According to the International Monetary Fund, a financial system can be considered a mix of both markets and institutions which interact with each other for the purpose of organising available funding for investments and also providing a platform for financing activities (International Monetary Fund, 2006). A financial intermediary on the other hand can be defined as an institution which supports transactions between the suppliers and the users of capital (Campbell, 2011).
Financial centres are typically found in most developed countries, however a certain few show a global dominance, including New York, London and Tokyo. These centres are able to create competition across a plethora of areas within a business in order to reach the status of being the most recognised financial system in the world, thus leading to increasing international business (Pilbeam, 2010). Although financial centres compete worldwide, there is also a large level of inter-continental competition, for example the constantly improving finance industry in Paris is providing competition for certain areas within the London financial centre.
Surplus and deficit agents consist of households, governments and public/private bodies and these are people that receive investments and borrow money within finance centres. In terms of the investments, surplus agents are more risk averse and consist of short-term investments, whereas deficit agents revolve around medium to long-term borrowing, however they are more likely to make riskier decisions. Both of these exist within a financial centre and it can be seen that funds gathered from dividends, profits and interests are typically transferred from the surplus agents to deficit agents through the use of financial intermediaries and financial securities via loans and debts/equity (Pilbeam, 2010).
Finance can be split into two subsections; direct and indirect. Direct finance can be described as the process where funds are transferred from lenders to borrowers (surplus units to deficit units) without the need for using a financial intermediary, therefore this particular branch of finance will occur regularly within a financial market. On the other hand, indirect finance consists of gathering funds from banks or other financial entities (third party) as opposed to using investors (Torres, 2012). Indirect financing also uses financial intermediaries in the process between borrowers and lenders, such as a building society or a bank.
According to Pilbeam (2010), financial intermediation is “the process of transferring sums of money from economic agents with surplus funds to economic agents that would like to utilize those funds” (p. 27). This process occurs through the use of financial intermediaries, such as insurance companies e.g. Aviva, financial advisories and building societies, for example Nationwide. Intermediaries are crucial in the smooth running of these systems in order to maintain and organise the activities which occur.
The actions and decisions which intermediaries make typically follow six functions. Size transformation is a function which explains that depositors within a financial system have smaller savings accounts, such as in a bank, when compared to the loans which are required by customers, also known as the borrowers (Buckle & Thompson, 2004, p. 39). Financial intermediaries play an important role in this as, if they did not exist, resource pooling would occur in order to increase the levels of savings. Resource pooling can take many forms, such as bank deposits, stock investments and insurance policies, dependent on the type of financial intermediary in question (Fabozzi, Neave, & Zhou, 2012, 125-126).
If financial intermediaries did not exist, it would be difficult for borrowers and lenders to manage their loans or their money which they have temporarily parted with and this would most likely lead to both of these parties having to settle on an agreement which doesn’t benefit either of them to a full extent. With a lack of financial intermediaries, it is likely that we would see lenders releasing their money for an extended period of time, and on the contrary we may also see borrowers only receiving short-term loans in order for the lenders to reduce the time they are without their money for. To prevent this, intermediaries use the maturity transformation function to match the desired habitat where borrowers are able to have a long-term loan to finance assets with a much longer life span, such as a property. Another preferred situation would be for savers/investors to be able to complete short-term investments, which are a way of reducing risk and allowing funds to be accessed at shorter notice. Without financial intermediaries, these optimal conditions would be unavailable (Williams, 2009).
The risk transformation function is used by financial intermediaries in order to minimise any risks which investors may face when making an investment through the use of asset transformation. This consists of the financial intermediaries selling assets with a low-risk factor in order to purchase other assets with a higher risk factor, which in turn allows investors to convert their high risk assets into safer, more reliable assets. These intermediaries are useful in a situation where there is a high risk as they not only help individuals manage these risks, but they also assist with businesses in purchasing and maintaining a high variety set of assets (Focardi, Fabozzi & Focardi, 2004).
Google regularly invest and also acquire smaller businesses to extend their global outreach once a risk evaluation has taken place in their financial departments. The top 10 largest acquisitions by Google have totalled over $24billion, with Motorola being their largest in 2011 at $12.5billion (Onfro, 2015). Google are also rumoured to be looking to acquire Spotify and Netflix to expand their market share even further, assuming that the acquisitions pay off as they both hold a high level of risk which will be accounted for. As long as appropriate remuneration is provided to the intermediary, they would be willing to take the risk, however, if intermediaries were not present, when a risky opportunity arises that has potential to be profitable, it is likely that these would not be implemented due to the lack of safety to fall back on.
