The term financial intermediary may refer to an institution, firm or individual who performs intermediation between two or more parties in a financial context. Typically the first party is a provider of a product or service and the second party is a consumer or customer.
Financial intermediaries are banking and non-banking institutions which transfer funds from economic agents with surplus funds (surplus units) to economic agents (deficit units) that would like to utilize those funds. FIs are basically two types: Bank Financial Intermediaries, BFIs (Central banks and Commercial banks) and Non-Bank Financial Intermediaries, NBFIs (insurance companies, mutual trust funds, investment companies, pensions funds, discount houses and bureaux de change).
Financial intermediaries can be:
- Building Societies;
- Credit Unions;
- Financial adviser or broker;
- Insurance Companies;
- Life Insurance Companies;
- Mutual Funds; or
- Pension Funds.
The borrower who borrows money from the Financial Intermediaries/Institutions pays higher amount of interest than that received by the actual lender and the difference between the Interest paid and Interest earned is the Financial Intermediaries/Institutions profit.
Financial Intermediaries are broadly classified into two major categories:
1) Fee-based or Advisory Financial Intermediaries
2) Asset Based Financial Intermediaries.
Fee Based/Advisory Financial Intermediaries: These Financial Intermediaries/ Institutions offer advisory financial services and charge a fee accordingly for the services rendered.
Their services include:
i. Issue Management
iii. Portfolio Management
iv. Corporate Counseling
v. Stock Broking
vi. Syndicated Credit
vii. Arranging Foreign Collaboration Services
viii. Mergers and Acquisitions
ix. Debentive Trusteeship
x. Capital Restructuring
ASSET-BASED Financial Intermediaries: These Financial Intermediaries/Institutions finance the specific requirements of their clientele. The required infra-structure, in the form of required asset or finance is provided for rent or interest respectively. Such companies earn their incomes from the interest spread, namely the difference between interest paid and interest earned.
The financial institutions may be regulated by various regulatory authorities, or may be required to disclose the qualifications of the person to potential clients. In addition, regulatory authorities may impose specific standards of conduct requirements on financial intermediaries when providing services to investors.
Role of Financial Intermediaries for Poverty Reduction
Finding innovative ways to provide financial services to the poor so that they can improve their productive capacity and quality of life is the role of the financial intermediaries in the 21st century.
Most of the poor live in the rural areas, and are engaged in agricultural activities or a variety of micro-enterprises.
- The poor are vulnerable to income fluctuations and hence are exposed to risk.
- They are unable to access conventional credit and insurance markets to offset this.
Most formal financial institutions do not serve the poor because of perceived high risks, high costs involved in small transactions, perceived low profitability, and most importantly, inability to provide the physical collateral generally required by such institutions. About 95 percent of poor households still have little access to institutional financial services. Most poor and low-income households continue to rely on meager self-finance or informal sources of finance.
Providing efficient micro-finance to the poor is important for many reasons:
- Efficient provision of savings, credit and insurance facilities can enable the poor to smoothen their consumption, manage risks better, gradually build assets, develop micro-enterprises, enhance income earning capacity, and generally enjoy an improved quality of life.
- Efficient micro-finance services can also contribute to improvement of resource allocation, development of financial markets and system, and ultimately economic growth and development.
- With improved access to institutional micro-finance, the poor can actively participate in and benefit from development opportunities.
- The latent capacity of the poor for entrepreneurship would be encouraged with the availability of small-scale loans and would introduce them to the small-enterprise sector.
- This could allow them to be more self-reliant, create employment opportunities, and, not least, engage women in economically productive activities.
- Micro-finance activities prove that poor households can and do save rather than borrow, and it is possible to successfully mobilize funds from poor households.
- Another important fact is that contrary to expectations, the poor are creditworthy and financial services can be provided to the poor on a profitable basis at low transaction costs without having to rely on physical collateral.
- Finally, micro-finance services contribute to the development of rural financial markets and to strengthening the social and human capital of the poor.
There are many problems that should be resolved for the further development of micro-finance in Poverty Reduction:
- Policy environments in many developing countries are not favorable for the sustainable growth of micro-finance. In particular, interest rate ceilings and subsidized credit limit the ability of micro-finance institutions to provide services to the poor.
- Inappropriate and extensive intervention by governments in micro-finance undermines its efficient operation.
- Inadequate financial infrastructure is another major problem in the region. Financial infrastructure includes legal, information, and regulatory and supervision systems.
- In addition, most microfinance institutions do not have adequate capacity to expand the scope and outreach of services on a sustainable basis to potential clients. Specifically, they lack the ability to leverage funds, provide services compatible with the potential clients' characteristics, adequate network and delivery mechanisms, and so forth.
Financial Intermediaries as Markets for Firm's Assets
- Financial intermediaries appear to have a key role in the restructuring and liquidation of firms in distress. In particular, there is rich evidence that financial intermediaries play an active role in the reallocation of displaced capital, meant both as the piece-meal reallocation of assets (such as the redeployment of individual plants) and, more broadly, as the sale of entire bankrupt corporations to healthy ones. A key part of reorganization under main bank supervision or management is the implementation of a plan of asset sales with proceeds typically used to recover bank loans. In Germany a function of banks during reorganizations is to "use bank contacts to facilitate a merger with another firm as a means of resolving the crisis". Knowing possible synergies among firms, banks can suggest solutions for the efficient reallocation of assets and of corporate control and that in several countries there is widespread anecdotal evidence, though not quantitative one, on this role of banks. Healthy firms search around for the displaced capital of bankrupt firms but matching is imperfect and firms can end up with machines unsuitable for them.
