Maturity Intermediation

Risk Reduction via Diversifi cation

Reducing the Costs of Contracting and Information Processing

Despite the important role of financial markets, their role in allowing the efficient allocation for those who have funds to invest and those who need funds may not always work as described earlier. As a result, financial systems have found the need for a special type of financial entity called a financial intermediary when there are conditions that make it difficult for lenders or investors of funds to deal directly with borrowers of funds in financial markets. Financial intermediaries include depository institutions, insurance companies, regulated investment companies, investment banks, and insurance companies.
The role of financial intermediaries is to create more favorable transaction terms than could be realized by lenders/investors and borrowers dealing directly with each other in the financial market. This is accomplished by financial intermediaries in a two-step process: (1) obtaining funds from lenders or investors and (2) lending or investing the funds that they borrow to those who need funds. The funds that a financial intermediary acquires become, depending on the financial claim, either the liability of the financial intermediary or equity participants of the financial intermediary. The funds that a financial intermediary lends or invests become the asset of the financial intermediary.
Here are two examples using financial intermediaries that we will elaborate further upon below. In our first example, consider a commercial bank, a type of depository institution. Everyone knows that a bank accepts deposits from individuals, corporations, and governments. These depositors are the lenders to the commercial bank. The funds received by the commercial bank become the liability of the commercial bank. In turn, as explained later, a bank will lend these funds by either making loans or buying securities. The loans and securities become the assets of the commercial bank.
In our second example, consider a mutual fund (one type of regulated investment company that we will discuss later in this chapter). A mutual fund accepts funds from investors who in exchange receive mutual fund shares. In turn, the mutual funds invest those funds in a portfolio of financial instruments. The mutual fund shares represent an equity interest in the portfolio of financial instruments and the financial instruments are the assets of the mutual fund.
Basically, the process we just described has allowed a financial intermediary to transform financial assets that are less desirable for a large part of the investing public into other financial assets—their own liabilities—which are more widely preferred by the public. This asset transformation provides at least one of three economic functions:

• Maturity intermediation.
  
• Risk reduction via diversification.
  
• Cost reduction for contracting and information processing.

We’ll describe each of these shortly.
There are other services that can be provided by financial intermediaries. They include:

• Facilitating the trading of financial assets for the financial intermediary’s customers through brokering arrangements.
  
• Facilitating the trading of financial assets by using its own capital to take a position in a financial asset the financial intermediary’s customer want to transact in.
  
• Assisting in the creation of financial assets for its customers and then either distributing those financial assets to other market participants.
  
• Providing investment advice to customers.
  
• Manage the financial assets of customers.
  
• Providing a payment mechanism.

Later in this chapter, when we discuss market participants, these other services of financial intermediaries will become clear. For example, we will see that the first and second functions services are brokerage and dealer or market maker services, respectively. The third service is the underwriting of securities.
We now discuss the three economic functions of financial intermediaries when they transform financial assets.