and firms in for illness, damage to return death, and property Charges premiums  Term insurance policies Whole of life insurance policies Endowment policies Annuities Invest in stocks or bonds issued by corporations

Pension funds Offered by most corporations and government

agencies Manage funds until they are withdrawn from the

retirement account Invest in stocks or bonds issued by corporations

or in bonds issued by the government