Describe the process of financial intermediation and how the deposit-taking

and non-deposit-taking financial intermediaries facilitate the transfer of liquidity from surplus to deficit units in the

economy.

Class : Name : ID :

Date :2011/12/12

Summary

This article mainly describe the process of financial intermediation and explain how the deposit-taking and non-deposit-taking financial intermediaries facilitate the transfer of liquidity from surplus to deficit units in the economy . Financial intermediaries can be divided into two mainly types : deposit-taking financial intermediaries and non-deposit-taking financial intermediaries . And in the economy at any given time there will be two groups of economic agents : surplus units and deficit units . Deposit-taking financial intermediaries and non-deposit-taking financial intermediaries connects surplus and deficit units . They channel funds from people who have extra money to those who do not have enough money to carry out a desired activity . And they have an advantage on some aspects , for example , they have low costs , convenience and safety . So people who don't have enough money would prefer to borrow some funds from financial intermediaries rather than direct borrow from who have surplus funds , people who have surplus funds also prefer to keep the funds in deposit-taking financial intermediaries and pay for some services non-deposit-taking financial intermediaries . If there is no financial intermediaries , the flow of funds is difficult . So the financial intermediaries facilitate the transfer of liquidity from surplus to deficit units .

CONTENTS

Summary

Financial intermediation

Functions performed by financial intermediaries

1.Maturity transformation

2.Risk transformation

3.Convenience denomination

Advantages of financial intermediaries

1.Cost advantage

2.Market failure protection

How the non-deposit-taking financial intermediaries facilitate the transfer of liquidity from surplus to deficit units

How the non-deposit-taking financial intermediaries facilitate the transfer of liquidity from surplus to deficit units

Bibliography

Financial intermediation

Financial intermediation consists of “channeling funds between surplus and deficit agents”. A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans.

Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities. As such, financial intermediaries channel funds from people who have extra money to those who do not have enough money to carry out a desired activity .

A financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly. That is, savers give funds to an intermediary institution , and that institution gives those funds to spenders . This may be in the form of loans or mortgages.

Functions performed by financial intermediaries Financial intermediaries provide 3 major functions:

1.Maturity transformation

Many savers like to be in a position to withdraw their savings with little delay rather than tie them up for long periods.Borrowers, on the other hand, especially house buyers and firms, often need to borrow for quite long periods. Since surplus units want liquidity and deficit units want a loan for a certain minimum period of time, then clearly what the surplus units are prepared to risk needs to be transformed into something which deficit units want.

Financial intermediation helps overcome this problem by

transforming short term deposits into long-term loans.

Provided that an institution keeps paying a competitive rate of interest on deposits,there is no reason why the total volume of funds placed with it should fall significantly.The ability of a financial institution to engage in maturity transformation and to provide the other elements of liquidity depends basically upon it being able to enjoy the benefits of economies of scale. With a large number of depositors institutions will

expect a steady inflow and outflow of deposits every day. These will largely cancel out each other and they will be subject only to small net outflows and inflows.

Furthermore, it is demonstrated statistically that these flows behave in a more stable manner the larger the number of depositors, and the greater will be the confidence they can place on net outflows.

Another advantage of economies of scale is that the greater the volume of assets the institution has, the greater scope available for arranging those assets in such a way that a proportion matures at regular intervals.

2.Risk transformation

When a loan is made there is always the danger that it will not be repaid; for example, a company might borrow money and

then go out of business. However, when one saves with a financial institution the risk is very much reduced. Of course, the institution itself then carries the risk that a borrower will default in repayment. However, financial intermediaries are able to reduce risk through specialist management and diversifying by making a large number of loans to different types of borrowers. Diversification reduces risk on the loan portfolio since, by combining assets in a portfolio, the overall risk is actually reduced below the average risk of the assets which comprise it. Financial intermediaries also take account of loan default losses in the rates of interest they charge to borrowers.

3.Convenience denomination

The savings of individuals may be small. However, financial institutions can combine, or aggregate comparatively small sums and make them available in a single loan to a borrower. So, although individually these savings balances or insurance premiums, for example, may be of little economic significance, aggregated together with the larger current account balances and insurance premiums of businesses, and the much larger deposit balances of the private sector as a whole, we have a vast pool of funds available for deficit units, from which relatively large sums can be lent to borrowers.

