Question

A bank is an example of a financial intermediary. Explain the role of financial intermediaries and
their usefulness to the private investor ( At least 500 words)

Answer 1

A financial intermediary is an entity that enables a financial transaction between two parties. Examples of such financial intermediary could be a bank, insurance companies, pension fund etc.

Such intermediaries charge a fee in exchange for the services they provide. Bank, is a typical example of a financial intermediary, is associated with various services. Banks serve as an investment vehicle for the investor as well as act as a lender for the borrowers. The biggest and most important function of financial intermediaries is to convert savings into investment and help create efficient markets that are ultimately based on lowering the cost of doing business and transactions. The basic premise of a financial intermediary is to transfer funds from the lender to borrowers. In this way, they provide a channel for investment for the depositors while making credit available for the growth of a business. These financial intermediaries are also associated with trading ie. buying and selling of securities. They act as a dealer by raising capital using various funding routes for the borrower. Due to the diverse and critical nature of tasks carried out by a financial intermediary, they are considered as the backbone of any economy and are subject to various regulations. Associated benefits of a financial intermediary include decreasing search costs. A borrower needs to spend his/her time or energy for finding a borrower, at the same time a borrower needs not to worry about borrowers of his/her money. Also, a financial intermediary especially a bank spreads the risk across various participants, thus, reducing the overall risk. Due to the financial intermediation being carried out at a huge level, economies of scale come into the picture. Due to this, the overall borrowing costs for a borrower comes down while at the same time interest rates earned by a private investor increases.

A private investor can leave the complexity associated with investing in various instruments with these financial intermediaries (FI's) like banks. Such FI's are specialists in investing and can invest an investor's money in various asset classes according to the risk-return profile of the private investor, in exchange for a fee. In short, these financial intermediaries enable the private investor's capital to be exposed to various instruments, which results in reducing the overall risk which hitherto could not have been possible without an intermediary. Other than this, financial intermediaries such as banks and other boutique investment banks act as an advisor for a private investor to understand their risk-return profile and suggest them financial products. Another type of financial intermediary, insurance advisors, enables a private investor to invest in securities which also provide the insurance cover. Broking firms allow a private investor to invest in equity and bond markets and also provide them with tailor-made recommendations and suggestions for their investments. Pension funds are another type of financial intermediary, which specializes in allowing pension planning for individual private investors. Such FI's invests capital into a long-term less risky asset which enables a private investment to plan his/her retirement. All these types of financial intermediaries enable a private investors to invest their capital in exchange of certain fees. Access to such wide markets and financial products would not had been possible without financial intermediaries.