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Financial Intermediaries: What are they and how do they work?

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Last editedNov 20203 min read

Financial intermediaries provide a middle ground between two parties in any financial transaction. A prime example would be a bank, which serves many different roles: it acts as a middleman between a borrower and a lender, and pools together funds for investment. However, there are many types of financial intermediaries, which we’ll explore below.

Financial intermediation meaning

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 to mutual satisfaction. Looking at the wider picture, intermediaries benefit consumers and businesses alike by offering services on a larger economy of scale than would otherwise be possible. A financial intermediary serves two fundamental purposes:

  • Creating funds

  • Managing the payments systems

Typically, the intermediary accepts a deposit from the investor or lender, passing this on to the borrower at a high interest rate to make up their own margin. At the same time, they make the market more efficient by conducting these activities on a large scale, lowering the overall cost of doing business.

How does the intermediation process work?

When banks act as financial intermediaries, they can accept deposits. However, other types of intermediaries don’t involve a deposit. Instead, the intermediation process involves the movement of funds from one party to another. The intermediary acts as a factor in this case, managing the cash flow.

Examples of this type of intermediary could include a financial advisor, who connects investors with businesses, or a pension fund that collects money from members and distributes payments to pensioners.

What are the types of financial intermediaries?

As you can see, there are many different types of financial intermediaries, from banks to private equity firms. Here’s a non-exhaustive list of some of the different types of organisations that fall into this business category.

  • Banks: Commercial and central banks serve as financial intermediaries by facilitating borrowing and lending on a widespread scale. Credit unions and building societies also work in the same way, but on a cooperative basis.

  • Stock exchanges: Investors can buy and sell stocks via a third-party stock exchange, facilitating security trading.

  • Mutual funds: These actively manage capital pooled together by shareholders. Fund managers make recommendations and purchase stock in companies, serving as middlemen between the businesses and investors. A mutual fund can benefit all parties involved, providing companies with capital and shareholders with assets.

  • Financial advisors: Investment brokers or financial advisors provide an additional level of guidance. They give expert advice to businesses or individuals, collecting funds and investing them in bonds, equities, or securities.

  • Insurance companies: An insurance company also qualifies as a financial intermediary because it takes the money from businesses or individuals to secure them against various risks. Insurance premiums are pooled together to pay for claims as necessary.

Advantages of business intermediation

Business intermediation offers myriad 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 behaviour 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.

Disadvantages of business intermediation

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.

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