A small saver, for example, could not fund a mortgage for the house purchase of a borrower, but the savings of many pooled together could. This is basically the principle employed by the early building societies.

Advantages of financial intermediaries

Advantages of financial intermediaries make people match their needs with financial intermediaries . There are 2 essential advantages from using financial intermediaries:

1.Cost advantage

If people want to save or borrow some moneys , they can direct save or borrow from financial intermediary and only need pay some relevant fee . But if there is no financial intermediation , people who want to save or borrow some money will have a big cost . For example , Search costs incurred in searching out potential transactors, obtaining information about them and negotiating a contract . Verification costs incurred in evaluating borrowing proposals . Monitoring costs incurred ensuring contract terms adhered to . Enforcement costs incurred in the event of default. If people who want to save or borrow some moneys , these costs would be the cost of financial intermediation . So savers and borrowers have an advantage on cost by using financial intermediation .

2.Market failure protection

The conflicting needs of lenders and borrowers are reconciled, financial intermediaries would try their best to prevent market failure to ensure itself revenue . Financial intermediaries have some advantages on the information of financial market and low transactions costs . Information is at the heart of all transactions and contracts . Gathering enough informations is difficult to individuals , however financial intermediaries have an advantage on acquiring all kinds of informations about savers and borrowers . Although financial intermediaries don't have the perfect information , they can better than individuals prevent market failure . That's mean financial intermediaries can help clients avoid losing .

Financial intermediaries perform the vital role of bringing together those economic agents with surplus funds who want to lend, with those with a shortage of funds who want to borrow. In doing this they offer the major benefits of maturity and risk transformation. It is possible for this to be done by direct contact between the ultimate borrowers, but there are major cost disadvantages of direct finance.

Indeed, one explanation of the existence of specialist financial intermediaries is that they have a cost advantage in offering

financial services, which not only enables them to make profit, but also facilitate the transfer of liquidity from surplus to deficit units and raises the overall efficiency of the economy. The other main explanation draws on the analysis of information problems associated with financial markets.

There are some different financial intermediaries :

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? Banks Building societies Credit unions Financial advisers or brokers Insurance companies Collective investment schemes Pension funds

These financial intermediaries provide different services to clients . Their services facilitate the transfer of liquidity from surplus to deficit units in the economy . And these financial intermediaries can be divided into two categories : deposit-taking financial intermediaries and non-deposit-taking financial intermediaries .

How the deposit-taking financial intermediaries facilitate the transfer of liquidity from surplus to deficit units

Deposit-taking financial intermediaries includes :

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? Banks Building societies Credit unions

Figure 1 Deposit-taking financial intermediation

(Creditor) (Debtor)

Saver Bank

Bank Borrower (Creditor) (Debtor)

As shown above , deposit-taking financial intermediation facilitate the transfer of liquidity from saver to borrower by accepting funds from savers and lending these to borrowers . Deposit-taking financial intermediaries usually provide many services about deposit to acquire funds from saver . In order to get revenue , deposit-taking financial intermediaries usually quick lend funds to borrowers . People also often choose the way keep funds in the deposit-taking financial intermediaries or borrow funds from deposit-taking financial intermediaries , because if savers direct lend fund to borrowers , both of them would have a big cost . So deposit-taking financial intermediaries facilitate the transfer of liquidity from surplus to deficit units in the economy .

How the non-deposit-taking financial intermediaries

facilitate the transfer of liquidity from surplus to deficit units

Non-deposit-taking financial intermediaries :

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? Insurance companies Investment Trust Unit trusts Pension funds

Figure 2 Non-deposit-taking financial intermediation Insurance companies

Pension funds

Individuals Funds market Unit trusts

As shown above , non-deposit-taking intermediaries provide some services to people who need it , and people who want to enjoy some services pay some moneys to these financial intermediaries . Then non-deposit-taking financial intermediaries would try their best to got more money by using these money from individuals to invest . Finally , people's money is used by who need money . Non-deposit-taking financial intermediaries provide some services which people require . If

there is no non-deposit-taking financial intermediaries , the liquidity of these funds from surplus to deficit units would be not exist or face a difficult .

