Financial markets bring together borrowers and lenders; why then, are Financial Intermediaries Needed

Introduction Financial system consists of lenders, borrowers and financial intermediaries. Lenders are people and business entities with surplus funds while borrowers are households and businesses, which are need of funds for different purposes. Since the lenders have excess funds while borrowers are in need of funds, it would be quite logical to expect these two parties to exchange funds without any intermediation between them. This is however not the case because no financial system exists in this world without financial intermediaries. According to Osman and Islam (2005), the fact that every financial system has financial intermediaries means that the latter play a very important role in an economy. This paper has been prepared with the main objective of assessing why financial intermediaries are needed. It is divided into four sections. The first section is an introduction. The second section provides a brief overview of financial intermediaries and their role in a financial system. In the third section, provides a detailed explanation of the reasons why lenders and borrowers need financial intermediaries. This section of the paper takes the form of an explanation of the role of financial intermediaries within a financial system. The last section is the conclusion. An Overview of Financial Intermediaries Andrieş (2009) defines financial intermediaries as financial institutions whose role in an economy is to buy and sell assets and financial contracts. They link the providers of funds and the users of such funds. The process through which funds are transferred from lenders with surplus to borrowers is called financial intermediation. According to Besley and Brigham (2011), the financial intermediaries obtain funds from lenders and ensure that such funds are available to borrowers as need arises. Through financial intermediation, households and business entities are able to obtain funds for different functions while lenders are able to give out loans to borrowers at a satisfactory interest. Lenders and borrowers need financial intermediaries for different reasons. These reasons can also be described as the roles of financial intermediaries in an economy. They include risk transformation, maturity transformation, and transformation of denomination. Lenders and borrowers need financial intermediaries to reduce transaction costs (Besley and Brigham, 2011). Role of Financial Intermediaries Lenders and borrowers need financial intermediaries to serve the following purposes: Risk Transformation In a financial system, one party to a transaction has very little knowledge over the other. For instance, the lender of funds may not have adequate information on the financial state of the borrower. This means that there are high chances that the lender will give funds to high risky borrowers. High risky borrowers are those business entities and individuals who are not creditworthy. According to Howells and Bain (2010 discussion such parties would therefore borrow funds and fail to pay back in accordance with the terms and conditions. The situation in which the lender is at risky or giving funds to high risky borrowers is referred to as adverse selection. It is also important to note that even after accurately assessing and selecting creditworthy individuals and businesses, the lenders may still be at risky of losing their funds. This according to Baker and Martin (2011) is because the borrowers may choose to use the funds for more risky purposes as opposed to what the lender had expected. An investor may borrow funds from a lender with an objective of using them to pursue a particular business opportunities. After being given the funds, the investor may however decide to use them for completely different purposes hoping to generate more income from such an investment opportunity. Besides, the investor may pursue such an investment opportunity regardless of the risky associated with it (Andrieş 2002). When eventually the risk occurs and investor loses all the invested funds, the lender would be the loser. The presence of asymmetrical information within a financial system results into problems after the transactions which fall under the class of moral hazards. According to Besley and Brigham (2007), financial intermediaries have the financial capacity and adequate human resources to accurately assess potential borrowers and hence select only the creditworthy ones. These financial institutions also have the capacity to monitor the activities of borrowers to make sure that the funds borrowed are being used in accordance with agreed terms and conditions. Consequently, financial intermediaries play an important role in protecting lenders’ funds through risk transformation. Maturity Transformation In financial system, individuals and businesses with surplus funds need investment opportunities, which would generate satisfactory income while providing access to their funds whenever need arises. Borrowers on the other hand, may need funds to finance long-term projects. This in McMenamin’s (2002) opinion therefore means that without financial intermediaries, it would be difficult for borrowers to meet their financial needs. On the one hand, lenders need to give short-term loans while borrowers on the other hand need funds to finance long-term projects. This situation would make it almost impossible for funds to flow from lenders to borrowers and back to lenders. Financial intermediaries bridge this gap by obtaining funds from lenders and investing the same in a variety of portfolios, which have different maturity periods. This makes sure that lenders would access their funds any time they need it. At the same time, borrowers will be able to access funds to finance their investment projects regardless of the maturity period. According to International Monetary Fund (2003), financial intermediaries play an imperative role in ensuring free flow of funds between borrowers and lenders within an economy. This addresses the needs of borrowers and lenders by making sure that borrowers can access funds for a period

