Financial Intermediaries (FIs): Meaning and Role

In this article we will discuss about:- 1. Meaning of Financial Intermediaries (FIs) 2. Process of Intermediation 3. Roles.

Meaning of Financial Intermediaries (FIs):

Financial intermediaries (FIs) are financial institutions that intermediate between ultimate lenders and ultimate borrowers. Funds flow from ultimate lenders to ultimate borrowers either directly or indirectly through financial institutions.

FIs are commercial banks, cooperative credit societies and banks, mutual savings banks, mutual funds, savings and loan associations, building societies and housing loan associations, insurance companies, merchant banks, unit trusts, and other financial institutions.

FIs are divided into:

(a) Commercial banks; and

(b) Non-bank financial intermediaries (NBFIs).

The essential function of FIs is to satisfy simultaneously the portfolio preferences of two types of individuals or firms. On the one side are borrowers who are non-financial (deficit) spending units. Their principal function is to produce and purchase current output and not to buy one type of security by issuing another, according to Gurley and Shaw.

They wish to expand their holdings of real assets like inventories, real estate, plant and equipment, etc. They finance these by issuing what Gurley and Shaw term primary securities which they define as “all liabilities and outstanding equities of non-financial spending units.” They are bonds, corporate equities, debts of individuals and businesses, mortgages, bills, etc. These are their liabilities. On the other side are lenders (surplus income units or savers) whose assets are in the form of bank deposits, insurance policies, pensions, etc.

FIs transfer funds from ultimate lenders to ultimate borrowers. They acquire the savings of surplus income units and offer in return claims on themselves. They also purchase primary securities from non- financial spending units by the creation of claims on themselves through indirect or secondary securities.

Thus FIs issue secondary securities. They are currency issued by the central bank, demand and time deposits of commercial banks, and savings deposits, insurance and pension funds of nonmonetary intermediaries. FIs are, therefore dealers in securities.

They purchase primary securities and sell their secondary securities. Thus FIs function as dealers by buying funds from ultimate lenders in exchange for their own secondary securities and selling funds to ultimate borrowers in exchange for the Iatter,s primary securities. The purchase of primary securities by surplus income units is called direct finance and by financial intermediaries as indirect finance. Both primary and secondary securities are referred to as financial assets.

Process of Intermediation:

When the distribution of income among the spending units is exactly the same, all units have balanced budgets on income and product account. When income and spending distributions differ, some spending units have surpluses while others have an equivalent amount of deficits.

Surplus units (ultimate lenders) supply options on current output equal to their surpluses and, in return, acquire an equal amount of net financial asset i.e. financial assets less debt increased and equities issued. Deficit units (ultimate borrowers) take up and exercise these options paying for them by increasing their net debt and equity. These budget imbalances normally lead to net issues of primary securities and net accommodation of financial assets.

First we take intermediation by the commercial banks or the monetary system. When the commercial banks intermediate, the ultimate borrowers sell them their primary securities and receive money in demand deposits of banks. These demand deposits are then spent by the borrowers for current output. The ultimate lenders acquire financial assets which represent the options on current output they have realised from the borrowers through bank deposits.

In this process of intermediation, ultimate borrowers have created primary securities, the banks have created money by purchasing them, and ultimate lenders have acquired financial assets as a reward for not spending. Unspent incomes have been transferred from surplus to deficit units through bank intermediation.

Now take intermediation by NBFIs. When the ultimate lenders having demand deposits with banks, write cheques and present them to NBFIs, they, in return, receive claims on these intermediaries. NBFIs endorse the cheques and send them to the banks having demand deposits. They use these deposits to purchase primary securities from ultimate borrowers.

The latter now have the demand deposits which they spend for current output, and are eventually received by ultimate lenders. The ultimate lenders end up with the same amount of demand deposits that they started with but now they have more of financial assets which represent unspent income they have transferred to the ultimate borrowers.

In this intermediation process, the borrowers have again created primary securities, NBFIs have created secondary securities, and the lenders have acquired financial assets. The nominal size of the monetary system measured by assets or liabilities has not changed.

The bank deposits have been transferred from ultimate lenders to NBFIs, then to ultimate borrowers, and finally back to the ultimate lenders. There has been no intermediation by the banking system, its role has been that of administering the payment mechanism of transferring demand deposits on to its ledgers. Thus both commercial banks and NBFIs intermediate in the transfer of unspent income from surplus to deficit units.

