FINANCIAL MARKETS
AE 322
MODULE
4
FINANCIAL
INTERMEDIARIE
S AND RISK
intermediaries and risks
associated to each are important
• Differentiate commercial banks,
COURSE LEARNING OUTCOMES investment banks, insurance
At the end of the module, you should companies, mutual funds, savings
be able to: associations and credit unions.
• Relate how knowledge of financial
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FINANCIAL INTERMEDIARIES
A financial intermediary is the organization which acts as a link between the investor and the
borrower, to meet the financial objectives of both the parties. These can be seen as business entities
which accept deposits from the depositors or investors (lenders) by allowing them low interest on
their sum. Further, these organizations, lend this amount to the individuals and firms (borrowers) at a
comparatively high rate of interest to make their margin.
The two of the significant roles played by the financial intermediary in the economy are the creation
of funds and governing the payments system.
Example
Mrs A. is a housewife and deposits her savings into her account with the XYZ bank every month.
On the other hand, Mr B is a young entrepreneur who is seeking a loan to start his venture. Now, Mr
B has two options for availing the loan:
• The first is that he can find and convince the individuals who are looking for investment
opportunities, or;
• he can approach the XYZ bank for a loan
We can see that the first option is uncertain, and it will take a lot of time to find the investors.
However, the second option is more convenient and quick.
Thus, we can say that the financial intermediary facilitates the lending and borrowing of funds on a
large scale.
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Types of Financial Intermediaries
There are several financial intermediaries formed to serve the different aims and objectives of the
customers or members or lenders and borrowers. These entities are explained in detail below:
Banks: The central and commercial banks are the most well known financial intermediaries
simplifying the lending and borrowing process, along with providing various other services to its
customers on a large scale.
Credit Unions: These are the cooperative financial units which facilitate lending and borrowing of
funds to provide financial assistance to its members.
Non-Banking Finance Companies: A NBFC is a financial company engaged in activities such as
advancing loans to its clients at a very high rate of interest.
Stock Exchanges: The stock exchange facilitates the trading of securities and stocks, and in every
trading activity, it charges the brokerage from each party which is its profit.
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Mutual Fund Companies: The mutual fund organizations club the amount collected from various
investors. These investors have identical investment objectives and risk-taking ability. The funds are
then collectively invested in the securities, bonds, and other investment options, to ensure a capital
gain in the long run.
Insurance Companies: These companies provide insurance policies to the individuals and business
entities to secure them against accident, death, risk, uncertainties and default. For this purpose, they
accept deposits in the form of premium, which is pooled into profitable investments to gain returns.
The insured person can claim the money in case of any mishap as per the agreement.
Financial Advisers or Brokers: The investment brokers also collect the funds from various
investors to invest it in the securities, bonds, equities, etc. The financial advisers even provide
guidance and expert opinions to the investors.
Investment Bankers: These banks specialize in services like initial public offerings (IPO), other
equity offerings, proving for mergers and acquisitions, institutional client’s broker services,
underwriting debts, etc. As a result of constant mediation, between the investor or public and the
companies issuing securities.
Escrow Companies: It is a third party acting as an intermediary and responsible for getting all the
conditions fulfilled at the time of loan provided by one party to the other for the real estate
mortgage.
Pension Funds: The government entities initiate a pension fund. A certain amount is deducted from
the salary of the employees each month. This collected sum is then invested in different schemes to
gain profits. The investor’s fund is returned with interest after their retirement.
Building Societies: These financial intermediaries are similar to the credit unions, owned and
facilitating mortgage loans and demand deposits to its members.
Collective Investment Schemes: Under this scheme, the various investors with common investment
objective come together to pool their funds and collectively invest this amount into a profitable
investment option. Later they distribute the interest among themselves as per the agreement.
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Advantages of Financial Intermediaries
The financial intermediaries are as crucial to the economy as the blood is to the body. Some of its
significant benefits are discussed below:
• Low Risk: The involvement of intermediaries reduces the risk of fraudulent, default and
even capital loss for the lender.
• Convenience: Exchange becomes suitable for the investor as well as the borrower. Since
both, the parties do not need to invest time and money in searching for each other. Instead,
they have to approach the intermediary for the purpose.
• Economies of Scale: The cost involved in the lending and borrowing of funds like analyzing
credit position, operational expenses and cost of paperwork decreases to a large extent. The
financial intermediaries perform such activities on a massive scale.
• Financial Specialization: These organizations or companies specialize in fund management
and investing activities providing better returns to the investors and easy loans to the
borrowers.
• Greater Liquidity: The financial intermediaries like banks allow investors or depositors to
withdraw their amount at any point of time, as per their requirement.
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• Safe Investment: For the investor’s point of view, financial intermediaries are considered to
be more trustworthy and reliable than lending money directly to an individual to yield
interest.
Drawbacks of Financial Intermediaries
Everything has two phases, one is positive, and the other is negative. As we already know that
financial intermediaries operate for profits, they are not charitable institutions; the following are
some of its disadvantages:
• Low Returns on Investment: The ultimate aim of the financial intermediaries is to earn a
profit and therefore, they usually provide a low rate of interest on the investment made by the
depositors.
• Opposing Goals: The goals of the investors and the financial intermediaries may not
complement each other, and therefore the objective of one may not be achieved.
• Fees and Commissions: These intermediaries impose charges, expenses and commission on
the financial assistance they provide to their customers.
