A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that consolidates deposits and uses the funds to transform them into loans. Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money or surplus savings (savers) to those who do not have enough money to carry out a desired activity (borrowers).
A financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages. Alternatively, they may lend the money directly via the financial markets, which is known as financial disintermediation.
In the context of climate finance and development, financial intermediaries generally refer to private sector intermediaries, such as banks, private equity, venture capital funds, leasing companies, insurance and pension funds, and micro-credit providers. Increasingly, international financial institutions provide funding via companies in the financial sector, rather than directly financing projects. Functions performed by financial intermediaries Financial intermediaries provide three major functions:
1. Maturity transformation. Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs)? 2. Risk transformation. Converting risky investments into relatively risk-free ones. (lending to multiple borrowers to spread the risk)? 3. Convenience denomination. Matching small deposits with large loans and large deposits with small loans? Types of financial intermediaries (FI) Advantages and disadvantages of financial intermediaries.
There are two essential advantages from using financial intermediaries: 1. Cost advantage over direct lending/borrowing 2. Market failure protection the conflicting needs of lenders and borrowers are reconciled, preventing market failure The cost advantages of using financial intermediaries include: reconciling conflicting preferences of lenders and borrowers. Risk aversion intermediaries help spread out and decrease the risks. Economies of scale using financial intermediaries reduces the costs of lending and borrowing.
Economies of scope intermediaries concentrate on the demands of the lenders and borrowers and are able to enhance their products and services (use same inputs to produce different outputs) Various disadvantages have also been noted in the context of climate finance and development finance institutions. These include a lack of transparency, inadequate attention to social and environmental concerns, and a failure to link directly to proven developmental impacts. Financial intermediaries perform the vital role of bringing together those economic agents with surplus funds who want to lend, with those with a shortage of funds who want to borrow.
In doing this they offer the major benefits of maturity and risk transformation. It is possible for this to be done by direct contact between the ultimate borrowers, but there are major cost disadvantages of direct finance. Indeed, one explanation of the existence of specialist financial intermediaries is that they have a related (cost) advantage in offering financial services, which not only enables them to make profit, but also raises the overall efficiency of the economy.
The other main explanation draws on the analysis of information problems associated with financial markets. Money held by ? nancial intermediaries other than monetary ? nancial institutions (MFIs) has become much more important in the analysis of monetary developments over the past decade.
This is particularly true for the FI sector,i. e. non-MFI ? nancial intermediaries other than insurance corporations and pension funds. FIs typically provide ? nancial services to households and non-? nancial corporations and/or trade in ? nancial markets on their own behalf. The sector also includes institutions created by MFIs to facilitate the securitisation of loans that would otherwise be held on the MFI balance sheet. Given the propensity of OFIs to implement ? nancial innovation, monitoring the relative size of the OFI sector (and sub-sectors) compared to the MFI sector might hint at ? nancial developments that may alter the transmission mechanism of monetary policy and/or the interpretation of traditional balance sheet data.
The growing signi? cance of the OFI sector has been particularly evident since mid-2004, as re? ected in its contribution to the annual growth rate of short-term deposits including repurchase agreements (referred to here as M3 deposits) – the broadest aggregation of M3 components for which a sectoral breakdown is available (see Chart 1).
In 2006, the OFI sector’s contribution to the 8. 1% average annual growth rate amounted to 1. 8 percentage points. This impact on monetary dynamics is particularly noteworthy, as OFIs in mid-2006 accounted for only around 11% of the total holdings of short-term deposits including repurchase agreements. As shown in the previous sections, the euro area OFI sector is characterized by a strong heterogeneity with respect to the types of activity undertaken. At the same time, the relevance of FIs for monetary developments varies considerably across countries. In part, this variation re? ects the different sizes of ? nancial markets, proxied by the relative shares of outstanding quoted shares and bonds in Table 2.
A look at the relative size of the FI sectors across the euro area indicates that OFIs resident in Luxembourg, the Netherlands and France are particularly important. However, an analysis of the distribution of M3 deposits relevant for monetary developments indicates that OFIs’ deposit holdings are more evenly spread. OFIs’ deposit holdings with MFIs resident in Germany, the Netherlands, Spain and France are among the larger holdings.
Putting M3 deposits into relation with nominal GDP indicates that the OFIs in Luxembourg, Ireland and the Netherlands have large “cash ratios” References: 1) “The General Theory of Employment, Interest, and Money” by J. M. Keynes, Published in NY City, 1997 by” Prometheus Books” 2) “Finance, Intermediaries, and Economic Development” by S. L. Engerman , P. T. Hoffman ; Cambridge University Press,2003 3) “The role of financial intermediaries in monetary and credit development ” by P. Moutot, D. Gerdesmeier by National Bureau of Economic Research, 2005