Understanding Financial Intermediation

Financial intermediation is the channelling funds from parts of the economy with surplus funds to parts with a deficit.

Example: consider a simple economy with just two sectors – households and firms.

·Households – save some of their current income in order to acquire claims on future output (and income) by lending.

·Firms – want to borrow funds to invest in productive equipment that will produce a return in future years.

Financial intermediation is the process by which households acquire claims on future income (assets) from firms and, equivalently, firms issue liabilities to households.   Note that an important underlying reason for all financial intermediation is that different economic agents have different rates of time preference (see below).

·Direct – lenders and borrowers are in direct contact.

·Indirect – funds are channelled from lenders to borrowers through specialist financial institutions,  financial intermediaries, and markets

Most intermediation in modern economies takes the form of indirect intermediation, with the ultimate lenders holding claims on financial institutions (inside assets) rather than on the ultimate borrowers. Thus financial intermediation can be described as the process of originating and exchanging financial assets and liabilities, converting outside assets into inside assets.

As James Tobin (Money, Palgrave, 1989, p162) notes:

“Intermediation converts outside, privately owned wealth of the economy into quite different forms in which the ultimate owners hold their accumulated savings (i.e. as inside wealth)”.

Note that in the simple representation of financial intermediation above, it is assumed that firms are in deficit and households in surplus.  This is not necessarily the case; households also borrow from financial institutions and firms lend.

Role of Financial Intermediaries

If most financial intermediation is indirect and comprises the originating and exchanging of inside assets, the question arises as to why lenders prefer to lend in this way rather than directly to ultimate borrowers.  In other words, what are the services provided by financial institutions and by markets in which financial instruments can be exchanged?  The conventional answer is that there are three major functions provided by financial intermediaries:

·Maturity transformation

This is the conversion of short-term financial instruments into long-term ones.  Financial institutions and markets reconcile the differing preferences and requirements of lenders and borrowers.

·Risk transformation

This is the conversion risky investments into relatively risk-free ones.

·Convenience denomination

(Sometimes known as “collecting and parcelling”)

This is the matching of small deposits with large loans, and large deposits with small loans.  It is equivalent to the role of the wholesaler and retailer in the distributive trade.

Advantages of Financial Intermediaries

The above description of the role of financial intermediaries is relatively uncontroversial in explaining what it is they do.  However, it does not explain how or why the advantages arise or, more specifically, where the gains to financial intermediation, and hence the incentive to form intermediaries, come from.  There are essentially two approaches.  

·The first suggests that there are cost advantages over direct lending/borrowing if financial transactions are undertaken by specialist intermediaries.

·The second approach emphasises information asymmetries between lenders and borrowers, i.e. lenders and borrowers do not have access to sufficient information about each other, leading to incomplete or missing markets. In short, there is market failure, and by specialising financial intermediaries are able to fill the gaps.

Cost advantages/profit opportunities

1.Preferences of lenders and borrowers differ

·Lenders → liquidity/short-term assets

·Borrowers → long-term debt

This gives rise to a yield gap, with lenders willing to accept lower returns than borrowers are willing to pay.  The gap will be exploited by intermediaries if can make a profit by reconciling the preferences of borrowers and lenders.

Lenders prefer lower yielding capital certain assets to higher yielding risky assets with the same expected value.  In other words, lenders are risk averse.  Again this produces a yield gap that can be profitably exploited by financial intermediaries since they can spread risks more easily than individual lenders.

The presence of specialist institutions reduces the cost of lending and borrowing, again making it profitable for financial institutions to make a profit from their activities.  Specifically, these cost advantages come from:

·Diversification / risk pooling

·Specialist management

·Arranging and contract costs

·Monitoring costs (information asymmetry)

Financial institutions are able to use the same inputs to produce different outputs.