Financial Intermediary

What Is a Financial Intermediary?

A financial intermediary is an entity that acts as the middleman between two
parties in a financial transaction, such as a commercial bank, investment bank,
mutual fund, or pension fund. Financial intermediaries offer a number of benefits
to the average consumer, including safety, liquidity, and economies of
scale involved in banking and asset management. Although in certain areas,
such as investing, advances in technology threaten to eliminate the financial
intermediary, disintermediation is much less of a threat in other areas of finance,
including banking and insurance.

Source: https://www.investopedia.com/terms/f/financialintermediary.asp

KEY TAKEAWAYS;OBJECTIVES

 Financial intermediaries serve as middlemen for financial transactions,

generally between banks or funds.
 These intermediaries help create efficient markets and lower the cost of
doing business.
 Intermediaries can provide leasing or factoring services, but do not accept
deposits from the public.
 Financial intermediaries offer the benefit of pooling risk, reducing cost, and
providing economies of scale, among others.

How a Financial Intermediary Works

A non-bank financial intermediary does not accept deposits from the general
public. The intermediary may provide factoring, leasing, insurance plans or other
financial services. Many intermediaries take part in securities exchanges and
utilize long-term plans for managing and growing their funds. The overall
economic stability of a country may be shown through the activities of financial
intermediaries and the growth of the financial services industry.
Financial intermediaries move funds from parties with excess capital to parties
needing funds. The process creates efficient markets and lowers the cost of
conducting business. For example, a financial advisor connects with clients
through purchasing insurance, stocks, bonds, real estate, and other assets. Banks
connect borrowers and lenders by providing capital from other financial
institutions and from the Federal Reserve. Insurance companies collect premiums
for policies and provide policy benefits. A pension fund collects funds on behalf of
members and distributes payments to pensioners.

Types of Financial Intermediaries

Mutual funds provide active management of capital pooled by shareholders. The
fund manager connects with shareholders through purchasing stock in
companies he anticipates may outperform the market. By doing so, the manager
provides shareholders with assets, companies with capital and the market with
liquidity.

According to the dominant economic view of monetary operations, [9] the following institutions are or
can act as financial intermediaries:

 Banks
 Mutual savings banks
 Savings banks
 Building societies
 Credit unions
 Financial advisers or brokers
 Insurance companies
 Collective investment schemes
 Pension funds
 cooperative societies
 Stock exchanges

According to the alternative view of monetary and banking operations, banks are not intermediaries
but "fundamentally money creation" institutions,[9] while the other institutions in the category of
supposed "intermediaries" are simply investment funds.[9]
Benefits of Financial Intermediaries
Through a financial intermediary, savers can pool their funds, enabling them to
make large investments, which in turn benefits the entity in which they are
investing. At the same time, financial intermediaries pool risk by spreading funds
across a diverse range of investments and loans. Loans benefit households and
countries by enabling them to spend more money than they have at the current
time. 

Financial intermediaries also provide the benefit of reducing costs on several

fronts. For instance, they have access to economies of scale to expertly evaluate
the credit profile of potential borrowers and keep records and profiles cost-
effectively. Last, they reduce the costs of the many financial transactions an
individual investor would otherwise have to make if the financial intermediary did
not exist. 

Example of a Financial Intermediary

In July 2016, the European Commission took on two new financial instruments
for European Structural and Investment (ESI) fund investments. The goal was
creating easier access to funding for startups and urban development project
promoters. Loans, equity, guarantees, and other financial instruments attract
greater public and private funding sources that may be reinvested over many
cycles as compared to receiving grants.

One of the instruments, a co-investment facility, was to provide funding for

startups to develop their business models and attract additional financial support
through a collective investment plan managed by one main financial
intermediary. The European Commission projected the total public and private
resource investment at approximately $16.5 million per small- and medium-sized
enterprise.

