Financial intermediaries are institutions that take funds saved by households and in turn make LOANS to others. The process of taking savings and providing funds to borrowers is called intermediation, or indirect finance. While most people think of banks as financial intermediaries, in the United States, SAVINGS AND LOAN ASSOCIATIONS, mutual INSURANCE companies, CREDIT UNIONs, pension funds, finance companies, MUTUAL FUNDS, and money market funds all function as financial intermediaries. Generally financial intermediaries specialize in particular types of lending practices and provide services for certain segments of the overall market. For example, savings and loan associations came into existence to provide lending to consumers for the purpose of building or purchasing homes. Early savings and loan organizations (many were mutual organizations rather than for-PROFIT businesses) were established by groups of immigrant workers who brought together their savings, which were then loaned to other members of their group. Until the 1980s savings and loan crisis (see RESOLUTION TRUST CORPORATION), one group of German Americans in Cincinnati, Ohio, ran their savings and loan out of a bar where they and their ancestors had socialized for almost 100 years. Financial intermediaries perform the following basic services.
• denomination divisibility: providing lending and savings options for different dollar amounts
• maturity flexibility: providing lending and savings options for different time periods
• credit RISK diversification: reducing risk through lending to multiple borrowers
• liquidity: providing access to funds when needed by depositors
Financial intermediaries pool the funds of many small savers and make loans in varying amounts to borrowers. This is preferable to the alternative, where a borrower would have to find and negotiate with tens or hundreds of savers in order to get sufficient funds. Financial intermediaries create securities with a wide range of maturities, from overnight to 50 years and also reduce RISK through diversification. Lending money to one person results in concentrated risk—that is, it depends on the repayment of one borrower. Financial intermediaries make loans to many borrowers, spreading the risk of DEFAULT among many loans and thereby reducing risk through diversification. Intermediaries also provide liquidity, facilitating the conversion of financial ASSETS into money. In the 1990s many Americans and American businesses decreased their use of financial intermediaries. With greater information obtained through INTERNET technology, more lenders and borrowers interacted directly with each other, with individuals buying shares of stock, businesses purchasing COMMERCIAL PAPER issued by CORPORATIONs, or direct placement of tax-exempt BONDS by state agencies. Nevertheless, financial intermediaries provide three basic benefits over direct borrowing and INVESTMENT: ECONOMIES OF SCALE, reduced transaction costs, and information. Because they handle a large volume of transactions, financial intermediaries can spread the fixed costs and start-up COSTS associated with lending. With their experience in lending, financial intermediaries lower the cost of searching and evaluating information associated with saving and lending actions. Most importantly, financial intermediaries generally have better knowledge of credit criteria and risk associated with particular financial instruments and borrowers.
See also FIVE CS OF CREDIT.