Liquidity can be defined as how easily assets can be converted into cash. Financial intermediaries act as an agent between buyers/sellers of assets. The lenders of assets, also known as surplus agents, would rather invest in assets which are classed as ‘liquid’, thus meaning that these assets can easily be liquidated. Conversely, borrowers within a financial system who are looking for a loan are likely to seek a long-term loan in order to fund their activities (Scholtens & Van Wensveen, 2003, p. 17). This is because it gives the recipient of the funding an extended period of time to pay off their debts to the intermediary which has provided the loan.
Liquidity provision is used to protect any outward cash flow from a pile up of liquid assets through implementing new accounts in financial systems. A building society that signs up a new customer means that the society would have access to their funds in the event that if someone wants to withdraw money from their account, it would be covered elsewhere, thus meaning that they can maintain a high level of people willing to deposit their money. Without financial intermediaries, investors would rarely be willing to invest and hold illiquid assets such as penny stocks and microcap stocks due to the massively increased risk in not getting their investment back. This can be seen to interplay with other roles which financial intermediaries play, such as using the risk transformation function to minimise this risk. This can occur through an agent selling off the risk they have acquired, however without a financial intermediary, this can have a snowball effect, whereby larger risks are created by others (Fabozzi, Neave, & Zhou, 2012, p. 125).
Another reason that financial intermediaries are necessary is due to the ability they have to provide value-addition for users through cost-reduction methods (Scholtens & Van Wensveen, 2000). Transaction costs which are inflicted on both buying and selling financial assets, such as brokers’ commissions and mutual funds expense ratios, can be reduced due to the amount of processes which the transactions have to go through being lowered by the intermediary as most of it is in-house within a firm such as a brokerage (Gurley & Shaw, 1960). This will benefit both surplus and deficit agents due to the rates at which loans are financed can be lowered to make it more beneficial for the borrowers and for lenders as it is likely that people will be able to pay the money back due to the reduced costs, such as interest rates.
Transaction costs can be reduced by financial intermediaries in two main ways: through the use of economies of scale and economies of scope. Economies of scale is a process where output increases and in turn this leads to production costs falling, providing cost savings for the firm. This can be applied to the financial system as intermediaries are likely to regularly complete transactions between surplus and deficit agents. As more of these increase, the costs surrounding the processes are able to decrease, thus allowing the benefits of economies of scale. Economies of scope is the process of reducing the price of production through using joint production, where the cost of providing multiple goods or services at the same time is less than if they were to be charged individually (Allen, 2014), and without financial intermediaries, these two processes would be very hard for firms to accomplish and execute successfully.
The final and possibly most modernistic role which financial intermediaries play is the ability to provide a payment system. Intermediaries act as a third party who are able to execute a transaction from one agent to another electronically through credit cards, bank transfers etc. at an ever increasing speed (Fabozzi, Neave, & Zhou, 2012, p. 123). This however has led to potential security issues with the holding of agents’ assets and so regulation and security has to be implemented within the financial intermediary in order to effectively manage the processes which occur between agents.
There will always be issues within a financial system which are near impossible to prevent. The most important factor which creates drawbacks within a financial system is the presence of asymmetric information, despite information asymmetry decreasing as technological advancements occur. Asymmetry means that not everyone has the same information and some members of a system may have access to important or inside information which others don’t. This inside information could prove very dangerous in a financial system as it can lead to insider trading in order for a company to gain competitive advantage within a market. An example of this would be in Australia which recently saw its largest ever insider trading scandal whereby the man responsible carried out over 100 illegal transactions whilst he managed a mining company and was sentenced to 8 years in jail (Malone, 2016).
A prolific example of a financial intermediary which has proven to be very useful and successful in todays society is the Wells Fargo bank which provides around 300 unique services, including the management of debt, risk profiling, mortgages etc. who saw an $85billion revenue in 2015. As an intermediary it has grown to be extremely successful in the fact that it regularly listens to customers’ recommendations and advice for change in order to market themselves as a bank which revolves around customer satisfaction (Ellis, 2000). In 2007, it was also the only bank in the US to be given a rating of AAA before the financial crisis occurred (Wells Fargo Company, 2016).
In conclusion, it can be seen throughout this essay that financial intermediaries play a key role in the successful running of a financial system. Although there are potential downsides, the positive factors which are generated through the use of financial intermediaries outweigh the restricting factors and so it should be seen that in the future, financial intermediaries must maintain their presence in financial systems and continue to adapt with technology to meet customers needs & wants, allowing effective financial management and assistance.