Role of Financial Intermediaries

Despite the important role of financial markets in attracting those who have funds to invest and efficiently allocating funds to those who need them, they may not always work. As a result, financial systems have come to require a specific type of financial entity, financial intermediation. This makes it difficult for borrowers or fund investors to deal directly with fund borrowers in the financial market. Financial intermediaries include regulated investment companies, depository institutions, non-deposit finance companies, investment banks and insurance companies.

The role of financial intermediaries is to create more favorable transaction terms than those realized by borrowers (investors) and borrowers dealing directly with each other in the financial market.

The role of financial intermediaries fulfills two major steps in the process.

Obtaining funds from lenders or investors.
They lend or invest funds to those who need funds.

The funds borrowed by the financial intermediary depend on the financial claim, either the financial intermediary's debt or the financial intermediary's equity participation. Funds that a financial intermediary provides or invests become the property of the financial intermediary.

Let's look at two examples of the use of financial intermediaries:

Commercial banks
Mutual funds

Commercial banks: - We all know that commercial bank is a type of deposit institution. A commercial bank accepts deposits from individuals, corporations and governments. These depositors are lenders to the merchant bank. Funds received by the merchant bank become the liability of the merchant bank. In turn, the bank provides these funds either by lending or by buying securities. Loans and bonds become assets of a merchant bank.

Mutual funds: - A mutual fund is a type of controlled investment company. A mutual fund accepts funds from investors who in return receive shares of the mutual fund. A mutual fund in turn invests those funds in a portfolio of financial instruments. Mutual fund shares represent an equity interest in a portfolio of financial instruments. Financial instruments are the assets of a mutual fund.

Generally this process allows financial intermediaries to convert financial assets. Investing in other financial assets is less desirable for a large portion of the investing public who have a greater preference for their own liabilities. This asset transformation provides at least one of the three economic functions of maturity intermediation, risk mitigation through diversification, and cost reduction for contracting and information processing.

Services that financial intermediaries can provide.

Facilitating trading of financial assets for clients of financial intermediaries through brokerage arrangements.
Facilitating the trading of financial assets using own capital to take other positions in financial assets to accommodate customer transactions.
Helping create financial assets for its customers and then distribute those financial assets to other market participants.
Providing investment advice to clients.
Providing payment mechanism.

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