Financial intermediation refers to borrowing by economic deficit units from financial institutions in preference to borrowing directly from economic surplus units.

1. The Principle ofThe Principle of
Intermediation and theIntermediation and the
Role of FinancialRole of Financial
InstitutionsInstitutions

2. The Principle of IntermediationThe Principle of Intermediation
Financial intermediation refers to borrowing by
economic deficit units from financial institutions
in preference to borrowing directly from
economic surplus units.
Funds are transferred from economic surplus units
(lenders) to economic deficit units (borrowers),
termed indirect finance since it involves a
financial intermediary that stands between
savers and the borrowers and helps in the
transfer of funds from one economic unit to the
other.

3. The process of indirect finance using financial
intermediaries,
termed financial intermediation, is the
principle means for transferring funds from
economic surplus units to economic deficit
units.
The Principle of IntermediationThe Principle of Intermediation

4. Role of Financial IntermediariesRole of Financial Intermediaries
in Financial Marketsin Financial Markets
Financial intermediaries are mainly
concerned with recycling funds from
economic surplus units to economic deficit
units.
Like financial markets, financial intermediaries
have two tasks:
 Matching savers and borrowers.
 Providing risk-sharing, liquidity, and
information services.

5.
In facilitating the process of intermediation
Financial intermediaries provide a number of
economic functions:
1. Provision of a payment mechanism
2. Size transformation
3. Maturity transformation
4. Risk transformation
5. Liquidity provision
6. Reduction of transaction, information and
search costs

6. Role of Deposit Institutions
Deposit institutions accept deposits from
economic surplus agents which become
their liabilities and provide credit to
economic deficit agents, which
become their assets.

7. Deposit institutions are popular because:
 Deposits are liquid
 They customize loans
 They accept the risk of loans
 They have expertise in evaluating
creditworthiness
They diversify their loans

8. Savings institutions
 Include building societies and savings banks
 Are mostly owned by depositors y y p (mutual)
 Concentrates on residential mortgage loans
Credit unions
 Are nonprofit institutions
 Restrict their business to credit union members
 Tend to be much smaller than other deposit institutions

9. Role of Nondepository financial
institutions
Nondepository institutions generate funds from
sources other than deposits
Finance companies
Obtain funds by issuing securities
Lend funds to individuals and small business
firms

10. Mutual funds
 Sell shares to surplus units
 Use funds to purchase a portfolio of securities
 Some focus on capital markets securities (e.g., stocks or
bonds)
Money market mutual funds concentrate on money
market securities

11. Hedge funds
Use funds to purchase a portfolio of securities (e.g., stocks, bonds,
options and futures contracts)
 Securities firms
 Broker function
 Execute securities transactions between two parties
 Charge a fee in the form of a bid-ask spread
 Investment banking function
 Underwrite newly issued securities
 Dealer function
 Securities firms make a market in specific securities by adjusting
their inventory

12. Insurance Companies
 Provide insurance policies to individuals and firms in
 for illness, damage to return death, and property
 Charges premiums
 Term insurance policies
 Whole of life insurance policies
 Endowment policies
 Annuities
 Invest in stocks or bonds issued by corporations

13. Pension funds
Offered by most corporations and government
agencies
Manage funds until they are withdrawn from the
retirement account
Invest in stocks or bonds issued by corporations
or in bonds issued by the government