Finance is the lifeblood of a business. Every entrepreneur needs finance for establishing a business, operating and developing it and for its expansion and diversification. But, entrepreneurs do not have enough funds in their own pockets to manage each and every activity. So, they seek to raise loans from various financial institutions or they seek the help of the financial market.
On, the other hand, individuals who form a major part of the household sector earn income, but, they do not spend the entire part of the income earned for fulfilling their consumption or other needs, they save or invest some or large portion of their income earned. Instead of keeping their savings idle they favor to deposit their surplus in financial institutions or invest them in the financial market.
So, here comes the role of the financial system in an economy. Financial System provides necessary lubricant to run each and every sector of the economy. A Financial System is a set of individuals, institutions and financial markets which trade in various financial instruments and provide various financial services which helps in capital formation.
Financial System has four major components which includes: financial institutions, financial markets, financial instruments and financial services.
A financial system cannot run on its own, so, it needs players to form a link between various parties associated with it. Thus, financial intermediaries serve as the link through the process of financial intermediation. What is financial Intermediation?
Financial Intermediation consists of two words: Financial, which signifies finance or monetary perspective and intermediation which simply means, a linkage. In simple words, financial intermediation is the process of channelizing funds from savers to borrowers or simply, from those who have surplus funds to those who need funds in order to facilitate financial transactions. The persons who provide such linkage are known as financial intermediaries, who act as middlemen between lenders and borrowers and help in mobilization of savings thus, resulting in capital formation.
For Example:
FINANCIAL FINANCIAL
INSTITUTIONS MARKETS
Now, here in the above flow chart, say, Company named as Company X wants to expand its operations, and it needs funds for the expansion purpose, so, it has two options, it can either raise funds by way of loans from financial institutions or it can raise funds from the general public by introducing IPOs, shares etc.
On the other hand, an individual say, Individual Y, is having surplus funds, instead of keeping it idle he wants to invest his surplus savings so that he may earn some interest or profit, he also has two options, he can either deposit the excess funds in financial institutions such as banks, or he can invest his savings in various securities to generate profit. Thus, it signifies that, financial institutions and financial markets serve as an intermediary and creates a network between Company X and Individual Y.
Moreover, all banking institutions act as intermediaries and many non-banking institutions also act as intermediaries, when they do so they are known as non-banking financial intermediaries (NBFIs). The various types of financial intermediaries are: banks, insurance companies, credit unions, stock exchanges, pension fund institutions, brokers, building societies, mutual fund companies etc.
Financial intermediation is a crucial process in a financial system which offers many advantages, some of the advantages are:
Saves time and costs: The process of financial intermediation helps in saving time and costs as there is no need for savers/lenders and borrowers to search for each other for the purpose of lending and borrowing, financial intermediaries provide a linkage between both the parties.
Capital Formation: By providing a link between savers and borrowers the process channelizes funds and results in mobilization of savings which further leads to capital formation and thus, overall economic development.
Convenient: It is a convenient process as savers can choose any investment plan and borrowers too can borrow as per their borrowing terms, through financial intermediaries there is no need to depend upon each other’s plans and terms, thus, helping both the parties.
Greater Liquidity: The process helps in liquidity as financial intermediaries such as banks allow savers to withdraw their deposited funds at any time and borrowers can also use the borrowed money at any time whenever the need arises.
Safe: It is a safe way of lending and saving as financial intermediaries are regulated by various financial bodies and they are governed by various rules and norms formed by financial bodies. This helps in investor protection and there is no exploitation of the borrowers as well. So, financial intermediaries act as trustworthy sources of finance.
Financial Specialists: Financial intermediaries act as financial specialists as they have wide knowledge about the financial system, so they help in providing better investment opportunities to investors and they also provide better borrowing plans to borrowers which charge them low rate of interest. Thus, the process offers specialization.
Maturity Transformation: Savers generally want to invest for short time and borrowers generally want to borrow for long time, so through the process of financial intermediation, financial intermediaries such as banks, helps in converting short-term savings to long-term borrowings which is nothing but, maturity transformation.
For every light side there is a darker side as well, because both dark and light are opposite to each other and opposite values are always complementary to each other, so, with advantages of the process of financial intermediation, there are some disadvantages too, following are some disadvantages of financial intermediation process:
Lower Returns: Financial intermediaries generally want to make profits, in the process of financial intermediation, intermediaries such as banks, accept deposits from depositors and pay them interest on the amount deposited by them, and on the other hand, they grant loans to borrowers charging them rate of interest on their borrowings, but they pay low rate of interest on the deposits in comparison to the interest amount charged on loans, the difference between interest charged on loan amount and interest paid by banks on deposits is their profit which is known as spread. So, it generates low returns to savers and charges more interest from borrowers.
Conflicting issues: Sometimes the goals of investors and financial intermediaries contradict each other’s point because an investor wants to make more money and financial intermediaries aim to generate more profits, so there may be conflicts between both the parties.
Fees and Charges: Financial intermediaries charge fees and commission for their work which may result in increased expenses for parties dealing with the intermediaries. There may be bank charges, brokerage fee, underwriting fee, transaction cost etc. which may reduce the return on the investment.
False Promises: Financial intermediaries may provide investment opportunities which may result in false promises if the investment fails to provide the promised return amount. There may be loss of money as well because financial intermediaries do not provide the information about the hidden risk involved in the opportunity.
Risk of loss: Risk can only be minimized, it cannot be eliminated. If an investor through an intermediary invests his funds in a company which runs away, then the ultimate loss is of the investor only, who may lose his funds. Moreover, if an investor invests his money in the financial market, and purchases shares of few companies then the price of a share may rise or fluctuate in every single second so, there is a risk of loss.
Lack of security: Some financial intermediaries deal in funds as per their own rules and norms, they may accept deposits and may lend money as per their own set structure or rules, in such case, they are not governed by regulators of financial system, so this may result in insecurity among depositors and borrowers as well. For example: money lenders charge high rates of interest on loans provided by them to the farmers.
So, it can be concluded that with various advantages, the process of financial intermediation suffers with some disadvantages too, and it is the duty of investors to invest and play safely and it is the responsibility of a borrower to borrow wisely after studying about various borrowing plans of various financial intermediaries. Financial intermediation is the one the most important process in working of the financial system of an economy.
Written By: Sneha Chhabra
