FINANCIAL INTERMEDIARIES

Financial Intermediaries.
Financial  intermediaries evolved  over many  years  to perform  the  financial-related functions  desired by the  four sectors  of the economy:  household, corporate,  government and  foreign sectors. However, some of them have been legislated  into being, such as the central bank.

Financial Intermediation
Income does not usually match expenditure; therefore surplus and deficit economic units exist. Given their  existence, which amounts to  a supply of  and a demand  for loanable funds,  some financial conduit is necessary  if the excess funds of surplus  units are to be transferred  to deficit units. The needs of these  units may  be reconciled  either through direct  financing or  indirect financing,  i.e. through the interposition of financial intermediaries.

Direct financing
This involves the bringing together of lenders and borrowers. However, a clash of  interests  exists between borrowers and lenders, and it is therefore rare that the ultimate lenders and borrowers are able to meet in order to consummate a deal. This is so because lenders tend to require investments (instruments / securities) that differ from those that  borrowers prefer to issue, and  the differences involve characteristics  such as size, term to maturity,  quality,  liquidity, etc. Borrowers  generally require  accommodation on terms differing from those  which lenders are willing or able to grant.

Financial intermediaries
Financial intermediaries performing indirect financing, assist in resolving this conflict between lenders  and  borrowers by  creating  markets  in  two types  of  financial  instruments,  i.e.  one type  for borrowers and another for lenders. They offer claims against themselves, customised to satisfy the needs (in terms of characteristics of instruments) of the lenders, in turn acquiring claims on the borrowers. The former claims are usually referred to as indirect securities and the latter as  primary securities.

The financial intermediaries receive a fee, represented by the difference between the cost of the indirect securities they issue and the revenue  earned  from the primary  securities they purchase(interest, dividends, capital gains).  In the case  of banks this is  called the margin.