• False Opportunities: Sometimes, the financial intermediaries come up with the investment
opportunities which guarantee high potential returns with the hidden risk involved in it. Even
some these, may not yield the promised returns and turn out to be a failure for the investor.
• High Interest on Loans: These financial intermediaries charge a high rate of interest on the
loan provided to the borrowers to earn a profit.
(Prachi, 2019)
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ROLE OF FINANCIAL INTERMEDIARIES
Depository Institutions
Depository institutions accept deposits from surplus units and provide credit to deficit units through
loans and purchases of securities. They are popular financial institutions for the following reasons.
■ They offer deposit accounts that can accommodate the amount and liquidity characteristics desired
by most surplus units.
■ They repackage funds received from deposits to provide loans of the size and maturity desired by
deficit units.
■ They accept the risk on loans provided.
■ They have more expertise than individual surplus units in evaluating the credit-worthiness of
deficit units.
■ They diversify their loans among numerous deficit units and therefore can absorb defaulted loans
better than individual surplus units could.
Commercial Banks –
• most dominant depository institution.
• serve surplus units by offering a wide variety of deposit accounts
• transfer deposited funds to deficit units by providing direct loans or purchasing debt
securities
• exposed to risk because their loans and many of their investments in debt securities are
subject to the risk of default by the borrowers
• subject to regulations that are intended to limit their exposure to the risk of failure
Savings Institutions
• sometimes referred to as thrift institutions
• include savings and loan associations (S&Ls) and savings banks
• offer deposit accounts to surplus units and then channel these deposits to deficit units.
* Whereas commercial banks concentrate on commercial (business) loans, savings institutions
concentrate on residential mortgage loans.
Credit Unions
• differ from commercial banks and savings institutions
• are nonprofit
• restrict their business to credit union members
• sometimes classified as thrift institutions in order to distinguish them from commercial banks •
credit unions tend to be much smaller than other depository institutions
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Nondepository Financial Institutions
Nondepository institutions generate funds from sources other than deposits but also play a major role
in financial intermediation.
Finance Companies
• obtain funds by issuing securities and then lend the funds to individuals and small businesses. •
functions of finance companies and depository institutions overlap
• Commercial banks serve both the private and public sectors; their deposit and lending
services are utilized by households, businesses, and government agencies.
Mutual Funds
• Sell shares to surplus units and use the funds received to purchase a portfolio of securities. •
dominant nondepository financial institution when measured in total assets
• Some mutual funds concentrate their investment in capital market securities, such as stocks
or bonds.
• Others, known as money market mutual funds, concentrate in money market securities.
Securities Firms
• provide a wide variety of functions in financial markets
• some securities firms act as a broker, executing securities transactions between two parties. •
act as dealers, making a market in specific securities by maintaining an inventory of securities
• provide underwriting and advising services
• some securities firms offer advisory services on mergers and other forms of corporate
restructuring
Insurance Companies
• provide individuals and firms with insurance policies that reduce the financial burden
associated with death, illness, and damage to property
• charge premiums in exchange for the insurance that they provide
• invest the funds received in the form of premiums until the funds are needed to cover
insurance claims
Pension Funds
• employees and their employers (or both) periodically contribute funds to the plan •
provide an efficient way for individuals to save for their retirement
• manage the money until the individuals withdraw the funds from their retirement accounts
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(Madura, 2015)
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TYPES OF RISKS OF FINANCIAL INTERMEDIARIES
1. Interest rate risk
a. Mismatch of asset and liability maturities.
b. Refinancing Risk
c. Reinvestment Rate Risk
d. Market Value Risk
2. Market Risk - combination of interest rate, foreign exchange, and equity return risks are
combined with an active trading strategy
3. Credit Risk - promised cash flows are not paid in full
4. Off-Balance-Sheet Risk - associated with contingent claims that do not show up on the balance
sheet.
5. Technology Risk - Technology investment may fail to produce anticipated cost savings. 6.
Operational Risk - The risk that support systems (often based on new technology) may break
down. Fraud and other back office issues are also operational risk
7. Foreign Exchange Risk - exchange rates affect the value of assets and liabilities.. 8. Country or
Sovereign Risk - Result of exposure to foreign government or legal systems which may impose
restrictions on repayments to foreign lenders and investors
9. Liquidity Risk - being forced to borrow, or sell assets in a very short period of time due to
needed cash.
10. Insolvency Risk - The risk that a sudden surge I liability withdrawals may require liquidation of
assets in a very short period of time and at less than fair market prices.
11. Other Risks and Interaction of Risks
a. Example - Interest rates and credit risk.
b. Include effects of war, market crashes, theft, malfeasance.
(Saunders & Cornett, 2008)
References
Madura, J. (2015). The Role Financial Markets and Institutions. In J. Madura, Financial Markets
and Institutions (pp. 4-25). Stamford: Cengage Learning.
Prachi, M. (2019, February 1). The Investors Book. Retrieved from theinvestorsbook.com:
https://theinvestorsbook.com/financial-intermediaries.html
Saunders, A., & Cornett, M. M. (2008). Risks of Financial Intermediation. In A. Saunders, & M. M. Cornett,
Financial Institutions Management: A Risk Management Approach ( pp. 168-184). New York:
McGraw-Hill/Irwin.
Property of and for the exclusive use of SLU. Reproduction, storing in a retrieval system, distributing, uploading or posting online, or transmitting in any form or by any
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