These days financial intermediaries are quite widespread because people prefer using them instead of entering financial markets directly. A commercial bank is a typical example of a financial intermediary, though not the only one. Among others are pension funds, loan associations, numerous insurance companies, mutual funds, and credit unions. Financial intermediaries function according to a simple scheme. The fund of any bank is constituted by money that people deposit daily. This money is then used for giving loans for the most various purposes. A financial intermediary is here a middleman between a bank and a person. The modern world with all its allocative efficiency and productivity could not exist without financial intermediaries for they perform important functions of maturity intermediation, diversification, and providing of payment mechanisms, which are necessary for transforming assets into those which the public prefers.
To begin with, maturity intermediation allows obtaining long-term loans to make short-term deposits. Most of the deposits the bank is operating with are short-term; there are some which have a mature date but it, as a rule, does not exceed two year’s term. If there were no commercial banks, “the borrower would have to borrow for a shorter term or find an entity that is willing to invest for the length of the loan sought” (Fabozzi, Modigliani, Jones, Ferry, 2002). Maturity intermediation makes it possible for the commercial bank to give a loan for the length of time which the borrower needs. This function allows the borrowers to extend their debt obligations and is also beneficial for the investors since the loan given for a longer time requires the borrowers to pay a higher interest rate.
As far as diversification is concerned, it gives investment companies a chance to reduce risks. Diversification is the distribution of investments between different investment companies to reduce risks. Obtaining the money from the investors, an investment company then invests them in the stock where a number of other companies have also invested. This can also be done by an individual investor but such a kind of diversification will not be as cost-effective as in the case with a financial intermediary.
And, finally, financial intermediaries provide financial markets with payment mechanisms that allow making payments without cash money. Most transactions in the modern world are performed by means of credit cards, checks, or electronic transfers of money rather than by means of cash. Some years ago the payments by checks were the most widespread; they were convenient mostly due to the fact that the client of a commercial bank did not have to pay any interest. The check was followed by a credit card which back then could be offered only by a commercial bank. However, today this right has been given to other depository institutions as well. Payment mechanisms are important for the proper functioning of financial markets because they make it possible to utilize assets of any kind and perform purchases immediately without cash.
In conclusion, financial intermediation is crucial for modern businesses and the people involved in them. They give the borrowers a possibility of getting long-term loans, reduce risks the investment companies take, and provide payment mechanisms, which allow making purchases and transactions without cash. Namely, these functions of financial intermediaries make them irreplaceable and help a great number of people to survive in the modern world of business.
References
Fabozzi, F.J., Modigliani, F., Jones, F.L., & Ferry, M.G. (2002). Foundations of Financial Markets and Institution. Prentice Hall.