FINANCIAL INTERMEDIARIES
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27th, February, 2012
Introduction
Financial markets bring together the borrowers and lenders, who transact with financial assets, depending on the type of needs they all have. This has therefore, resulted in the argument about the role or the importance of financial intermediaries in financial markets. Financial intermediaries in financial markets are of essence to both the borrowers and the lenders, and therefore, their role in financial markets cannot be underestimated (Besley and Brigham 2011). In this essay, I will discuss the importance of financial intermediaries in financial markets by identifying the roles these play in financial markets, including both the positive and negative ways. Nonetheless, from this essay, one will understand that financial intermediaries are here to stay, considering their positive influence in the economy, which supersedes their negative influence in the economy.
Financial markets exist in almost all countries in the world, as these play an important role in the economy of a country. A financial market can be defined as a type of market where there is the trade of money and other assets, which are in the form of finances. In this kind of market, financial assets are traded in different manners. For instance, this includes the exchange of previously traded financial assets, as well as the trade of new financial assets. Besley and Brigham (2011) note that, financial markets are different from asset markets, and that this is a conceptual term, since financial markets lack a specific location, as in the case of asset markets. In the financial markets, borrowers and lenders interact at different levels. Therefore, there is also borrowing and lending activities in financial markets. There are different examples of financial markets in the world today, and these include but not limited to the New York Stock Exchange, which specializes in the selling of stock shares issued previously; the United States Treasury, bills auction, and the United States government bond market, among others. Financial institutions on the other hand, are those types of institutions, which make profits primarily basing on the transactions of financial assets. These include banks, discount brokers, and insurance firms, among others (Besley and Brigham 2011).
Financial markets are significant to an economy, because of the roles they play in a country. First, financial markets enable lending and borrowing to take place. This is through the granting of purchasing power to various agents, to transfer funds for different purposes, including investments and consumption (Burton, Nesiba & Brown 2009). Financial markets also play a significant role in determining prices for new financial assets and the existing ones. These also allow for the risk sharing between providers of funds and the investors. In addition, the stockholder in a financial market is given an opportunity to resell their financial assets, a process known as liquidity. Finally, financial markets help in the reduction of both the costs incurred in transaction and information, thus increasing the level of efficiency. Besley and Brigham emphasize the importance of financial markets, as enabling the flow of cash in the economy, since these avail different ways for lenders and borrowers to transact financially (2011).
In the financial markets, there are different types of players, just as the case of any ordinary market dealing with goods and services. These various players in financial markets are what are referred to as ‘financial institutions.’ These mainly make their profits from the transactions between the borrowers and lenders in the financial markets. These financial institutions in the United States of America are classified into four major broad categories. These include brokers, financial intermediaries, dealers, and investment bankers. All these have their specific functions in financial markets, and therefore, are of high value. Sometimes, the financial markets might not be able to survive without these four categories of players in the market. This essay will however dwell on the ‘financial intermediaries,’ and why their presence in financial markets is important, even though financial markets can bring lenders and borrowers together by themselves (Burton, Nesiba & Brown 2009).
The first and most important reason why financial intermediaries exist in financial markets is that these act as an entry point to both the lenders and borrowers in financial markets. Today, most people, who are lenders and borrowers in financial markets, will find their way into the financial markets through the financial intermediaries. The most popular financial intermediaries in different countries are the ‘commercial banks.’ These are existent in the macroeconomics. However, other intermediaries include loan associations, credit unions, pension funds, and mutual funds (Burton, Nesiba & Brown 2009). When people deposit their money in banks, the money does not just lie in the banks, instead, the banks use the money for various purposes, which bring them interests. This especially includes loaning out the money to different individuals to meet their different needs and giving out loans to people interested in buying homes, through the mortgage. In this case, the bank benefits from other people’s money, which they deposit in order to save. It is also possible that a person who has money can seek people interested in borrowing this money, instead of depositing it in a bank. In this case, the owner of the money is the one who benefits from the interests on the loan. Therefore, it is possible for savers to do away with the financial intermediary so that the get a higher return on their money, instead of the intermediary, who gets the highest return from the savers’ money. However, this is not the case today, as most people prefer using financial intermediaries, and it is hard to do away with them (Sinha 2001). Therefore, the question that emerges is ‘why are the financial intermediaries important in financial markets?’
Apart from serving as an entry for lenders and borrowers into the financial market, the financial intermediaries play other very important roles, no wonder they keep rising in the economy. It is less risky for a person to lend out their financial assets using the financial intermediaries, than lend out directly. The main reason is that a financial intermediary has more financial security, compared to an individual saver. On the part of a financial intermediary, it is possible for the institution to diversify. In addition, financial intermediaries give out many loans to people, compared to an individual saver, who might make only a few loans. Therefore, financial intermediaries are in a higher position to withstand losses, compared to an individual saver, who will fall out if they experience great losses. Therefore, this is why most people will prefer to use the intermediary in their financial transactions, as security is key in matters concerning finances (Sinha 2001).
