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For every question, please write down each main step before you obtain the final answer. Correct final answer with incorrect related work (calculation) or without any work may receive 0 point. On the contrary, incorrect final answer with correct related work (calculation) will receive partial credits.

Question 3 – Financial Intermediaries [10 points]: Assume that you recently graduated with a degree in finance and have just reported to work as an investment adviser at the firm of Balik and Kiefer Inc. Your first assignment is to explain the roles financial intermediaries play in the U.S. banking system to Michelle Delatorre, a professional tennis player who has just come to the United States from Chile. Delatorre is a highly ranked tennis player who expects to invest substantial amounts of money through Balik and Kiefer. She is also extremely bright, and, therefore, she would like to understand in general terms what will happen to her money. Your boss has developed the following questions, which you must answer to help explain the nature of financial intermediaries and the U.S. banking system to Ms. Delatorre.

What is a financial intermediary? What is the financial intermediation process?

What roles do financial intermediaries fulfill?

What are the different types of financial intermediaries? Give some characteristics that differentiate the various types of intermediaries.

Describe the banking system found in the United States.

What role does the Federal Reserve play in the U.S. banking system?

Explanation / Answer

(1). A Financial Intermediary is an entity that helps to ensure that the funds supplied by the sources of capital are made available to those that needs them (the users of capital). A financial intermediary is a financial institution such as bank, building society, insurance company, investment bank or pension fund. A financial intermediary offers a service to help an individual/ firm to save or borrow money. A financial intermediary helps to facilitate the different needs of lenders and borrowers.

Examples of Financial Intermediaries

1. Insurance Companies: If you have a risky investment. You might wish to insure, against the risk of default. Rather than trying to find a particular individual to insure you, it is easier to go to an insurance company who can offer insurance and help spread the risk of default.

2. Financial Advisers: A financial adviser doesn’t directly lend or borrow for you. They can offer specialist advice on your behalf. It saves you understanding all the intricacies of the financial markets and spending time looking for best investment.

3. Credit Union: Credit unions are informal types of banks which provide facilities for lending and depositing within a particular community.

4. Mutual funds/Investment trusts: These are mutual investment schemes. These pool the small savings of individual investors and enable a bigger investment fund. Therefore, small investors can benefit from being part of a larger investment trust. This enables small investors to benefit from smaller commission rates available to big purchases.

(2).

Financial intermediation is the process by which the financial intermediaries--usually banks or other similar firms--borrow money from one source to give it to another company that needs funding, investment or resources. Basically, when people put their money in a bank or other savings fund, these financial intermediaries can then use, or "borrow," this money, allowing other companies to use to create or expand their own businesses. Since the money is not being used sitting in the bank, it seems clear that it would be put to better use by allowing it to serve as investments for others.

The financial intermediation is defined as the process which had been carried out by the financial intermediaries as the middleman between the borrower (spender) and lender (saver) to smooth the flow of fund. The financial intermediation called as the process of using the indirect finance in the financial system, which the primary route to transfer funds from lender to borrower. Those savers who have the surplus money will deposits their fund in the financial institution, which will lends those funds to borrowers such as business firms, households, government or foreigners who shortage of fund. Financial intermediary are those financial institution such as commercial bank, finance company, merchant bank, Islamic bank and Brokerage Company. The financial intermediary help to transfer the funds between the lender and borrower in the ways of borrow money from the lender-saver and then using this money to make loan to borrower-spender. For example, the financial institution acquires funds through public by issuing liabilities such as time deposits and saving accounts. After that, the bank might use that fund to acquire an asset by making loan to the people needed fund for investment or buying that company bond in the financial market. As a result, with the help of financial intermediary, the money successfully transfers from public to the borrower.

Financial intermediaries play an important role in the financial system because they help to facilitate the risk transfer and in dealing with the increasingly complex of financial instruments and markets. The financial intermediary's role is to transform the assets which are less desirable by a large portion of public in to assets that are more preferable by the public. This transforming have serve four economic function which are providing maturity intermediation, reduction of risk by diversification, reducing the contracting and information processing costs and to provide a efficient payment mechanism.

Due to the financial intermediaries are very specializing in information processing, they have create the well-functioning financial institutions that has greatly reduced the transaction and information for customer. They can achieve the economy of balance through specialization; this is because they are handling very large number of transaction so they are able to minimize the fixed costs by ward off the same production of information faced by borrower and lender. As a result, there are more funds are made available for investments.

