Financial Intermediation

What is Financial System?

A Financial system is a network of;

• Financial institutions
• Financial Market
• Financial instrument
• Financial Services to facilitate the transfer of funds

The system consists of savers, intermediaries, instruments and the ultimate user of funds.

Then we look what is Financial intermediation;

Financial intermediation is the process of channeling funds from ultimate lenders (agents who have surplus funds) to ultimate borrowers (agents in deficit).

Financial Intermediaries move funds from parties with excess capital to parties needing funds.

Savings are transformed in to investment in an economy via financial intermediaries such as Banks, Mutual savings banks, Savings banks, Credit unions, Financial advisers or brokers, Stock Brokerage Firms, Insurance Companies, Building societies, Collective investment schemes, Pension Funds, Cooperative societies and Stock exchanges.

Functions performed by financial intermediaries.

1. Reduction of transaction cost
2. Converting risky investments into relatively risk-free ones. (lending to multiple borrowers to reduce risk)
3. Convenience denomination: Matching small deposits with large loans and large deposits with small loans

Importance of Financial Intermediation

• Cost reduction:

Financial intermediaries collect information on behalf of savers so that they will not have to incur these direct and opportunity cost.

• Economies of scale:

Reducing the average cost of fund management by polling savings and spreading management costs across many people.

• Information Availability:

Deposits are mostly short term but loans are mostly long term. This mismatch can be overcome using financial intermediation.

• Risk Transformation:

Depositors are reluctant to give their money to borrowers due to risk of fraud. Intermediaries have the experience and the credit management skills to overcome this problem.

• Geographical location:

Lenders may not be able to locate the borrowers even within the same geographical area this mismatch can be overcome through financial intermediaries.

Potential Problems of Financial Intermediation 

1. Lack of transparency
2. Intermediaries rely on liquidity and confidence.
3. Inadequate attention to social environmental concern.
4. Failure to link directly to proven developmental impacts.