Financial intermediaries

Financial intermediaries are institutions (such as banks, insurance companies, mutual funds, pension funds, and finance companies.) that borrow funds from people who have saved and then make loans to others.

Most people do not enter financial markets directly but use intermediaries or middlemen. Commercial banks are the financial intermediary we meet most often in macroeconomics, but mutual funds, pension funds, credit unions, savings and loan associations, and to some extent insurance companies are also important financial intermediaries. When people deposit money in a bank, the bank uses the funds to make loans to home buyers for mortgages, to students so they can pay for their education, to business to finance inventories, and to anyone else who needs to borrow. A person who has extra money could, of course, seek out borrowers himself and bypass the intermediary. By eliminating the middleman, the saver could get a higher return. Why, then, do so many people use financial intermediaries?

Financial intermediaries provide two important advantages to savers. First, lending through an intermediary is usually less risky than lending directly. The major reason for reduced risk is that a financial intermediary can diversify. It makes a great many loans, and even though some of those loans will be mistakes, the losses will be largely offset by loans that are sound. In contrast, an average saver could directly make only a few loans, and any bad loans would substantially affect his wealth. Because an intermediary can put its "eggs" in many "baskets," it insures its depositors from substantial losses.

Another reason financial intermediaries reduce risk is that by making many loans, they learn how to better predict which of the people who want to borrow money will be able to repay. Someone who does not specialize in this lending may be a poor judge of which loans are worth making and which are not, though even a specialist will make some mistakes.

A second advantage financial intermediaries give savers is liquidity. Liquidity is the ability to convert assets into a spendable form, money, quickly. A house is an illiquid asset; selling one can take a great deal of time. If an individual saver has lent money directly to another person, the loan can also be an illiquid asset. If the lender suddenly needs cash, he must either persuade the borrower to repay quickly, which may not be possible, or he must find someone else who will buy the loan from him, which may be very difficult. Though the intermediary may use its funds to make illiquid loans, its size allows it to hold some funds idle as cash to provide liquidity to individual depositors. Only when a great many depositors want to withdraw deposits at the same time, which happens when there is a "run" on the institution, will the financial intermediary be unable to provide liquidity. It will then be forced to suspend payments to depositors.

Financial intermediaries help large numbers of people to use, though indirectly, financial markets. Though these intermediaries are important in the macroeconomic functioning of the economy, they are usually stable and change only slowly. With the exception of those intermediaries that issue deposits against which checks may be written, economists do not expect disturbances to arise in financial intermediaries. As a result, macroeconomic theory does not pay much attention to them.