What is a Financial Intermediary?
A financial intermediary is an entity that acts as a bridge between two parties in a financial transaction. Examples include commercial banks, investment banks, pension funds, and mutual funds.
These institutions provide various consumer benefits, such as asset security, liquidity, and economies of scale in banking and asset management services. While technological advancements in areas like investment threaten to reduce the reliance on financial intermediaries, their role remains indispensable in other sectors like banking and insurance.
How Financial Intermediaries Work
Financial intermediaries transfer funds from entities with surplus capital to those in need of financing. This process enhances market efficiency and reduces operational costs for businesses.
Examples:
• Banks: Connect borrowers and lenders by utilizing available capital and collaborating with other financial institutions.
• Insurance Companies: Collect premiums and provide benefits in the event of a risk.
• Pension Funds: Manage members’ funds and provide payouts upon retirement.
Some intermediaries also offer other services, such as leasing or investment management, highlighting their significant influence on a country’s economic stability.
Types of Financial Intermediaries
Mutual Funds
Mutual funds actively manage the pooled capital of shareholders by investing in companies expected to outperform the market. This enables investors to enjoy potential returns while providing liquidity to companies needing capital.
Banks and Insurance Companies
Banks and insurance companies are prime examples of financial intermediaries. Banks facilitate transactions between borrowers and lenders, while insurance companies offer financial protection against risks in exchange for premiums.
Benefits of Financial Intermediaries
1. Facilitating Large Investments: Financial intermediaries pool small savings from numerous individuals to fund large-scale projects, driving economic growth and development.
2. Risk Distribution: By diversifying investments and loans, financial intermediaries help mitigate financial risks.
3. Cost Reduction: Financial intermediaries reduce transaction costs through their expertise and economies of scale, such as credit assessments and efficient record-keeping.
4. Stimulating Spending and Growth: Loans provided by intermediaries enable households and businesses to spend beyond their current resources, propelling economic activity.
A Practical Example of a Financial Intermediary
In July 2016, the European Commission introduced two financial instruments under the European Infrastructure and Investment Fund to support startups and urban development projects.
One of these tools, the Joint Investment Facility, aimed to provide financing for startups to develop their business models through a collective investment plan managed by a primary financial intermediary. The Commission anticipated total investments in small and medium-sized enterprises to reach around €15 million (approximately $17.75 million) per company, attracting greater public and private support to sustain these investments.
A financial intermediary is not just a channel for transferring funds; it is a cornerstone of economic efficiency and development. Its vital role in providing financing, mitigating risks, and promoting economic stability makes it an indispensable pillar of the global financial system.