Roles of Financial Intermediaries:

1. Role in the Modern Financial System:

Financial intermediaries play an important role in the modern financial system and benefit the economy as a whole.

They have the following economic effects:

(i) Reduce Hoarding:

By bringing the ultimate lenders (or savers) and ultimate borrowers together, FIs reduce hoarding of cash by the people under the “mattress”, as is commonly said.

(ii) Help the Household Sector:

The household sector relies on FIs for making profitable use of its surplus funds and also to provide consumer credit loans, mortgage loans, etc. Thus they promote saving and investment habits among the ordinary people.

(iii) Help the Business Sector:

FIs also help the non-financial business sector by financing it through loan’s, mortgages, purchase of bonds, shares, etc. Thus they facilitate investment in plant, equipment and inventories.

(iv) Help the State and Local Government:

FIs help the state and local bodies financially by purchasing their bonds.

(v) Help the Central Government:

Similarly, they buy and sell central government securities and thus they help the central government.

(vi) Lenders and FIs both Earn:

When savers deposit their funds with FIs, they earn interest. When FIs lend to ultimate borrowers, they earn profits. In fact, the’ reward of intermediation arises from the difference between the rate of return on primary securities held by FIs and the interest or dividend rate they pay on their indirect debt.

(vii) Spread of Risks:

FIs possess greater resources than individuals to bear and spread risks among different borrowers. This is because of their large size, diversification of their portfolios and economies of scale in portfolio management. They can employ skilled portfolio managers and other financial experts.

They also benefit by exploiting economies of scale in lending and borrowing. On the lending side, they can invest and manage investments in primary securities at unit costs far below the experience of most individual lenders.

The large size of their portfolio permits a significant reduction in risks through diversification. The maturity of primary securities can be phased in such a manner that liquidity crises are minimised. Similarly, on the borrowing side, since the number of depositors is very large, FIs can spread the repayment schedule over a longer time period and can reduce the illiquidity of their portfolios.

There are also external economies associated with FIs. External economies are particularly evident in the case of the monetary system. An efficient monetary system is an essential condition for the real growth in the economy. External economies are also important in the case of social and private insurance, and of mortgage and consumer finance.

(viii) Creation of New Assets and Liabilities:

All FIs create financial assets. The banks create money when they purchase primary securities. Other intermediaries create various forms of non-monetary indirect assets when they deposit money. Non-financial spending units create primary securities. In each case, the financial asset is created by the purchase of another financial asset or by the purchase of tangible assets.

Banks purchase various types of primary securities. They create money in an amount which is the multiple of primary securities they hold. NBFIs initially purchase currency and demand deposits when they create indirect securities. In the same way, these intermediaries create liabilities by some multiple of either their currency or deposit balance. Since they can sell money for primary securities, they can create liability by some multiple of any type of asset they hold.

Prof. Gardner Ackley has shown that in intermediation between ultimate savers and direct investors, FIs add greatly to the stock of financial assets available to savers. For every extra asset, they also create an equal new financial liability. Since FIs also own each others’ liabilities, they create increments of assets and liabilities. Still, intermediation does not affect total net worth. He concludes that although the increment of assets and liabilities does not increase total wealth or income, we can assume that it increases welfare.

(ix) Provide Liquidity:

FIs provide liquidity when they convert an asset into cash easily and quickly without loss of value in terms of money. When FIs issue claims against themselves and supply funds they, especially banks, always try to maintain their liquidity.

This they do by following two rules: first, they make short-term loans and finance them by issuing claims against themselves for longer periods; and second, they diversify loans among different types of borrowers.

(x) Help in Lowering Interest Rates:

Competition among FIs leads to the lowering of interest rates. FIs prefer to keep their savings with FIs rather than in cash. The FIs, in turn, invest them in primary securities. Consequently, prices of securities are bid up and interest rates fall.

Moreover, when people keep their cash holdings with FIs which are safe and liquid, the demand for money falls thereby lowering interest rates. This can be illustrated diagrammatically in Fig. 1. The supply of money is given, as shown by the vertical curve MS. The demand for money is shown by the curve MD. When FIs shrink the demand for money, the curve MD shifts to M,D, and consequently the interest rate falls from r to r₁

Patikin has shown in his Money, Interest and Prices (1965) that when the interest rate is influenced by FIs, it, in turn, affects the price level of the economy. The greater this effect is, the smaller will be the effect of FIs on the interest rate.

