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Financial intermediation is the process performed by banks of taking in funds from a depositor and then lending them out to a borrower. The banking business thrives on the financial intermediation abilities of financial institutions that allow them to lend out money at relatively high rates of interest while receiving money on deposit at relatively low rates of interest.

Direct lending between savers and borrowers is like barter, inefficient. In order for financial transactions to be completed there must be a double coincidence of wants.

People with savings will have a given amount of funds that they will want to lend for a particular time period.

They will need to find someone to lend to with matching circumstances, the same approximate amount of funds and the same time period.

Direct lending will necessitate a contract of some sort which will have to be negotiated. Subsequent transactions involving repayments of interest and principle will have to be accounted for.

Another problem encountered by lenders is that they will have limited ability to diversify and minimise their exposure to default risk. Financial intermediation resolves this problem.

A financial intermediary offers a service to help an individual or firm to save or borrow money.

A financial intermediary helps to facilitate the different needs of lenders and borrowers. For example, if you need to borrow $1 000 – you could try to find an individual who wants to lend pound1 000.

But, this would be very time consuming and you would find it difficult to know how reliable the lender was.

Therefore, rather than look for individuals to borrow a sum, it is more efficient to go to a bank (a financial intermediary) to borrow money.

The bank raises funds from people looking to deposit money, and so can afford to lend out to those individuals who need it. Some of the roles played by banks as financial intermediaries are as follows.

1. Pooling the resources of small savers: Many borrowers require large sums, while many savers offer small sums. Without intermediaries, the borrower for a $100 000 mortgage would have to find 100 people willing to lend him or her $1 000. That is hardly efficient. Banks, for example, pool many small deposits and use this to make large loans.

2. Mobilising Wholesale finance and Lines of Credit: Banks will also mobilise large sums of money from the wholesale markets for on-lending to many small borrowers across various productive sectors. Such facilities can be mobilised offshore, where a smaller company would not be able to negotiate favourable terms by themselves. Examples of such facilities are offshore credit facilities raised by banks to fund SMEs or mortgages locally.

3. Providing safekeeping, accounting, and payments mechanisms for resources: Banks are an obvious example for the safekeeping of money in accounts, the records of payments, deposits and withdrawals and the use of debitATM cards. Financial intermediaries can do all of this much more cheaply than individuals because they take aantage of economies of scale. All of these services are standardized and automated on a large scale, so per unit transaction costs are minimized.

4. Providing liquidity: Financial intermediaries make is easy to transform various assets into a means of payment through ATMs, credit cards, debit cards, etc. In doing this, financial intermediaries manage many short-term outflows and investments with long-term outflows and investments in order to meet their obligations while profiting from the spread between long and short term interest rates

5. Diversifying risk: Financial intermediaries’ help investors diversify in ways they would be unable to do on their own. Banks spread depositor funds over many types of loans, so the default of any one loan does not put depositor funds in jeopardy.

6. Collecting and processing information: Financial intermediaries are experts at collecting and processing information in order to accurately gauge the risk of various investments and to price them accordingly. Individuals do not likely have to tools or know-how to do the same, and certainly could not do so as cheaply as financial intermediaries (once again, economies of scale are important here). This need to collect and process information comes from a fundamental asymmetric information problem inherent in financial markets.

The process of financial intermediation is a very important role in an economy like ours. The majority of economic agents are in need of resources which they cannot generate on their own while some have surplus resources.

The ability of the two economic agents can be quickened by a financial intermediary. Some of the aantages of having financial intermediaries include the following:

(i) Lower search costs: You don’t have to find the right lenders you leave that to a specialist.

(ii) Spreading risk: Rather than lending to just one individual, you can deposit money with a financial intermediary who lends to a variety of borrowers — if one fails you won’t lose all your funds.

(iii) Economies of scale: A bank can become efficient in collecting deposits, and lending. This enables economies of scale — lower average costs. If you had to sort out your own saving, you might have to spend a lot of time and effort to investigate best ways to save and borrow.

(iv) Convenience of Amounts: If you want to borrow $10 000 — it would be difficult to find someone who wanted to lend exactly $10 000. But, a bank may have 1 000 people depositing $10 each.

Therefore, the bank can lend you the aggregate deposits from the bank and save you finding someone with the exact right sum.

Sanderson Abel is an Economist. He writes in his capacity as Senior Economist for the Bankers’ Association of Zimbabwe. For your valuable feedback and comments related to this article. He can be contacted on abel@baz.org.zw or on numbers 04-744686 and 0772463008.

Source : The Herald