- Financial intermediaries arise as internal, centralized markets where information on machines and buyers is readily available, allowing displaced capital to migrate towards its most productive uses. Financial intermediaries can perform this role by aggregating the information on firms collected in the credit market. The function of intermediaries as matchmakers between savers and firms in the credit market can support their function as internal markets for assets. Intuitively, by increasing the number of highly productive matches in the credit market, intermediaries increase the share of highly productive second hand users in the decentralized resale market. This improvement in the quality of the decentralized secondary market reduces the incentive of firms to address financial intermediaries for their ability as re-deployers. However, by increasing the number of highly productive matches in the credit market, intermediaries create also wealthy buyers without assets and contribute to decrease the thickness of the decentralized resale market. This makes the decentralized market less appealing and increases the incentive of firms to use intermediaries as resale markets. When the quality improvement in the decentralized market is not too big and the second effect prevails, better matchmaking in the credit market supports the function of intermediaries as internal markets for assets.
Role of Pension Funds as Financial Intermediaries
Pension funds may be defined as forms of institutional investor, which collect pool and invest funds contributed by sponsors and beneficiaries to provide for the future pension entitlements of beneficiaries. They thus provide means for individuals to accumulate saving over their working life so as to finance their consumption needs in retirement, either by means of a lump sum or by provision of an annuity, while also supplying funds to end-users such as corporations, other households (via securitized loans) or governments for investment or consumption.
We now assess pension funds relative to the various financial functions one by one, in order correctly to identify the role funds play in stimulating change in the financial landscape.
- Clearing and settling payments: Pension funds have had an important indirect role in boosting the efficiency of the financial systems, by influencing the structure of securities markets. By demanding liquidity, pension funds help to generate it, firstly by their own activity in arbitrage, trading and diversification, secondly via the fact that liquidity is a form of increasing return to scale, as larger markets in which pension funds are active attract more trading, reducing costs and improving liquidity further. A third effect arises from funds' countervailing power as they press for improvements in market structure and regulation. These include deregulation and reduction in commissions, advanced communication and information systems, reliable clearing and settlements systems, and efficient trading systems, all of which help to ensure that there is efficient arbitrage between securities and scope for diversification.
- Provision of a mechanism for pooling of funds and subdivision of shares: Pension funds offer much lower costs of diversification by proportional ownership. Pension funds can also offer the possibility of investing in large denomination and indivisible assets such as property which are unavailable to small investors. Furthermore, pension funds reduce the cost of transacting by negotiating lower transactions costs and custodial fees. The direct participation costs to households of acquiring information and knowledge needed to invest in a range of assets, as well as in undertaking complex risk trading and risk management are reduced (although costs of monitoring the asset manager remain). The net effect is that individuals are likely to switch to pension funds from direct holdings of securities and from bank deposits.
- Provision of ways to transfer economic resources: Pension funds act in an unusual manner in this regard, in that they may increase the volume of saving besides the disposition of household funds. At a micro level, company or other obligatory pension funds can implement enforced saving by deferring wages and salaries, thereby reducing risk of a low replacement ratio. At a macro level, the increase in saving is not usually one-to-one, as increased contractual saving via pension funds is typically partly or wholly offset by declining discretionary saving. Pension funds increase the supply of long term funds to capital markets, and reduce bank deposits, even abstracting from changes in aggregate saving, so long as households do not increase the liquidity of the remainder of their portfolios fully to offset growth of pension assets.
- Provision of ways to manage uncertainty and control risk: Pension funds provide risk control directly to households via the forms of retirement income insurance they provide, an advantage which largely reflects the unusual (among financial intermediaries) link of pension funds to employers. To assist in undertaking this risk control function they diversify assets as noted above and also act in securities and derivatives markets to hedge and control risk.
- Providing price information: pension funds seek publication of information from companies directly, and press for market-value based accounting systems. This is of benefit to all users of the market - although it disadvantages banks, which in making loans tend to rely on private information not available to other investors.
- Providing ways to deal with incentive problems: Dealing with incentive problems in equity finance is one of the most crucial aspects of pension funds' activities as financial intermediaries. The basic issue in corporate governance is simply stated. Given the divorce of ownership and control in the modern corporation, principal-agent problems arise, as shareholders cannot perfectly control managers acting on their behalf. Managers, who have superior information about the firm and its prospects and at most a partial link of their compensation to the firms' profitability, may divert funds in various ways away from those who sink equity capital in the firm, notably expropriation or diversion to unattractive projects from a shareholder's point of view. Principal-agent problems in equity finance imply a need for shareholders such as pension funds to exert control over management, while also remaining sufficiently distinct to let them buy and sell shares freely without breaking insider trading rules. If difficulties of corporate governance are not resolved, these market failures in turn also have implications for corporate finance in that equity will be costly and often subject to quantitative restrictions. Effectiveness of corporate governance is typically enhanced by presence of large investors, such as pension funds. They will have the leverage to oblige managers to distribute profits to providers of external finance either directly or via the threat to sell to takeover raiders. They are needed because individual investors may find it difficult to enforce their rights, owing to difficulty of acting in a concerted manner against management and related free rider problems which make it not worthwhile for an individual to collect information and monitor management. Since pension fund stakes are typically limited to 5% of a company, they also avoid the "downside" to dominant investors, who if they own a large proportion of the company may override the interests of minority shareholders and could even reduce measured profitability.