Financial Intermediaries – Financial Intermediary Definition
A financial intermediary is an entity that acts as the middleman between two parties in a financial transaction. Intermediaries include commercial banks, investment banks, mutual funds, or pension funds. Financial intermediaries provide a middle ground between two parties in any financial transaction. For example, a bank serves many different roles. It acts as a middleman between a borrower and a lender, and pools together funds for investment.
Financial intermediaries offer a number of benefits to the average consumer. Benefits include safety, liquidity, and economies of scale involved in banking and asset management. In certain areas, such as investing, advances in technology threaten to eliminate the financial intermediary. However, other areas of finance, like banking and insurance still rely on the services intermediaries provide.
Financial intermediaries serve as middlemen for financial transactions between banks or funds. These intermediaries help create efficient markets and lower the cost of doing business. Intermediaries can provide leasing or factoring services, but do not accept deposits from the public. Financial intermediaries offer the benefit of pooling risk, reducing cost, and providing economies of scale.
How Financial Intermediaries Work
Financial intermediation refers to the practice of linking an investor and borrower. Acting as a third party, an intermediary aims to meet the financial needs of both parties. Looking at the bigger picture, intermediaries benefit consumers and businesses alike. They offer services on a larger economy of scale than would otherwise be possible. A financial intermediary serves two fundamental purposes – generating funds and managing the payments systems. A non-bank financial intermediary does not accept deposits from the general public. Instead, the intermediary may provide factoring, leasing, insurance plans, or other financial services. Many intermediaries take part in securities exchanges. They utilize long-term plans for managing and growing their funds. The overall economic stability of a country may be shown through the activities of financial intermediaries and the growth of the financial services industry.
Financial intermediaries move funds from parties with excess capital to parties needing funds. The process creates efficient markets and lowers the cost of conducting business. For example, a financial advisor connects with clients through purchasing insurance, stocks, bonds, real estate, and other assets. Banks connect borrowers and lenders by providing capital from other financial institutions and from the Federal Reserve. Insurance companies collect premiums for policies and provide policy benefits. A pension fund collects funds on behalf of members and distributes payments to pensioners.
Types of Financial Intermediaries
When it comes to financial intermediaries, there is a long list of those who qualify. Oftentimes, people may not even realize that they are interacting with a middleman who is just overseeing the transaction in question. Financial intermediaries have emerged as a useful tool for the efficient market system. They help channel savings into investment. Without these entities, the investment markets would be crippled and unable to operate.
- Bank – A bank is a financial intermediary that is licensed to accept deposits from the public and create credit products for borrowers. Banks are highly regulated by governments, due to the role they play in economic stability. They are also subject to minimum capital requirements based on a set of international standards known as the Basel Accords.
- Credit union – A credit union is a type of bank that is member-owned. It operates on the principle of helping members access to credit at competitive rates. Unlike banks, credit unions are established to serve their members and not necessarily for-profit purposes. Credit unions claim to provide a wide variety of loan and saving products at a relatively lower price than other financial institutions offer. They are governed by a board of directors, who are elected by the members.
- Mutual funds – Mutual funds pool savings from individual investors. They are managed by fund managers who identify investments with the potential of earning a high rate of return. Then, they allocate the shareholders’ funds to the various investments. This enables individual investors to benefit from returns that they would not have earned had they invested independently.
- Stock Exchanges – The stock exchange facilitates the trading of securities and stocks. In every trading activity, it charges the brokerage from each party which is its profit.
- Financial advisors – A financial advisor is an intermediary who provides financial services to clients. In most countries, financial advisors must undergo special training and obtain licenses before they can offer consultancy services. In the U.S., the Financial Industry Regulatory Authority provides the series 65 or 66 licenses for investment professionals, including financial advisors. (Source: corporatefinanceinstitute.com)
Benefits of Financial Intermediaries
Through a financial intermediary, savers can pool their funds enabling them to make large investments. This in turn benefits the entity in which they are investing. At the same time, financial intermediaries pool risk by spreading funds across a diverse range of investments and loans. Loans benefit households and countries by enabling them to spend more money than they have at the current time.
Financial intermediaries also provide the benefit of reducing costs on several fronts. For instance, they have access to economies of scale. Also, they expertly evaluate the credit profile of potential borrowers and keep records and profiles cost-effectively. Last, they reduce the costs of the many financial transactions an individual investor would otherwise have to make if the financial intermediary did not exist.
Business intermediation offers many benefits to all parties involved. When using a financial intermediary, savers can make larger investments by pooling funds together. At the same time, businesses gain access to a broader pool of investors. Here are some additional advantages provided by business intermediation:
- Reduced costs – By growing economies of scale, costs are kept lower for start-up businesses or borrowers. Operational costs, paperwork, and credit analysis are all handled at scale.
- Reduced risk – Funds are spread across a diverse range of investment types. A diversified portfolio spreads out the risk of capital loss.
- Reduced fraud – Intermediaries also reduce the risk of fraudulent behavior as they have additional security measures in place.
- Convenience – Rather than spending time on research, investors are connected with borrowers via a third party who does all the work.
- Greater liquidity – Financial intermediaries have the assets in place to allow for greater asset liquidity. Borrowers can withdraw funds as needed.
However, there are also a few disadvantages to financial intermediaries. Here are some of the potential drawbacks to be aware of:
- Lower investment returns – Because the intermediary has its own financial interests, the returns are not as high as they would be without the middleman. Additional commission fees or expenses may be charged.
- Mismatched goals – A financial intermediary may not be working as an impartial third party. They may offer investment opportunities that come with hidden risk or that don’t align with an investor’s best interests.
Example of Financial Intermediaries in Action
In July 2016, the European Commission took on two new financial instruments for European Structural and Investment (ESI) fund investments. The goal was to create easier access to funding for startups and urban development project promoters. Loans, equity, guarantees, and other financial instruments attract greater public and private funding sources. As a result, they may be reinvested over many cycles as compared to receiving grants.
One of the instruments, a co-investment facility, is to provide funding for startups. The goal is to develop their business models and attract additional financial support. They achieve this through a collective investment plan managed by one main financial intermediary. The European Commission projected the total public and private resource investment at approximately €15 million (approximately $17.75 million) per small- and medium-sized enterprise. (Source: investopedia.com)
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