What are the economic functions that financial intermediaries perform that benef

Question

What are the economic functions that financial intermediaries perform that benefit society? In your answer, discuss the relationship of financial intermediaries and financial markets to the savings-investment process within an economy and to each other. As part of your discussion provide an analysis of the differences in preferences among economic agents as an explanation for the wide variety of primary and secondary securities found in financial markets. Be sure to explain how depository intermediaries, like banks, differ from other financial institutions such as investment banking firms or securities brokerage companies, and how financial intermediaries profit from the transformation of primary securities into secondary claims. Carefully, DEFINE YOUR TERMS.

Explanation / Answer

Financial intermediaries issue (indirect) debt of their own to buy the (primary) debt of others. Their issues attract funds from alternative expenditures by nonfinancial spending units on consumption, tangible investment, or primary debt. Their lending directs the flow of funds to expenditure by borrowers on consumption, tangible investment, or primary debt. They intermediate between the sources of funds that flow to them and the ultimate users of these funds.

The intermediaries may be identified by their balance sheets, which show a high proportion of financial to tangible assets and of indirect debt to equity. Their income statements report high ratios of income from interest and dividends to total income and of expense for interest and dividends to total expense.

There are bank (monetary) intermediaries and nonbank (nonmonetary) intermediaries. The former are commercial banks and the central bank, together constituting the monetary system, which issues indirect debt, subject to unique regulations, in the form of money. The indirect debt which is issued by nonbank intermediaries is not used as a means of payment.

Both types of intermediary are to be distinguished from other institutions that transmit funds from ultimate lenders to ultimate borrowers. These other institutions do not issue their own indirect debt in soliciting funds. They include security dealers, brokers, and exchanges.

Types of intermediary . The principal nonbank financial intermediaries in the United States are the following:

Depositary intermediaries
Credit unions
Mutual savings banks
Savings and loan associations

Insurance and pension intermediaries
Casualty and miscellaneous insurance companies
Fire and marine insurance companies
Fraternal insurance organizations
Government retirement, pension, insurance, and
social security funds
Group health insurance
Private life insurance companies
Private noninsured pension funds
Savings bank life insurance departments

Finance companies
Factors
Mortgage companies
Personal finance companies
Sales finance companies

Investment companies
Closed-end companies
Face-amount certificate companies
Industrial loan companies
Open-end companies

Agricultural credit organizations
Federal land banks
Livestock loan companies
National farm loan associations
Production credit associations

Government lending institutions
Banks for cooperatives
Federal Home Loan Banks
Federal intermediate credit banks
Federal National Mortgage Association
Federal Savings and Loan Insurance Corporation

Nonbank financial intermediaries participate in four markets. They are net buyers on markets for primary securities; on markets for money balances—to be held as reserves of liquidity either voluntarily or by regulatory rule; and on markets for productive factors—labor in particular, but also capital goods and land. They are sellers on markets for their own issues of indirect debt—in such forms as savings and loan shares, savings bank deposits, and pension claims.

Intermediaries can promote growth by increasing the fraction of resources society saves and/or by improving the ways in which society allocates savings. Consider investments in firms. There are large research, legal, and organizational costs associated with such investment. These costs can include evaluating the firm, coordinating financing for the firm if more than one investor is involved, and monitoring managers. The costs might be prohibitive for any single investor, but an intermediary could perform these tasks for a group of investors and lower the costs per investor. So, by researching many firms and by allocating credit to the best ones, intermediaries can improve the allocation of society’s resources. Intermediaries can also diversify risks and exploit economies of scale. For example, a firm may want to fund a large project with high expected returns, but the investment may require a large lump-sum capital outlay. An individual investor may have neither the resources to finance the entire project nor the desire to devote a disproportionate part of savings to a single investment. Thus profitable opportunities can go unexploited without intermediaries to mobilize and allocate savings. Intermediaries do much more than passively decide whether to fund projects. They can initiate the creation and transformation of firms’ activities. Intermediaries also provide payment, settlement, clearing and netting services. Modern economies, replete with complex interactions, require secure mechanisms to settle transactions. Without these services, many activities would be impossible, and there would be less scope for specialization, with a corresponding loss in efficiency. In addition to improving resource allocation, financial intermediaries stimulate individuals to save more efficiently by offering attractive instruments that combine attributes of depositing, investing and insuring. The securities most useful to entrepreneurs – equities, bonds, bills of exchange – may not have the exact liquidity, security, and risk characteristics savers desire. By offering attractive financial instruments to savers – deposits, insurance policies, mutual funds, and, especially, combinations thereof – intermediaries determine the fraction of resources that individuals save. Intermediaries affect both the quantity and the quality of society’s output devoted to productive activities. Intermediaries also tailor financial instruments to the needs of firms. Thus firms can issue, and savers can hold, financial instruments more attractive to their needs than if intermediaries did not exist. Innovations can also spur the development of financial services.

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