FINN11B - Financial Intermediaries

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Financial Intermediaries

These were formed during the time when market conditions make it hard for lenders of funds to transact directly with borrowers of funds

Financial Intermediation

This is the process of indirect financing using financial intermediaries as the main route to transfer funds from lenders to borrowers.

Benefits from Financial Intermediaries

These include Acceleration of flow of funds between entities, Efficient allocation of funds, Creation of money, and Support in price discovery.

Acceleration of Flow of Funds Between Entities

This benefit is when fund providers use financial intermediaries to transfer funds to fund demanders.

Efficient Allocation of Funds

This benefit is when Financial intermediaries possess the expertise to make sure that funds will flow in the economy in the most efficient manner.

Asymmetric Information

It occurs when potential borrowers have more information about the transaction compared to the bank.

Adverse Selection and Moral Hazard

Asymmetric information may lead to two further problems:

Adverse Selection

It means that high-risk borrowers that would tend to default are more likely to be more active in borrowing funds than low-risk borrowers who pay on time.

Moral Hazard

It occurs when borrowers have the tendency to take undesirable or immoral risks (for the lender) with the money, once they receive it, not disclosed during the loan granting process.

Creation of Money

This benefit allows existing and new funds to be allocated efficiently.

Support in Price Discovery

This benefit is when they play the role as experts and facilitators to enable to assign values to financial instruments based on different factors.

Improved Liquidity for Lenders

This support in price discovery happens when financial intermediaries can manage cash from different lenders immediately in cashable products such as current and savings deposit accounts.

Reduced Price Risk for Lenders

This support in price discovery happens when financial intermediaries offer very low-risk financial products to ultimate lenders and offer financial products with high price risk to borrowers resulting in lenders enjoying mitigated price risks as they course the transfer of funds with lower risk to financial intermediaries.

Price Risk

This means that prices of financial instruments may vary over time.

Risk Sharing

It happens when financial intermediaries create and sell financial assets with risk profiles that their clients are comfortable investing in.

Asset Transformation

Another term for Risk Sharing

Diversification of Lenders

This support in price discovery happens when lenders put their funds through financial intermediaries, which have wider access to investment possibilities and allow these household members to diversify their portfolios better.

Diversification

It is the process of investing funds in a portfolio of assets that have individual returns that do not move in the same direction together.

Economies of Scale

This support in price discovery happens when fixed costs are optimized per unit as a result of the sheer volume of transactions.

Payments System

This support in price discovery happens when the financial system serves as the main structure for making payments for any goods, services, or securities that are purchased.

Risk Mitigation

This support in price discovery happens when financial intermediaries offer protection to individuals and organizations against adverse incidents that may occur.

Depository Institutions and Investment Intermediaries

Two Classifications of Financial Intermediaries

Depository Institutions

These are firms that accept cash deposits from individuals, companies and entities.

Investment Intermediaries

These are organizations whose primary objective is to maximize return from investments in various financial instruments to add value for the investors.

Commercial Banks

These banks are authorized to accept drafts/checks and issue letters of credit, discount and negotiate promissory notes, drafts, bills of exchange, and other evidences of debts; receive deposits; buy and sell foreign exchange and gold or silver bullion; and lend money against securities consisting of personal property or first mortgages on improved real estates and the insured improvement thereon.

Thrift Banks

These banks are primarily mobilized small savings and provide loans at generally longer and easier terms than do commercial banks as they cater to the lower income groups.

Savings Bank

These are organized to accumulate savings deposits and invest them for specified purposes.

Types of Deposit Accounts Issued by Banks

This include Demand Deposits/Checking Accounts, Savings Deposits, Money Market Demand Account, and Time Deposits.

Demand Deposits or Checking Accounts

This type of deposit can be withdrawn upon demand through checks and offers very minimal interest since this can be withdrawn easily.

Savings Deposits

This type of deposit earns interest at a level below market interest rates, can be withdrawn upon demand, and does not have a specific maturity.

Money Market Demand Account

This type of deposit is placed on money markets that have slightly higher interest rates (money market rates) compared to savings deposits but can be withdrawn only after a short period.

Time Deposits

This type of deposit have a fixed maturity date and depositors may earn interest at a fixed or floating interest rate.

Insurance Companies

These offer unique services to assume risk or become underwriters of the risk associated with various insurable occurrences.

Investment Intermediaries

These are organizations whose primary objective is to maximize return from investments in various financial instruments to add value for the investors.

Asset Management Firms

These are companies that manage funds owned by individuals, companies or the government through buying and selling of financial instruments.

Investment Banks

These are highly leveraged institutions that have significant influence on how primary and secondary markets work as they assist entities (individual, corporate, government) in raising money to fund their initiatives.

Other Participants

Aside from financial intermediaries, there is a significant number of participants who interact with each other or buy or sell different kinds of financial instruments.

Household Sector

This is composed of individuals and families, including families serving charitable, religious and non-profit organizations as well as unincorporated businesses.

Government

This is focused more on regulating all participants and the market in general.

Financial Corporations

This includes depositary institutions, investment banks, asset management companies, and insurance companies. All other companies not classified as financial are known to be non-financial corporations.

Non-financial corporations

They issue financial instruments to raise funds for their business requirements and trade financial instruments in the money market or capital market as investment in case they have excess funds.

Foreign Sector

It consists of all entities, individuals, assets and organizations that are situated outside of the jurisdiction of a certain country.

Non-Profit Organizations

These are business that exist to respond to specific causes like humanitarian aid, socio-civic causes, environment, arts and many more. These do not necessarily operate to generate profit or monetary for its investors.