BUS202: Principles of Finance

LEARNING OBJECTIVES

• Review the purpose and types of financial institutions
• Identify the roles played by financial intermediaries

KEY POINTS

• Financial intermediaries provide access to capital.
• Banks convert short-term liabilities (demand deposits) into long-term assets by providing loans; thereby transforming maturities.
• Through diversification of loan risk, financial intermediaries are able to mitigate risk through pooling of a variety of risk profiles.

TERMS

• pooling
  grouping together of various resources or assets

• financial intermediary
  A financial institution that connects surplus and deficit agents.

A financial intermediary is an institution that facilitates the flow of funds between individuals or other economic entities having a surplus of funds (savers) to those running a deficit of funds (borrowers). Banks are a classic example of financial institutions.

Banks provide a safe and accessible environment for individuals and economic entities to deposit excess funds Additionally, banks also provide a service by packaging deposits into loans that are made available to economic agents (individuals and entities) in need of funds.

Banks are the most common financial intermediaries. Banks convert deposits to loans and thereby increase access to capital by serving as a financial intermediary between savers and borrowers.

Though, perhaps the most well-known of financial intermediaries, banks represent only one intermediary within a larger group. Other financial intermediaries include: credit unions, private equity, venture capital funds, leasing companies, insurance and pension funds, and micro-credit providers.

Major functions of financial intermediaries

As noted, financial intermediaries provide access to capital. However, in conjunction with increasing access to funds, through their ability to aggregate funds, intermediaries also reduce the transaction and search costs between lenders and borrowers.

By repurposing funds from savers to borrowers financial intermediaries are able to promote economic growth by providing access to capital. Through diversification of loan risk, financial intermediaries are able to mitigate risk through pooling of a variety of risk profiles and through creating loans of varying lengths from investor monies or demand deposits, these intermediaries are able to convert short-term liabilities to assets of varying maturities.

Returning to the example of a bank used above, banks convert short-term liabilities (demand deposits) into long-term assets by providing loans; thereby transforming maturities. Additionally, through diversified lending practices, banks are able to lend monies to high-risk entities and by pooling with low-risk loans are able to gain in yield while implementing risk management.

Source: Boundless
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