(xi) Low Interest Rates Benefit both Savers and Investors:

When interest rates decline, both savers and investors benefit. First, the real costs of lending to borrowers are reduced. These, in turn, tend to reduce costs and prices of goods and services. With reduction in interest rates, the return on time deposits is also reduced which induces savers to deposit their funds with FIs even though the latter pay lower interest rates.

Still the savers benefit because FIs provide greater safety, convenience and other related services to them thereby increasing the savers’ real return and income.

(xii) Bring Stability in the Capital Market:

FIs deal in a variety of assets and liabilities which are mostly traded in the capital market. If there were no FIs, there would be frequent changes in the demand and supply of financial assets and their relative yields, thereby bringing instability in the capital market.

As FIs function within a legal framework and set rules, they provide stability to the capital market and benefit savers and firms through diversified financial services. In fact, the extensive regulation under which FIs operate in advanced countries like the United States has reduced the threat of stock scam, as it occurred in India.

(xiii) Benefit to the Economy:

FIs are of immense help in the working of financial markets, in executing monetary and credit policies of the central bank and hence in promoting the growth of an economy. By transferring funds from surplus to deficit units, FIs create large financial assets and liabilities. They provide the economy with money supply and with near money assets.

Thus they help in the working of financial markets. Since the financial markets govern the working of the economy, the monetary and credit policies of the central bank are changed in such a manner from time to time that the financial markets function smoothly in the country. In fact, the growth of the economy is dependent upon the proper functioning of the financial system which, in turn, depends to a large extent upon the FIs.

2. Role of Financial Intermediaries in Economic Growth:

Financial intermediaries which consist of commercial banks, cooperative credit societies, mutual savings funds, mutual funds, saving and loan associations, insurance companies, and other financial institutions, help in the growth process of the economy. They intermediate between ultimate lenders who are savers and ultimate borrowers who are investors. By performing this function they discourage hoarding by the people, mobilise their savings and lend them to investors.

Investors can borrow funds internally by using their own savings or/and externally by using the savings of others. FIs provide external finance. Savers who are ultimate lenders deposit their savings with FIs, and FIs, in turn, lend these funds to ultimate borrowers. The difference between lending and borrowing rates are the profits of FIs. FIs lend to borrowers by purchasing primary securities issued by the latter. These are bonds, equities, mortgages, bills, etc. FIs buy them with the funds kept by the savers with them.

They are, therefore, able to profit by this transformation process by exploiting the economies of scale in lending and borrowing. On the lending side, the intermediaries can invest and manage investments in primary securities at unit cost far below the experience of most individual lenders. The large size of their portfolios permits a significant reduction in risks through diversification.

They can schedule maturities of primary securities in such a manner that chances of liquidity crises are minimised. They are favoured with tax benefits that are not available to individual savers. On the borrowing side, with a large number of depositors they can normally rely on a predictable schedule of claims for repayment. Thus FIs encourage saving and investment which are essential for promoting economic growth.

Savings are essential for capital formation without which economic growth is not possible. Mere savings are not enough for capital formation. They are required to be mobilised which is done by FIs. Even mobilisation of savings does not lead to capital formation. They must be channelised into productive investments. By lending to ultimate borrowers, FIs promote investment.

Thus the role of FIs in the growth process is partly that of buying securities of one kind from borrowers and selling securities of another kind to lenders, and thereby contributes to an increase in the willingness to save and the inducement to invest. More importantly they try to find out better investment opportunities and facilitate their exploitation by helping industry.

Among other factors, investment depends upon the rate of interest. The lower the interest rate, the higher is the investment. Competition among FIs for primary securities raises their prices and lowers the interest rate. Moreover, when savers keep their cash holdings with FIs which involve less risk, and are safe and liquid, the demand for money falls which further lowers the interest rate.

The fall in interest rate encourages investment which increase the rate of capital formation and hence promotes economic growth. Goldsmith’s study has shown that the growth of FIs has been responsible for the economic growth of developed countries in a significant way.

3. Role of Financial Intermediaries in Under­developed Countries:

Financial intermediaries play a special role in under-developed countries. In such countries the capital market is unorganised and undeveloped. The majority of the people are poor and they cannot save. Those who save, invest their savings in gold, jewellery, real estate, speculation, foreign exchange, and conspicuous consumption.

Under these circumstances, FIs undertake the task of encouraging the flow of personal savings from unproductive to productive uses. They encourage households to hold financial assets instead of physical assets. To the extent households are willing to switch from the purchase of physical assets to financial assets to serve as their instruments of saving, resources are released for development purposes.

