Financial Intermediaries

 

We will discuss the need for financial Intermediation and their functions.

An economic community can prosper only when it is able to employ its resources optimally. But this does not happen automatically, as all people are not endowed with resources that could be deployed productively.

Therefore, the resources are required to be moved from those who have it and made available to those who can make use of it. This aspect brings out the need for financial intermediaries.

The process of transferring the funds from the savers to the entrepreneurs is called Intermediation. Intermediaries who have the ability to insulate the savers from the risks. They manage the risks.

Such risks are as follows:

Credit Risk:   It is the risk of default by the borrower for any reason. It is possible that the business does not generate sufficient income to repay the loan and the borrower is not honest enough to honour his commitment. Credit risk is the most serious risk that any lender faces and individual lenders cannot afford to take such risk.

Liquidity Risk: Borrower may have every intention to repay the loan and the business may be doing well too.However, there could be occasions when the borrower is not able to withdraw funds from the business when the lender demands repayment. There could be many types of temporary problems, which may or may not be in the control of the borrower.

Interest Rate Risk: Another risk in lending money is the possibility of loss due to change in the rate of interest in the market. At the time of the transaction, the borrower may have agreed to give interest at the prevailing rate of, say ,10%.Subsequently, the borrower may ask for reduction in the rate of interest, as money is available at a cheaper rate from other sources.

The risk-averse nature of normal savers and the risks inherent in any entrepreneurial activity necessitates intermediaries who have the ability to insulate the savers from the risks inherent to business. This also makes available the funds to entrepreneurs by managing the risk in an effective manner to minimize the chance of loss. Intermediaries also generate employment and promote economic welfare by enabling production of goods and services required by the community. Therefore, intermediation is a very important economic function.

Due to important role as financial intermediaries, banks have emerged as unique institutions enjoying the trust of people.

As a financial institution, banks perform the following roles:

• Financial Intermediary
• Constituent of the payment system
• Provider of other financial service