1.1.2Financial institutions as ‘intermediaries’

We now know that nancial institutions take different forms and offer a wide

range of products and services. Is there anything that they have in common? As a

general rule, nancial institutions are all engaged to some degree in what is called

intermediation. Rather obviously ‘intermediation’ means acting as a go-between for

two parties. The parties here are usually called lenders and borrowers or sometimes

surplussectors or units, and decitsectors or units.

What general principles are involved in this ‘going-between’? The rst thing to say

is that it involves more than just bringing the two parties together. One couldimagine

a rm which did only this. It would keep a register of people with money to lend and

a register of people who wished to borrow. Every day, people would join and leave

each register and the job of the rm would be to scan the lists continuously in order

to match potential lenders whose desires matched those of potential borrowers. It

would then charge a commission for introducing them to each other. With today’s

technology this would be quite easy and protable, as many dating agencies and

insurance brokers have discovered. This process, however, is not intermediation.

If anything, it is best described as broking. When we use the term intermediation,

the ‘going-between’ involves more than just introducing the parties to each other.

Something else has to be provided.

As a general rule, what nancial intermediaries do is:

to create assets for savers and liabilities for borrowers which are more attractive to each

than would be the case if the parties had to deal with each other directly.

What this means is best understood if we consider an example. Take the case of a

person wishing to borrow £140,000 to buy a house, intending to repay the loan over

twenty years. Without the help of an intermediary, this person has to nd someone

with £140,000 to lend for this period and at a rate of interest which is mutually

agreeable. The borrower might be successful. In that case, the lender has an asset (an

interest-bearing loan) and the borrower has a liability (the obligation to pay interest

and repay the loan). In practice, however, even if the would-be borrower employed

a broker, it seems unlikely that the search would be successful. There are probably

not many people willing to lend £140,000 to a comparative stranger, knowing that

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1.1 Financial institutions

they cannot regain possession of the money for twenty years. Even if such a would-be

saver were to be found, he would probably demand such a high rate of interest as

compensation for the risk that no borrower would contemplate it.

Financial intermediary:An organisation which borrows funds from lenders and lends

them to borrowers on terms which are better for both parties than if they dealt directly

with each other.

Suppose now that some form of nancial intermediary like a building society

were to emerge. This might operate (as societies do) by taking in large numbers of

relatively small deposits on which the society itself pays interest. These could then

be bundled together to make a smaller number of the large loans that people require

for house purchase. Borrowers would then pay interest to the society. Obviously,

this is benecial to both parties – savers and borrowers. Savers can lend and earn

interest on small sums, even though no one wishes to borrow small sums. Provided

the society does not lend all the deposits but keeps some in reserve, individual savers

know that they can get their deposit back at short notice. Because the conditions are

so attractive to savers, the rate of interest charged to borrowers can be much lower

than it otherwise would be.

If we persist with the idea of nancial intermediaries as rms which, unlike brokers,

producesomething, then we may say that what they produce or create is liquidity.

Precisely how it is that intermediaries can perform this function of creating more

attractive assets and liabilities in safety (since it typically involves taking in short-

term deposits and lending them on for longer periods) is something we shall discuss

in more detail in the next section, after we have discussed some of the consequences

of intermediation.