Definition of financial intermediaries


Functions and Examples of
Financial Intermediaries
 A financial intermediary is a financial institution such as bank, building
society, insurance company, investment bank or pension fund.
 A financial intermediary offers a service to help an individual/ firm to save
or borrow money. A financial intermediary helps to facilitate the different
needs of lenders and borrowers.
 For example, if you need to borrow £1,000 – you could try to find an
individual who wants to lend £1,000. But, this would be very time
consuming and you would find it difficult to know how reliable the lender
was.
 Therefore, rather than look for individuals to borrow a sum, it is more
efficient to go to a bank (a financial intermediary) to borrow money. The
bank raises funds from people looking to deposit money, and so can afford
to lend out to those individuals who need it.
Source: https://www.economicshelp.org/blog/6318/economics/functions-
and-examples-of-financial-intermediaries/

Examples of Financial Intermediaries

1. Insurance Companies
If you have a risky investment. You might wish to insure, against the risk of
default. Rather than trying to find a particular individual to insure you, it is easier
to go to an insurance company who can offer insurance and help spread the risk
of default.

2. Financial Advisers
A financial adviser doesn’t directly lend or borrow for you. They can offer
specialist advice on your behalf. It saves you understanding all the intricacies of
the financial markets and spending time looking for the best investment.
3. Credit Union
Credit unions are informal types of banks which provide facilities for lending and
depositing within a particular community.

4. Mutual funds/Investment trusts

These are mutual investment schemes. These pool the small savings of
individual investors and enable a bigger investment fund. Therefore, small
investors can benefit from being part of a larger investment trust. This enables
small investors to benefit from smaller commission rates available to big
purchases.

Benefits of Financial Intermediaries

1. Lower search costs. You don’t have to find the right lenders, you leave
that to a specialist.
2. Spreading risk. Rather than lending to just one individual, you can deposit
money with a financial intermediary who lends to a variety of borrowers – if
one fails, you won’t lose all your funds.
3. Economies of scale. A bank can become efficient in collecting deposits,
and lending. This enables economies of scale – lower average costs. If
you had to sought out your own saving, you might have to spend a lot of
time and effort to investigate best ways to save and borrow.
4. The convenience of Amounts. If you want to borrow £10,000 – it would
be difficult to find someone who wanted to lend exactly £10,000. But, a
bank may have 1,000 people depositing £10 each. Therefore, the bank
can lend you the aggregate deposits from the bank and save you finding
someone with the exact right sum.
Potential Problems of Financial Intermediaries

 There is no guarantee they will spread the risk. Due to poor management,
they may risk depositors money on ill-judged investment schemes.
 Poor information. A financial intermediary may become complacent about
spreading the risk and invest in schemes which lose their depositors
 money (for example, banks buying US mortgage debt bundles, which
proved to be nearly worthless – precipitating the global credit crunch.)
 They rely on liquidity and confidence. To be profitable, they may only keep
reserves of 1% of their total deposits. If people lose confidence in the
banking system, there may be a run on the bank as depositors ask for their
money bank. But the bank won’t have sufficient liquidity because they can’t
recall all their long-term loans. (This can be overcome to some extent by a
lender of last resort, such as the Central Bank and / or government)

What is a financial instrument? Definition and examples

A financial instrument is a monetary contract between parties. We can create, trade,

or modify them. We can also settle them. A financial instrument may be evidence of
ownership of part of something, as in stocks and shares. Bonds, which are contractual
rights to receive cash, are financial instruments.

Checks (UK: cheques), futures, options contracts, and bills of exchange are also
financial instruments.

Securities, i.e., contracts that we give a value to and then trade, are financial
instruments.

Put simply; a financial instrument is an asset or package of capital that we can trade.

The Association of Chartered Certified Accountants (ACCA) has the following

definition or a financial instrument:

“A financial instrument is any contract that gives rise to a financial asset of one entity
and a financial liability or equity instrument of another entity.”

“The definition is wide and includes cash, deposits in other entities, trade receivables,
loans to other entities. investments in debt instruments, investments in shares and other
equity instruments.”
A financial instrument can represent ownership of something, a loan that an investor made to the asset’s
owner, or a foreign currency.

Financial instrument – cash or derivative

Source: https://marketbusinessnews.com/financial-glossary/financial-instrument/

There are two main types of financial instruments, derivative or cash instruments.
Derivative instruments

Derivative instruments are instruments whose worth we derive from the value and
characteristics of at least one underlying entity. Assets, interest rates, or indexes, for
example, are underlying entities.

We also call them ‘derivatives.’ They are contracts whose values come from the
performance of an underlying entity.

