FINANCIAL INTERMEDIATION

Financial intermediaries are the financial institutions that act as a

bridge between investors and savers (surplus units or SU) and borrowers or
security issuers (deficit units or DUs). They may simply act as a bridge
between deficit units and surplus units without owning the securities issued
by the deficit units. However, they can transfer them directly to the surplus
units or investors, just like market specialists or brokers, or in certain
instances, like investment banks/merchant banks which underwrite certain
original issues. Generally, financial intermediaries buy the securities issued
by the deficit units for their own account. What they do is issue their own
financial instruments called secondary securities, which they sell directly to
investors or surplus units. Financial intermediaries can therefore either help
sell the primary securities issued by the original issuers or issue their own
financial instruments as secondary securities.

DIRECT AND INDIRECT FINANCE

A borrower-lender relationship is the typical direct finance
relationship or transaction. A bank and a bank depositor are engaged in
direct finance; similarly, a bank and a bank borrower are engaged in direct
finance. If you borrow money from your friend, that is direct finance. There
is no need for any financial intermediary. The checking account, savings
account, or time deposit certificate is originally issued by the bank to the
depositor that acts as the buyer of the security. The depositor pays for the
checking, savings, or time certificate of deposit issued by the bank. The
claims arising from a direct finance transaction, in our example: the deposit,
loan, and stock, are all primary or direct securities. A direct security/primary
security flows directly from the borrowing unit to the lending or investing
unit.

Likewise, when someone or a company borrows from a bank, he or

the company issues a promissory note, which is the primary security for the
funds given by the bank in exchange. In essence, the borrower sells his
promissory note and he is paid by the bank through the funds given to him
that he borrowed. The relationship between the borrower and the bank is
direct. However the relationship between the depositors where the funds
lent to borrowers came from, and borrower from the bank , is indirect
finance. The borrowers do not even know who the depositors are.

Borrowers Investors
Direct / Primary Security
(Deficit Units) (Surplus Units)

Banks, Borrowers, Banks, Depositors,

Issuing Corporations Funds Corporations

According to Kidwel et al., direct financing is one “where funds flow

directly through financial markets. The primary or direct security goes
directly from the issuer/borrower to the investor/saver. The market
specialist still transfers the original issue/primary security (same issue issued
by the issuing company), which is the direct security, and does not create a
new or secondary issue. These financial institutions that channel funds
directly to deficit units from the surplus units but do not issue their own
financial instruments or securities are called market specialists. Direct
securities or primary securities such as stocks and bonds sold in the open
market through market specialists are termed as open market securities.
Market specialists are a special type of financial intermediary in the sense
that they provide the connection between surplus and deficit units but do
not issue their own securities.

Borrowers Market Specialists

Investors
(Deficit Units) Brokers, Financial
(Surplus Units)
Banks, Borrowers, Institutions
Depositors, Banks,
Issuing (does not own;
Corporations
Corporations resells)

Indirect finance is like the relationship between the depositor of a

bank and the borrowers of the same bank. The funds lent to the borrowers
came from the deposits of the bank`s depositors. Another transaction that
involves indirect finance is the use of a middleman or an intermediary,
which generally happens in the secondary financial market. When
intermediaries pool deposits and transform them into secondary securities
which they sell to investors, it is called indirect finance.

Depositors BAnk Borrower

 Indirect Finance

CHANGING NATURE OF FINANCIAL INTERMEDIARIES

Financial intermediaries have changed over time not only in structure
but also in its functions. Old simple financial intermediaries, which
specialized in a single function like getting deposits and granting loans, had
become complex in structure with different departments performing several
specialized functions.

The Old Financial Environment

OFE was a highly specialized financial system where banks were set up
to take in deposit and grant only short term loans.

The New Financial Environment

NFE was characterized by market-determined or deregulated rates on
assets and liabilities of financial intermediaries and by greater homogeneity
among financial institutions.

CLASSIFICATION OF FINANCIAL INTERMEDIARIES

DEPOSITORY INSTITUTIONS - refer to financial institutions that accept
deposits from surplus units

1. Commercial banks
a. Ordinary Commercial banks

b. Expanded commercial or Universal banks

2. Thrift banks

a. Savings and mortgage banks

b. Savings and loan associations

c. Private development banks

d. Microfinance thrift banks

e. Credit unions

3. Rural banks

NON-DEPOSITORY INSTITUTIONS - issue contracts that are not deposits.