Further, as the economy develops, the non-monetized sector is gradually transformed into the monetized sector. With the increase in the rate of monetization of the economy, the banking habits of the people also grow. In such a situation, the commercial banks alone are not sufficient to mobilise savings and put them into productive channels. So the role of FIs becomes all the more important in mobilising and investing these savings for capital formation and economic development.

In UDCs, there is the absence of an environment for entrepreneurship because of the lack of effective lending institutions. FIs help small firms to a greater degree than the large firms. They find investment opportunities and facilitate their exploitation by helping small, and new enterprises in UDCs.

The growth of FIs in the course of development in such countries helps in economising the use of money. As these financial institutions grow, they sell indirect securities to savers. These securities are close substitutes for money. So the savers buy securities instead of keeping money in cash.

It is in this way that these financial intermediaries help in economising the use of money which, in turn, controls the money supply and the demand for goods and services from increasing. Thus FIs help in controlling inflation indirectly in underdeveloped countries.

4. Role of Financial Intermediaries in the Saving-Investment Process:

Financial intermediaries transmute funds between savers who lend and investors who borrow. They mobilise savings and channel them into the hands of investors who need more funds than they have on hand. In other words, they are conduits through which savers can lend their excess funds to investors.

FIs are commercial banks, cooperative societies and banks, mutual savings banks, mutual funds, savings and loan associations, insurance companies, merchant banks, unit trusts, and other types of financial institutions. They act as middlemen by transferring funds from savers to investors.

By lending their surplus funds, savers stand to gain because they earn interest or dividend on their funds. On the other hand, investors stand to benefit when they borrow to carry out their investment plans. Without financial intermediaries, savers would hoard their surplus funds, and investors (borrowers) would not carry out their investment plans except those who can finance internally.

The essential function of FIs is to satisfy simultaneously the portfolio preference of both savers and investors. Savers are ultimate lenders whose assets are bank deposits, insurance policies, pensions, etc. Investors are ultimate borrowers or non-financial units who wish to expand their holdings of such real assets as inventories, real estate, plant and equipment, etc. They finance these by issuing primary securities which are bonds, corporate equities, debts of individuals and businesses, mortgages, bills, etc. These are their liabilities.

FIs issue indirect or secondary securities. They are currency, demand and time deposits of commercial banks, and saving deposits, insurance and pension funds of nonfinancial intermediaries. FIs intermediate between original savers and ultimate borrowers or investors.

Savers deposit funds with FIs instead of directly purchasing bonds, mortgages or equities, and FIs, in turn, lend funds to ultimate borrowers. FIs acquire primary securities issued by ultimate borrowers, and in turn, issue their own secondary securities for the portfolio of ultimate lenders (savers).

In other words, investors sell securities to banks and receive newly created demand deposits in return in banks. These deposits are then spent on current output and ultimately accrue to the savers in the community as financial assets. Investors also sell securities to non-bank financial intermediaries. These, in turn, sell claim on themselves to the savers.

Thus the non-bank financial intermediaries are able to supply debt instruments particularly suitable to the needs of the borrowers independent of the type of assets that the lenders want. Similarly, they offer financial assets to the lenders independent of the type of debt instrument the borrowers are prepared to issue.

Besides bringing savers and lenders together, FIs transmute the primary securities issued by the nonfinancial units (borrowers) into secondary securities (issued by FIs themselves) possessing greater liquidity, convenience, lower risk, etc. in order to attract wealth holders (savers). Thus FIs turn primary securities into secondary securities for the portfolio of ultimate lenders.

They give lenders a wide variety of financial assets particularly suited to their needs. They also make it less necessary for borrowers to issue those types of securities which are ill-adapted to their own businesses. Thus FIs by liquifying and diversifying the securities issued by the lenders encourage saving or discourage dissaving.

Further, the techniques of intermediation get primary securities distributed efficiently from ultimate borrowers to ultimate lenders and from one lender to another through dealers and security exchanges. They tend to raise the level of saving and investment by increasing the marginal utility of last dealer’s worth of financial assets to the lender and reducing the marginal disutility of the last dealer’s worth of debt to the borrower.

They also tend to increase the efficiency of resource allocation by placing more investment projects against one another for lenders to examine. Thus FIs are able to improve the efficiency of distributive techniques of intermediation in many ways. Their role in the saving-investment process is quite similar to that of distributive techniques, lotteries or land sales. They enable investors to spend more efficiently.