Derivative instruments are securities that we link to other securities such as stocks or
bonds. ‘Stocks,’ in this context, means the same as ‘shares.’ Derivative instruments can
also be linked to Forex andCryptocurrencies.

According to TradingOnlineGuide.com, the term FOREX stands for the Foreign

Exchange Market.

Cash instruments

Cash instruments are instruments that the markets value directly. Securities, which are
readily transferable, for example, are cash instruments. Deposits and loans, where both
lender and borrower must agree on a transfer, are also cash instruments.

Financial instrument by asset class

We can also categorize financial instruments by asset class, depending on whether they
are debt or equity based.

Debt-based financial instruments reflect a loan the investor made to the issuing

entity.

Equity-based financial instruments, on the other hand, reflect ownership of the

issuing entity.

Regarding these types of financial instruments, Wikipedia writes:

“If the instrument is debt, it can be further categorized into short-term (less than one
year) or long-term.”

“Foreign exchange instruments and transactions are neither debt- nor equity-based and
belong in their own category.”
Source: https://www.proschoolonline.com/blog/financial-instruments-different-types-of-financial-
instruments

A financial instrument is a monetary contract between two parties which can be created, traded,
modified and settled. It can be evidence of ownership of an asset. “A financial instrument is any
contract that gives rise to a financial asset of one entity and a financial liability or equity instrument
of another entity.”

Debt vs Equity Instruments

Debt and Equity instruments differentiated based on them based on the type of claim that the holder
has on it. When the claim os for a fixed dollar amount it is a debt instrument. For example a car loan,
Infrastructure bonds issued by the Government of India, Bonds issued by private companies. Debt
instruments can be either short term less than one year or long term with tenure greater than one
year.

In comparison to this equity, instruments obligate the issuer of the financial instrument to pay the
holder an amount only if profits have been earned and after the debt payments are made. Common
examples of equity instruments are common stock or a partnership share in the business. However,
some securities fall in both these categories and have attributes of both. One such example is
preferred shares, convertible bonds.

Foreign Exchange

Foreign exchange does not fall into any of the above buckets and has its category. Foreign
exchange instruments in the form of cash are spot foreign exchange and in the form of exchange-
traded derivatives are currency futures and in the over the counter derivatives are foreign exchange
options and outright forwards. 

Instruments based on Types –

Cash vs Derivatives 

Cash instruments can be defined as the instruments whose value can be determined directly in the
markets and securities which are readily transferrable. Derivative instruments derive their value and
characteristics from an underlying asset, index, common stock. They can either be exchange-traded
or over the counter derivatives.  
1. Bonds – Bond is a type of long term debt instrument in which the issuer owes the holder debt
and is obligated to pay interest (coupon payments) for the specified amount of period (maturity
date) at a later date.
2. Loans – Loan is basically lending money from individuals, organizations, banks, trust etc.
Till the time the entire amount is given back the recipient has to pay interest.
3. Bond Futures – Futures contract is a predetermined contract where the buyer or the seller
agrees to buy or sell something at a predetermined time and a predetermined price in the future.
The asset is usually a commodity or a financial instrument. In the case of bond futures, it is a
bond.
4. Options on Bonds – Options gibe the buyer the right but not the obligation to buy or sell the
underlying asset on the option at a specified date and a specified price depending on the type of
option. In case of options on bonds, the underlying asset bonds.
5. Interest rate swap – It is a type of interest rate derivate which involves exchanging interest
rates between two parties. 
6. Interest rate cap and floor – This again is a type of interest rate derivative where the
underlying is the interest rate and in case of interest rate cap the buyer receives payment if the
interest rate exceeds the agreed strike price. Similarly, for the interest rate floor, the buyer
receives payments if the interest rate is lower than the specified strike price.
7. Exotic derivatives – These are customized derivative products and are complex to the
generally traded vanilla options.
8. T bills, Deposits, Certificate of Deposits – Treasury bills popularly known as T bills are
issued by the government and are available for 30,60,90,120,360 days. They are considered to
be very liquid. Deposits can be a savings bank account, current account. Certificate of deposits
are again issued by the government and are very liquid.
9. Foreign exchange instruments – These include currency swaps, foreign exchange options,
foreign exchange swaps and are mainly related to currencies.