Financial Intermediaries

An economic community can prosper only when it is able to employ its resources optimally. However, this does not happen on its own, as all people are not endowed with resources that could be deployed productively.

Therefore, the resources are required to be moved from those who have it and made available to those who can make use of it. If this function is not achieved, the economy may stagnate. This aspect brings out the need for financial intermediaries.

Need for Financial Intermediation

Financial intermediaries play an important economic function by facilitating the productive use of the community’s surplus money. The continuous use of such resources by an economy will foster greater demand for goods and services and in generation of incomes and employment in an economy.

The combined wealth created gets channelised in the form of assistance to entrepreneurial activities, which are undertaken by another set of people who have the necessary inclinations. However the following questions arise:

• How does it happen?
• Will the savers voluntarily pass on their savings to entrepreneurs?
• If not, what kind of risks do they face?
• How do they want to protect themselves from such risks?

These questions will get answered only when the process of transfer takes place and the roles played by a third agency, which is known as a financial intermediary, facilitates such transfers.

Intermediation and management of risks

The need for a financial intermediary arises because the savers would not voluntarily come forward to lend directly fearing certain risks.

In the process, intermediaries manage the risks in an effective manner to minimize the chances of loss. The process of transferring the funds from the savers to the entrepreneurs is call intermediation. In essence, intermediation is the management of risks. Such risks are as follows:

• Credit Risks: It is the risk of default by the borrower for any reason. It is possible that the business does not generate sufficient income to repay the loan and the borrower is not honest enough to keep his commitment. Credit risk is the most serious risk that any lender faces and individual lenders cannot afford to take such risks.

   

• Liquidity Risk: The borrower may have every intention to repay the loan and the business may be doing well too. But there could be occasions where the borrower is not able to withdraw funds from the business when the lender demands repayment or when the repayment is due. There could be many types of temporary problems, that may or may not be in the control of the borrower and which stand in the way of timely repayment of the loan.

   

• Interest Rate Risk: Another risk in lending money is the possibility of loss due to change in the rate of interest in the market. At the time of transaction, the borrower may have agreed to give interest at the prevailing rate of interest, say, 10%. Subsequently, the borrower may ask for a reduction in the rate of interest, since money is available at a cheaper rate from other sources. Conversely, while the interest rate may have gone up in the market, the borrower may refuse to pay a higher rate or repay the loan before the due date, quoting the terms of the original contract. Both these situations are detrimental to the lender and individuals prefer to insulate themselves from such chances or risks of loss due to the change in interest rates.

The risk-averse nature of normal savers and the risks inherent in any entrepreneurial activity necessitates intermediaries who have the ability to insulate the savers from the risks inherent to business. Intermediaries not only manage such risks associated with business, but also generate employment and promote economic welfare by enabling production of goods and services required by the community. Hence, intermediation by the financial intermediaries is also an important economic function.