Financial Intermediaries Essay Example | Topics and Well Written Essays - 1500 words

Financial Intermediaries - Essay Example An understanding of Financial Institution A financial intermediary can be defined as an institution that acts as the middleman between investors and firms raising funds. (Investopedia, 2012) Several types of financial intermediaries such as Banks, Insurance companies, building societies, pension funds, credit unions etc functions in an economy. The function of a financial intermediary is of prime importance in economic growth as it brings in contact two parties i.e. one having a surplus of funds who is looking for a venture to invest in so to earn a return on the money, and the second type which is looking to borrow funds. Since in the real world, it is rare that the demand of lender and borrower reconcile and thus a financial intermediary comes into play. A financial intermediary, such as banks, acquires funds from the lenders and subsequently lends them to the borrowers according to their desire rates. In this particular exercise the financial intermediary takes into consideration various needs of the lender and borrower such as maturity (which means the duration or term for which the lender wants to lend and the borrower wants to acquire) and rate of return/cost of debt (the lender wants to maximize the return, whereas the borrower wants to minimize the cost). ... In addition, the financial intermediary also offers risk aversion which assists the parties involved in spreading out and reducing the risk. Common Functions of Financial Institutions There are three main ways in which capital is transferred between savers and the one who needs it. In the first procedure, the saver directly receives stocks or bonds which a business sells. This transaction is done in the absence of any financial institution. The business in order to get the money it needs, provide savers with its securities. The second way is indirect way, which includes an investment banking house such as Merill Lynch, which underwrites the issue. Underwriter here plays the role of a middleman and guarantees the issuance of securities. The stocks or bonds of the company are sold to the investment bank, which in turn sells these same securities to the savers. In such transaction, the business’s securities and the savers money is only passing through the investment banking house . It should be noted that in this particular transaction that the investment bank buys the securities and held them for a particular period of time. By doing so the investment bank is taking a risk that it may not be able to resale these securities in the future for as much amount as it paid. This transaction is termed as a primary market transaction. The third way is an indirect way in which transfer is made through a financial intermediary such as bank or mutual fund. In this case, by exchanging its own security, the intermediary obtains funds from the saver. After acquiring the funds, the intermediary purchases businesses’ security with the money it obtained from the saver. For example, a bank