1. Insurance companies
2. Fund managers
3. Investment banks/houses/companies
4. Finance companies
5. Securities dealers and brokers
6. Pawnshops
7. Trust companies and departments
8. Lending investors

RISKS OF FINANCIAL INTERMEDIATION

Risk is the possibility that actual returns will deviate or differ from
what is expected. If you expect prices to go up and you buy securities, you
are taking risk because prices could either go up or down. If prices go up,
you gain; if prices go down, you lose. Financial intermediation is highly
market sensitive; that is it changes with the market environments.
1. Interest rate/Market Price risk

It is the risk that the market value (price) of an asset will decline (when
interest rate rises), resulting in a capital loss when sold. The market value of
an asset or liability is theoretically equal to its discounted future cash flows.
Therefore, when interest rates increase, the discount rate on those cash
flows increases and reduces the market value of the asset or liability. On the
other hand, when interest rates fall, the market values of the assets and
liabilities increase. In short, securities decline in price when interest rates
rise.

2. Reinvestment risk

It arises as a result of interest rate/market price risk. It is the risk that

earnings from a financial asset need to be reinvested in lower-yielding assets
or investment because interest rates have fallen or decreased.

3. Refinancing risk

It is the risk that the cost of rolling over or re-borrowing funds could
be more than the return earned on asset investments. If the cost of rolling
over borrowed funds is, say 8%, and the return that will be earned or
investing the borrowed funds will only result in a rate of, say 7%, the
financial intermediary loses 1%.

4. Default/Credit risk

It is the risk that the borrower will be unable to pay interest on a loan
or principal of a loan or both.

5. Inflation/Purchasing power risk

It is the risk of increase in value of goods and services reducing the

purchasing power of money to purchase goods or services. As prices rise,
purchasing power decreases. They go in opposite directions just like in
market prices and interest rates do.

6. Political risk

It is the risk that government laws or regulations will affect the

investor`s expected return on investment and recovery of investment
adversely or negatively.

7. Off – balance sheet risk

Off balance sheet transactions are those transactions that do not

appear in the financial institution`s balance sheet but represent transactions
that pose contingent assets or contingent liabilities on the financial
institution. Happening of contingent asset is favourable, but happening of
contingent liability becomes unfavourable and disadvantageous to a
financial intermediary.

8. Technology and Operation risk

It arises when these investments in technology do not produce the

desired results, that is, fail to get more customers, unable to produce
economies of scales as desired, and fail to increase profit or reduce costs,
among others.

9. Liquidity risk

It results from the withdrawal of funds by investors or exercise of loan

rights or credit lines of clients. The first sign of a liquidity problem faced by a
financial intermediary can cause a “run”. When bank depositors demand
withdrawals of their funds deposit with a certain bank at the same time, it
will cause a “bank run”, which will ultimately result in bank insolvency and
bankruptcy. When depositors use their credit lines with a certain bank at the
same time, the bank will be faced with a funding source problem. Deposit
insurance and discount windows were designed to help with such liquidity
problems.

10. Currency or Foreign exchange risk

It is the possible loss resulting from an unfavourable change in the

value of foreign currencies. Financial intermediaries usually do not only own
domestic securities. They also own securities denominated in foreign
currencies. Diversification reduces their foreign exchange risk because
holding only securities denominated in one currency will make the financial
intermediary at a losing end should the currency of the securities it is
holding fall in value without any security to offset the loss.

11. Currency or Sovereign risk

It overrides credit risk from a foreign borrower because even if the

borrower is in good credit standing, the government of that foreign country
can set up regulations that prohibit debt repayments to outside or foreign
creditors. Lending to a foreign borrower needs an evaluation of the credit or
default risk of the borrower and an evaluation of the country or sovereign
risk of the country where the borrower is located.

ECONOMIC BASES FOR FINANCIAL INTERMEDIATION

It deals with the spread of risk made possible by the pooling funds
through diversification through economies of scale by bearing a large
part f the cost that individuals and small borrowers should have
shouldered if they themselves had done what the financial
intermediaries are doing, absorbing transaction costs and gathering
information.