2. Financial intermediation.
Financial intermediation is an activity of financial intermediaries. A
financial intermediary is an institution that links lenders with borrowers,
by obtaining deposits from lenders and then re-lending them to borrowers.
The role of financial intermediaries in an economy, such as banks and
building societies, is to provide means by which funds can be transferred
from surplus units in the economy to deficit units. Surplus units are those
economical agents, which have more money, than they need for their
immediate needs. Deficit units are those, which have less money, than they
need in order to fund their current activity.
Financial intermediaries help to reconcile different requirements of
borrowers and lenders.
They provide obvious and convenient ways in which a lender can save
money. Instead of having to find a suitable borrower for his money, the
lender can deposit his money with a bank etc. All the lender has to do is
decide for how long he might want to lend money, and what sort of return he
requires, and choose a financial intermediary, that offers a financial
instrument of the fitting conditions.
They can package up the amounts lent by savers and lend on to borrowers
in bigger amounts.
They provide for a risk reduction. Provided that the financial
intermediary is itself financially sound, the lender would not run any risk
of losing his investment. Bad debts would be borne by the financial
intermediary in its re-lending operations.
They provide a ready source of funds for borrowers. Even when money is
in short supply, a borrower will usually find a financial intermediary
prepared to lend some.
Most importantly they provide maturity transformation, i.e. they bridge
up the gap between the wish of most lenders for liquidity and the desire of
most borrowers for loan over longer periods. They do this by providing
investors with financial instruments, which are liquid enough for the
investors’ needs, and by providing funds to borrowers in a different longer-
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