The financial intermediaries help them channel funds more efficiently to productive investments through funding pooling, better identification and monitoring of profitable investments and risk diversification. Diversification allows allocating assets and bearing risks more efficiently. Those investments are protected against from unconscientiously borrowers by the institution's qualified loan officers and well-trained investment analysts seek good investment opportunities and screen prospective securities so as to obtain the best yield available for the risk level that suits the investor's preferences. Thus, the financial intermediaries are vital part for our economic system and in order to maintain the flow of money in the economy.

The financial intermediaries can improve the risk sharing and thus improve the economy welfare. The financial intermediary's help to diversify the risk of the lenders (savers) by help them to investigate their savings across different sector of business. They have the ability to get the important information that concern about the borrowers' financial position compare to those in direct finance route which lender directly lends their money to borrowers in financial market without any information about the borrowers.

Financial intermediaries can have the borrowers' such important information is because they already have a history of exercising discretion with this type of information, and help to reduce unreliable information concerning the borrowers. This will help to solve the problems create by asymmetric information which are adverse selection and moral hazards.

Financial intermediaries help them to screen risk, monitor risk and evaluate risk. It is more efficient for financial institution to screen the investment opportunity and risk on behalf of individuals compare to an individual to screen its. Since the institution has all the important information available about the lenders and borrowers, it helps to reduce the information costs for analyzing their data and save their time. Thus, individual can enjoy other services provided by the financial institution which can enable them to deposit and withdrawal funds without negotiation whereas the borrowers can avoid having a deal with individual investors. It concludes that it helps those individual not only save their time and money, and also offer low risk investment opportunity to them. If there is no the financial intermediaries, the lenders-savers and borrowers-spenders have to pay higher transaction and information costs and the facing the problem create by the asymmetric information such as adverse selection problem and moral hazards problems.

In conclusion, the existence of financial intermediary played a very important role in the economic development of the country. In this modern world, it would not have been so efficient, aggressive and progressive without the financial intermediation. Financial intermediaries provide a convenient and safe place where lenders can safely invest excess money and borrowers can easily borrow fund with the low cost and low risk.

(3) The Functions of Intermediation: Financial intermediation can improve economic efficiency in at least five ways, by:

1) facilitating transactions;

2) facilitating portfolio creation;

3) easing household liquidity constraints;

4) spreading risks over time; and

5) reducing the problem of asymmetric information.

Brokerage: Brokerage is acting as an agent to bring buyers and sellers together in order to complete financial transactions. Financial institutions such as stockbrokers specialize in brokerage, while some financial institutions engage in brokerage in addition to intermediation.

Externalities: Spillover effects, negative or positive, generated by the actions of financial institutions in particular, and the financial system in general, are called externalities. Negative spillover effects are often used as a justification for government regulation of the financial system.

Lower search costs. You don’t have to find the right lenders, you leave that to a specialist.

Spreading risk. Rather than lending to just one individual, you can deposit money with a financial intermediary who lends to a variety of borrowers – if one fails, you won’t lose all your funds.

Economies of scale. A bank can become efficient in collecting deposits, and lending. This enables economies of scale – lower average costs. If you had to sought out your own saving, you might have to spend a lot of time and effort to investigate best ways to save and borrow.

Convenience of Amounts. If you want to borrow £10,000 – it would be difficult to find someone who wanted to lend exactly £10,000. But, a bank may have 1,000 people depositing £10 each. Therefore, the bank can lend you the aggregate deposits from the bank and save you finding someone with the exact right sum.

4. These are institutions which mediate/link between the savers and investors:

Examples of financial intermediaries

1. Commercial Banks: They act as intermediary between savers and users (investment) of funds.

2. Savings and Credit Associations: These are firms that take the funds of many savers and then give the money as a loan in form of mortgage and to other types of borrowers. They provide credit analysis services.

3. Credit Unions: These are cooperative associations whose members have a common bond e.g employees of the same company. The savings of the member are loaned only to the members at a very low interest rate e.g. SACCOS charge p.m interest on outstanding balance of loan.

4. Pension Funds: These are retirement schemes or plans funded by firms or government agencies for their workers. They are administered mainly by the trust department of commercial banks or life insurance companies. Examples of pension funds are NSSF, NHIF and other registered pension funds of individual firms.

5. Life Insurance Companies: These are firms that take savings in form of annual premium from individuals and them invest, these funds in securities such as shares, bonds or in real assets. Savers will receive annuities in future.

6. Brokers: These are people who facilitate the exchange of securities by linking the buyer and the seller. They act on behalf of members of public who are buying and selling shares of quoted companies.

7. Investment Bankers: These are institutions that buy new issue of securities for resale to other investors.

They perform the following functions:

Giving advice to the investors

Giving advice to firms which wants to

Valuation of firms which need to merge

Giving defensive tactics incase of forced takeover

Underwriting of securities.

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