The insurance companies provide life insurance to those seeking life cover and general insurance as cover against particular risks, such as burglary, fire, accidents and damages. Their income comes from the premiums paid by policy holders and from the returns on the assets in which they have invested the premium income. The word insurance is generally used to cover all types of savings and investment against life’s vicissitudes. Along with the other institutional investors with their massive multi-billion funds, they are a powerful force in the financial markets.

The claims against insurance companies arising out of their general insurance business tend to be short term, and those arising from their life business are long term. Therefore, insurance companies have to exercise financial prudence by adjusting their asset maturity structures to cope with the short and longterm nature of their liabilities and, simultaneously, to adjust their asset portfolios so as to obtain maximum benefit from asset diversification. Insurance companies’ long term investment is mainly in shares of companies, government bonds, mortgage and other loans, and property. Their short term investment is in general funds with a more

even spread over the different types of investments. The bulk of their investments is long term and is held in the life fund .

The pension funds can be confident of the source and scale of their contributions since these are a contractual obligation for employers and employees contributing to the pension schemes, and given that the funds’ future obligations per retired employee are known, their total obligations are a matter of actuarial computation which involves the size of the current workforce, its age distribution, the average life expectancy after retirement, etc. In UK pension contributions also receive favorable tax treatment at one’s marginal rate of income tax, thereby favoring the higher earning contributor who currently pays tax at 40%, thus contributing only 60% of the total premium, compared to 80% for standard rate taxpayers.

Like other financial intermediaries, the nature of these liabilities determines the structure of the asset portfolio. If the fund collects lifetime contributions aimed at providing pensions related to final salary, for example, it needs to invest the regular contributions in a way that will ensure that their value rises in line with real earnings . In this way , the funds is transferred from workers to fund market . So it facilitate the transfer of liquidity from surplus to deficit units .

Unit trusts are funds into which individuals and companies can contribute with the aim of sharing in the capital and income returns generated by the

fund’s diversified portfolio. The institution is constituted as a trust in law and is, therefore, subject to trust law. The trustee, usually a specialist subsidiary of a major bank, acts as guardian of the assets on behalf of the beneficial owners, ensuring that the fund is managed within the terms of the trust deed, and that the managers are not acting ultra vires. For example, by law, unit trusts cannot borrow; so they cannot issue debentures. This means that they cannot be “geared”, unlike investment trusts which, as companies in law, can borrow and can, therefore have some degree of capital gearing .

These differ from unit trusts, and indeed all of the other financial intermediaries, in that they are closed-ended funds since they are public limited companies limited by their authorised share capital in raising funds. Being closed-ended allows the investment trust manager to plan ahead more effectively than the unit trust manager who has to make investment decisions in the wake of sudden inflows and outflows of money. As they are limited companies they are subject to company law. Unlike unit trusts, they issue shares which can be traded on the stock exchange like any other listed company’s shares. Also, unlike unit trusts, they can enjoy the benefits of gearing by borrowing through issuing loan stock to enable them to buy more of their stock in trade; the shares of other companies. They can also invest in property , an area of investment barred to unit trusts . It could quickly acquire a large number of funds ,

invest huge money in some projects . It facilitate the transfer of liquidity from surplus and deficit units .

Conclusion

Financial intermediaries provide a lot of services for surplus and deficit units . It make us conveniently use funds . Due to financial intermediation it is now no longer necessary for savers to seek out potential borrowers with matching needs . Financial intermediaries facilitate the transfer of liquidity from surplus to deficit units in the economy . It is a powerful factor to spur economic growth .

Bibliography

[1]Buckle, M & Thompson, J (latest edition) The UK Financial System: Theory and practice, (4thed.); Manchester University Press.

[2]Howells, PGA & Bain, K (2007) Financial Markets and Institutions, (5th ed.), Harlow: FT Prentice Hall.

[3]Mishkin, F S, Eakins, S G (2009) Financial Markets and Institutions (6th ed.).

[4]Pilbeam, K. Finance and Financial Markets (latest ed.); MacMillan Business.

[5]Fell, L (2000) An Introduction to Financial Products and Markets; London : Continuum.