What are Financial Intermediaries?
What are the different types of intermediaries?
What do they do?
In this article, we will break down the definition of Financial Intermediaries so you know all there is to know about it!
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What Are Financial Intermediaries
Financial intermediaries, as the name suggests, are financial institutions that facilitate financial transactions between different parties.
In other words, a financial intermediary acts as a middle person between parties looking to transact with one another.
They link investors to borrowers or those who need capital.
Financial intermediaries include:
- Commercial Banks
- Investment banks
- Mutual funds
- Pension funds
- Pooled investment funds
- Stock exchanges
One key characteristic of such “financial” intermediaries is that they move assets, capital, funds, or reallocate them in such a way that those who have excess funds can earn some investment income, and those who need funds can make productive use of the funds.
You can look at it from another perspective, the process of intermediation allows capital to move from savers to investors.
The intermediation process provides various benefits to the parties involved in a financial transaction:
- Spreading risk
- Economies of scale
- Economies of scope
In fact, the intermediaries, in an attempt to protect themselves in the transaction, reduce the potential negotiation conflicts between the parties, provide parties with reduced transaction costs, and create a market or demand.
Financial Intermediaries Definition
What is the definition of “financial intermediaries”?
According to Investopedia, financial intermediaries are defined as follows:
A financial intermediary is an entity that acts as the middleman between two parties in a financial transaction, such as a commercial bank, investment bank, mutual fund, or pension fund.
In essence, they are:
- Acting as middlemen
- Between other parties
- In a financial transaction
Types of Financial Intermediaries
What are the different types of financial intermediaries?
Different institutions may offer different types of services.
For instance, you can have intermediaries operating in the areas of:
- Investment banks
- Insurance companies
- Credit unions
- Mutual funds
- Pension funds
- Stock exchanges
- Venture capital funds
- Leasing companies
As a way of illustration, financial intermediaries are companies that move capital from parties in need of capital to parties having excess capital.
In this context, a financial advisor, portfolio manager, or financial broker may connect investors and companies in the process of transacting stocks or bonds.
Investments can be broader such as real estate transactions, insurance products, or others.
Another type of financial intermediary is a mutual fund that provides asset management services to investors.
As such, the mutual fund is the intermediary between investors (or clients) who have money to invest and companies who need capital for their business.
Some argue that banks should not be considered as financial intermediaries although they intermediate between lenders and borrowers by taking deposits and lending money.
Role of Financial Intermediaries
In general, financial intermediaries act as middlemen in the context of financial transactions, create funds and manage the payment system.
Through financial intermediaries, capital is channeled from those who have capital to those who need the capital for productive use.
For example, banks take consumer deposits and then issue loans and mortgages to those who need funds for their business or personal projects.
This is how the financial institution (in this case the bank) is able to allocate funds from those with excess capital (its clients giving deposits) to those who need capital (business who need a business loan or individuals who need a mortgage for instance).
The financial intermediary is a third party to the transaction between different parties whose objective is to earn a profit by satisfying the parties’ needs.
In this example, the intermediary is able to pool funds by taking client deposits, then creates financial instruments, and passes the funds to those who need them like businesses in need of a business loan.
The reason why financial intermediaries are used and are attractive is that they allow parties to a transaction to reduce their transaction costs.
Consumers also benefit in dealing with intermediaries such as benefiting increased safety of the transaction, much greater liquidity, and economies of scale.
In certain industries, such as the financial markets, technology is slowly eliminating the need to have an intermediary in a process called “disintermediation”.
Other industries, such as banking and insurance are not facing the increased thread of disintermediation as the financial market industry.
Financial Intermediaries Example
Let’s look at a few examples of financial intermediaries.
As we already discussed, financial intermediaries are institutions that act as a middleman between those who need capital and those who have capital.
A non-bank financial intermediary such as a financial advisor is able to connect investors (those who have capital) to companies and organizations (those who need capital to operate their business).
Another example of a non-bank financial intermediary is a pension fund.
Pension funds collect money from their members during the years they are actively working and in their career and distribute them to pensioners who have retired or are eligible to receive their pension.
The pension fund essentially pools funds from those actively working and have capital to those that have retired and are in a greater need of capital.
Although some argue that banks are not financial intermediaries but are more money creation institutions, we consider banks to be financial intermediaries.
A bank is a financial institution that takes money from those putting their money in checking accounts, saving accounts, or other types of accounts, and then uses that capital to lend money to borrowers looking for capital.
Advantages And Disadvantages of Business Intermediation
Just like many other business and financial operations, there are benefits and drawbacks with business intermediation.
The most notable benefits are:
- Redacted transaction costs
- Reduced financial risk to the parties
- Greater convenience
There’s a reduced transaction cost directly as a result of the economies of scale in the company intermediation services able to handle large volumes of transaction in a standardized fashion and at low costs.
The financial intermediaries also offer reduced risk to the parties as they are able to spread their risk across a wide range of investments.
This results in the diversification of their investment portfolio resulting in reduced risks to the parties involved.
The services offered by the intermediary institution offer convenience to the parties and is streamlined.
Finally, through the business intermediation process, the parties are able to benefit from greater liquidity to deposit or withdraw funds as needed.
The most notable drawbacks are:
- Lower investment returns
- Lack of impartiality
Clients dealing with intermediaries may not earn a large return on their excess capital in the intermediation cycle.
In fact, the companies acting as intermediaries are for-profit businesses looking to enhance their own bottom line.
As such, they will offer a lower return to those who provide capital and charge higher fees to those who need capital so they can earn higher profits.
Another drawback is that financial intermediaries are not impartial third parties in a transaction but rather may have their goals and interests in mind.
In this context, clients bear a risk that they may not be fully informed of the intermediary’s investment strategy or risks involved.
“Financial Intermediairies” Takeaways
So, what does “Financial Intermediaries” mean?
Why do financial intermediaries exist?
Why do we need financial intermediaries?
Let’s look at a summary of our findings.
Define Financial Intermediaries
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