FUNCTIONS OF FINANCIAL INTERMEDIARIES

. Economic functions of financial intermediaries
As noted, the financial  intermediaries essentially metamorphose the unacceptable claims on  borrowers into acceptable claims on  themselves. From this a number  of benefits for the economy arise:

1..Facilitation of flow of funds:

In essence,  financial intermediaries facilitate  the flow  of funds from  surplus economic  units to deficit economic units. Without sound financial intermediaries, much of the savings of the ultimate lenders will not be available to the ultimate borrowers.

This function may also be described as a savings and wealth storage function, i.e. surplus economic units have an  outlet  for their  funds and  are  thus able  to store  (preserve)  their wealth  in low-risk  (certain non-government securities) or risk-free (government  securities) or even risky (other non-government) financial instruments.
2.
Effcient allocation of funds
Financial intermediaries have the expertise to ensure that the flow of funds is allocated in the most efficient manner.
Intermediaries, particularly the  banks, are  aware of  the existence  of asymmetric  information and its two by-products, the  problems of adverse selection and moral hazard.

Asymmetric information means that the potential borrower has more information than the bank does about his/her business.
Adverse selection means that  bad risk borrowers are more  likely to want loans than  good risk borrowers.
  Moral hazard purports that once a loan is granted the borrower may be  inclined to take risks with the money that are not disclosed to the bank  in the application.
They thus ensure that available funds are allocated to borrowers that are expected to utilise the funds prudently, which in turn leads to an increase in economic activity.

3. Assistance in price discovery

Closely allied  with efficient  allocation of funds  is price discovery. 
The financial  intermediaries are the professionals on the financial  system, and are therefore keenly involved in price discovery. They are actively involved in the pricing of financial services and securities.

The central bank plays a major role in this regard via  its monetary policy.
As this is implemented via the banking sector, this sector  also plays a major role in the discovery  of interest rates.
Certain  institutions  also play  a  major  role  in the  discovery  of  other  asset  prices.
For  example, fund managers that manage pension funds are active in  differentiating between the market price and the  fair value of  equities, and influence the  pricing of equities via  their actions of either buy or sell in  the equity market.

4.
Money creation
This function may  also be  termed the bank loan/credit  function, because  it is this  action of  banks that  creates money  in the form  of new deposits.
Not only  are existing funds allocated  efficiently, but new  loans are allocated efficiently by the banking sector.
They  have the  unique ability  to create  money provided of course that the central bank assists in the process through the supply of borrowed cash reserves to the  banks.

The banks may thus be seen as the intermediaries that ease the constraint of income on expenditure, thereby enabling the consumer to spend in anticipation of income and the entrepreneur to easily acquire physical capital. 
These activities  are crucial  in terms  of output  and employment growth.

5. Enhanced liquidity for lender
If an individual purchases the securities of  the ultimate borrower  (such as making  a loan to  a company), liquidity is zero until maturity of the loan. Intermediaries purchase less or non-marketable indirect securities, and offer liquid investments to  the ultimate lenders.

A good example  is the banking  sector that makes non-marketable  securities such as  mortgages, leases and instalment credit contracts, and finances these by offering products that are immediately “cashable” such as current accounts and savings  accounts.

6. Price risk lessened for the ultimate lender

Financial  intermediaries take on price  risk and offer products  that have little or zero price risk. An example is an insurer that has a portfolio of shares and bonds that involve substantial price  risk, but offers products that have zero  price risk, such as guaranteed annuities.

Another fine  example is banks  that have  a diverse portfolio  that includes  price-sensitive bonds, loans and share/equity investments, and offer products that  have zero price risk such  as fixed deposits to depositors.

7. Improved diversification for lender

Members of  the household sector (i.e.  ultimate lenders) usually  have a smaller  wealth size and  can therefore only  achieve limited diversification compared  to a  financial intermediary  that aggregates  small amounts  for investment in the securities of the ultimate borrowers.
Thus, an individual has limited diversification possibilities and therefore carries a higher risk level than financial intermediaries, which are able to hold a wide variety of investments.
The central doctrine of portfolio theory (and practice) is that risk is reduced as the number of securities in a portfolio is increased.

8.Economies of scale
Because of the sheer  scale of financial intermediaries compared with individual participants, a number of economies are achieved. Two main economies are realised: Transactions costs and Research costs.

Transaction Costs:
The  largest  benefit  of  financial  intermediation  is  the  reduction  in  transactions  costs.
Even more important is  payment system costs.  The banking system,  through the use  of sophisticated technology, provides an efficient  payments service
(cheque clearing,  EFTs, ATM withdrawals, etc.) that  is relatively inexpensive.
Individual participants in the financial system cannot achieve this reduction in transactions costs.
Research Costs:
Another benefit is in terms of research costs. An individual holder of a diversified portfolio of shares has the task of monitoring the performance of each company,  which involves economic  analysis, industry analysis, ratio analysis, etc.
Financial  intermediaries do have the resources to  carry out research, which essentially benefits the holders of its products. A good example  is the retirement fund.  The retirement fund  member has a “share” or “participation interest” in the  portfolio of the fund, and  the fund has the resources to research  the investments on behalf of  the many members.

9.Payments system
The financial system (speciffically the banking sector) provides the mechanism for the making of payments for anything that  is purchased (goods, services,  securities).
Certain financial assets  serve as a means of payment and purchases are settled efficiently. The financial assets that are  accepted as a means of  payment (i.e. money) are: Bank notes and coins , and Bank deposits [transferred by cheques, credit cards, debit cards, EFTs etc.].

10. Risk alleviation
Certain financial  intermediaries are in  the business of offering protection against adverse occurrences such as untimely death, health problems, damage to property and loss of income.
In addition, the financial system allows for self-insurance, i.e. the storage and building of wealth in order to protect against adverse life, property and income  occurrences.