Financial intermediaries guarantee agents security, since they know about different strategies of reducing risks. The financial intermediaries, compared to an individual saver, are exposed to a greater number of people, and this is beneficial to them as institutions. First, having diverse loanees helps financial intermediaries to be able to predict well the nature of these borrowers, and establish the characteristics of borrowers who can be trusted to repay the loan, and the nature of those borrowers who cannot be trusted to repay a loan. An individual saver might lack the experience and knowledge of establishing and differentiating between a trustful borrower and one that cannot be trusted to repay the loan. In this case, therefore, an individual saver might dish out loans to the wrong borrowers, who might not repay, thus leading to losses, and probably falling out of business. On the other hand, financial intermediaries will predict well the nature of a borrower, and will therefore give out loans to borrowers, who will repay the loans within the stipulated time (Smart & Megginson 2008).
Engerman (2003) notes that, financial intermediaries in financial markets offer liquidity to the savers. Through liquidity, savers are able to change or convert non-financial assets into financial assets, within a short time. For instance, a house is an asset, which illiquid. Therefore, if one needs money urgently, it might require them a lot of time to find a willing buyer for the house. This is the case with an individual lender and borrower. It might be hard for a borrower to pay back the lender’s loan, if it was an illiquid asset, and the lender needs the repayment within the shortest time possible. Here, the borrower might be forced to seek another person who can purchase the loan from him, which is also hard. Therefore, when people transact directly, liquidity is not guaranteed in the course of their transactions. On the other hand, financial intermediaries are able to provide liquidity to savers. Only in rare circumstances will these fail to provide this. Nonetheless, if this happens, these financial intermediaries can seek financial aid from their governments, which they can still paid back after stabilizing back to normal (Engerman 2003).
Financial intermediaries in financial markets also contribute to the market when they trade among themselves. In the United States’ federal-funds market, banks and borrow money from each other, and lend to each other. These banks also participate in the purchase and trading of foreign exchange. Therefore, these banks, being financial intermediaries in the financial markets, not help the borrowers and lenders in their participation in the financial markets, but they also contribute positively to a county’s economy, when they operate their business and transact successfully (Engerman 2003).
Although financial intermediaries are beneficial in the financial markets and to the economy of a country in general, some of the threats these pose cannot be overlooked. Today, some economists have questioned the usefulness of financial intermediaries in financial markets. These claim that the financial intermediaries are a threat to the economy, in case their financial operations backfire or in case they experience great losses that cannot be recovered. This is so because of different reasons. First, most financial intermediaries, such as banks, normally have debts, and their debt is in form of money. Therefore, if these encounter experiences that influence them negatively and destabilize them, this means that the flow of money in a country’s economic system will as well be influenced negatively, and destabilized too. When this takes place, the concerned country suffers economically (Burton, Nesiba & Brown 2009).
Secondly, according to Sinha (2001), financial intermediaries are considered a threat to the economy because, these intermediaries are interconnected, with other financial bodies through financial assets and debts, and together, these form a network. Therefore, in this network, one financial body influences the other, since it is like a chain. This means that, if one intermediary succeeds, this will strengthen the chain and bond. On the other hand, if one or more of the intermediaries collapse or lose out, the chain will weaken, and might even break, if the impact is big. If this is the case, most financial institutions will be influenced adversely. If this effect is immense, the economy of a country might as well get injured, or even collapse if it is hit the hardest. Therefore, financial intermediaries, apart from being beneficial in financial markets, they also pose serious risks to the economy, in case they fail to succeed.
Smart and Megginson (2008) note that today, financial markets have continued to grow, but the importance of financial intermediaries has kept decreasing, as far as their interaction with corporations is concerned. Today, most corporations do not turn to financial intermediaries, such as banks, for a debt or for borrowing. Instead, these seek such services from capital markets. Financial intermediaries today therefore, deal with more individuals and groups, compared to corporations.
In conclusion, financial intermediaries play an important role in financial markets. These act as an entry point for lenders and borrowers into the financial market. Additionally, these facilitate borrowing and lending activities among agents. It is more advantageous for one to lend or borrow through intermediaries, as compared to directly through another individual saver. Intermediaries guarantee participants in the financial market, security, since these are more stable than individual savers, and therefore, are more stable and strong to counter different economic waves, while ensuring smooth and uninterrupted transaction with its clients. Therefore, these are some of the reasons why the presence of intermediaries in financial markets is justified. However, these need to be managed with expertise, as they are volatile, and any wrong financial decision undertaken is capable of resulting into great losses of the intermediary. This loss will eventually be transferred to the national economy, which might be crippled in the process. Nonetheless, as far as intermediaries are of essence in financial markets, these should be managed with great expertise, as their failure poses a risk to the economy of a country.
Works Cited
Besley, S. & Brigham, E 2011, Principles of Finance, Cengage Learning, New York.
Burton, M., Nesiba, R. & Brown, B 2009, An Introduction to Financial Markets and Institutions,
M.E. Sharpe, London.
Engerman, S 2003, Finance, Intermediaries, and Economic Development, Cambridge University Press, London.
Sinha, T 2001, “The Role of Financial Intermediation in Economic Growth: Schumpeter Revisited,” (in Dahiya, B. and Orati, V. (eds.) Economic Theory in the Light of Schumpeter’s Scientific Heritage, Spellbound Publishers, Rohtak, India.) Viewed 26 February 2013 < http://icpr.itam.mx/papers/SinhainDahiya.pdf>
Smart, S. & Megginson, W 2008, Corporate Finance, Cengage Learning EMEA, New Jersey.
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