Over the course of time, it can be seen that the role of financial intermediaries has increased exponentially, primarily because of the underlying importance it has pertaining to the establishment of a strong linkage between the borrowers and the lenders.
In this regard, the main premise of financial intermediaries is to establish a bridge between the two parties, so that they are able to divide the risks and proportionately manage their risks and returns to create a beneficial impact for all three parties involved, the borrower, the lender, as well as the financial intermediary involved.
Importance of Financial Intermediaries
The importance of financial intermediaries is often justified using the higher dependence of these organizations to create a positive impact when it comes to facilitating the transaction between the borrowers and lenders. In exception to this underlying principle, there are also a couple of other factors which make the existence of financial intermediaries highly important.
Firstly, it can be seen that financial intermediaries promote a high degree of value transformation. This means that there are certain borrowers who require considerably large sums of money.
In this regard, they might find it hard to pay a single investor who would be ready to contribute that particular amount. However, in the case of financial intermediaries, they can pool smaller deposits together in order to lend this amount to those who are in need of larger funds.
Secondly, financial intermediaries also ensure that the relevant parties in the economic circuit are able to deal with the aspect of maturity transformation. This highly lies in the realm of the fact that most depositors are in search of depositing money for the shorter term, in order to retain a certain level of liquidity.
In this case, financial intermediaries are then able to manage liquidity preferences between the borrowers and the lenders by establishing a middle ground so that they are able to cater to both the parties, on the terms they want.
Financial Intermediaries are also important because they significantly reduce the transaction costs that are associated with the process.
For example, if borrowers and lenders are able to use the services of the intermediaries, they would not have to go through the legal process of establishing and writing contracts. This can also be considered as a significant cost-saving advantage of financial intermediaries.
The overall risk profile of borrowers and lenders tends to differ on numerous grounds. Risk diversification, however, tends to be a common denominator in this regard, essentially because of the fact that both parties want maximum return with the least amount of risk.
Therefore, in this regard, financial intermediaries, share the risk (in return for their profit), by guaranteeing that in the case where a borrower defaults on the loan, the lender will still be paid back the amount on behalf of the financial intermediary himself. Additionally, it also reduces the risk of the borrower and the lender because the return on individual savings is not solely reliant on the performance of a single borrower.
Financial intermediaries are formed on basis of specialist knowledge and resources that are expected to assess the underlying risk and the predicted profitability of the proposed projects. Therefore, the overall risk is further reduced on the part of lenders, since they have proper clarity about the inherent risk profile of the borrower. This expertise saves the lender from a lot of hassle, and a considerable amount of risk.
Therefore, in this regard, it is also highly important to understand the fact that these financial intermediaries are formed to provide a service, and therefore, they earn their profits from the interest spread that exists between the interest rate offered to the borrower versus the interest rate that is paid to the lender.
The importance of financial intermediaries cannot be undermined in comparison to the overall benefits it has for the economy at large. It is also important to understand how it ensures that the market functionality is smooth and normalized, without any misconceptions of trust deficits that would deter lenders from extending money to those in need.
The importance of financial intermediaries can, therefore, be seen as factors that fuel the transactions within the economy, on grounds of ensuring that there is no trust deficit between the borrowers and the lenders. By acting as an extremely important chain of command, they ensure that they are able to create a positive working style, which can subsequently lead to higher transactions to contribute positively to the overall economy.