of time that is most suitable to them. Moreover, financial intermediaries also enable small-scale lenders to take part in issuing long-term loans thus enabling the latter to earn high interest rates from such investments. Transformation of Denomination A large number of lenders in an economy are individuals who can only save a relatively small amount of funds. In contrast, most borrowers are large scale business entities, which need huge amounts of money. It would therefore be difficult for large scale corporations to access funds from small scale savers within the economy. The cost of obtaining loans from thousands of individual savers within a financial system would be too high for the business entity. According to Beck et al., (2001), this process would require a large number of personnel, which in the end would be more costly than the financial benefit of acquiring such funds. Financial intermediaries solve this problem by collecting funds from many savers within an economy and making sure that such funds are available in large denominators to borrowers. This in Bolton and Freixas’ (2000) opinion enables large scale business entities to access funds without having to go through many complicated processes of borrowing funds from individual borrowers within the economy. Financial intermediaries thus play an important role in the economy by making sure that even small savers are able to invest their funds and generate a substantial income. This in Arner’s (2007) opinion ensures that financial success is not just a reserve of people with large amounts of money. In fact, when small savers are allowed to invest, funds would increase because in most economies, small-scale savers are the majority. Financial intermediaries therefore

play a significant role in an economy through increasing the flow of funds from savers to borrowers. The role of financial intermediaries in bringing enabling lenders and borrowers to achieve their financial goals can therefore not be overstated. Reduction of Transaction Costs Financial intermediaries also reduce the transaction costs for both lenders and borrowers. If borrowers operate in a financial system devoid of financial intermediaries, they will be required to incur the cost of screening potential borrowers to ascertain their creditworthiness. They will also be compelled to monitor the activities of the borrowers ensure that the funds are being used in the most appropriate manner. Undertaking these processes would be somewhat challenging for lenders of funds. According to Fabozzi and Drake (2009), this is due to the large number of borrowers who may be geographically dispersed within the economy. It would be therefore costly for the lenders to assess the many borrowers and ascertain they are indeed creditworthy. After giving them funds, it would even be more difficult to monitor their activities due their large number and geographical dispersal. In the end, the cost incurred in assessing and monitoring the activities of borrowers would be higher than the income generated from such investments. Adrian and Shin (2010) explain that the duty of screening potential borrowers and monitoring their activities is delegated to financial intermediaries. These financial institutions have the financial capacity to accurately assess borrowers and make sure that loans are given out only to investors who deserve. According to Thakor and Boot (2008), the cost assessing these borrowers is therefore passed on from lenders to financial intermediaries. As the financial intermediaries, have the financial capacity, human resource and technological resources to effectively assess potential borrowers before the transaction and monitor their activities after the transaction. Financial intermediaries as well assess different lenders to guide the borrower on which loans to borrow. The transaction cost incurred in this process thus transferred from borrowers to the financial intermediary. Conclusion Financial intermediaries are financial institutions which facilitate the transfer of funds between lenders and borrowers within an economy. Lenders and borrowers cannot profitably engage in their respective businesses without the help of financial intermediaries. Financial intermediaries manage risks on behalf of lenders. They screen potential borrowers to ascertain that their creditworthiness. Even after funds have been given to borrowers, financial intermediaries follow up to make sure that borrowers are using the funds in the most appropriate manner. This therefore reduces adverse selection and moral hazard thus making sure that lenders are guaranteed of getting their returns. Financial intermediaries also provide the service of maturity intermediation. They enable lenders to provide long-term loans and still have access to money at any time. This ensures that borrowers who need funds to finance long-term projects can access them from lenders who are only interested in giving out short term loans. Financial intermediaries also enable collection of funds from many small-scale savers, making the funds available in large denominations to large-scale borrowers. This function can be described as transformation of denomination. 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