What Are the Roles of Financial Intermediaries?

Financial intermediaries are those entities with "low-cost" money (banks, credit unions, savings & loan associations, mutual and pension funds and insurance companies) that act as providers of money (as loans or investments) to those needing funding. They have developed a sophisticated network to allow them to have these funds available and deliver them as quickly and efficiently as electronically possible. 1. Function o Financial intermediaries perform as provider of funds to those who need money. From banks, credit unions, savings & loans, mutual funds, insurance companies and pension funds, financial intermediaries provide funds for all manner of borrowers and investors. Whether it's a bank providing a personal loan, a mortgage lender or financial entities creating investment markets, financial intermediaries keep the flow of funds moving. Benefits
o

Individuals and businesses often need funds for working capital, asset purchases (homes, cars, equipment, buildings and computer systems) and the financial intermediary network serves as the source of this money. Borrowing from savers (depositors in banks and credit unions), financial intermediaries provide monies at a reasonable cost to those who need them. Their network, a finely tuned money machine, eliminates most difficulties for those needing funds.

Theories/Speculation

Financial intermediaries exercise great power and control over the country's economy. In theory, their network allows the country's financial transactions and money movement to keep funds flowing. At most times, this theory is the reality. However, they can also enhance the effects of a negative economy by refusing to become players in the global financial game. When regional, national or global economic problems occur, financial intermediaries sometimes choose to tighten their requirements or even to suspend money offerings. This action often makes a bad situation worse.

Features
o

While always necessary components to the economy, the sophistication of computers and the Internet has allowed financial intermediaries to become even more efficient and important. Those needing funds can often be anywhere in the world and receive the money they need electronically. The risk of transferring funds, the time delay and the need for "hard cash" have all been effectively eliminated. This has allowed financial intermediaries to serve just as professionally as banking institutions. For example, mutual and pension funds effectively offer financial intermediary services to individuals and businesses at reasonable rates.

Considerations
o

It is important to understand both what financial intermediaries are able to do and what they are willing to do for you. Having large amounts of money for loan or investment without the desire to provide these monies to others serves little purpose to those individuals and companies needing funding. Carefully consider your need for funds and those financial intermediaries most interested in providing the money.

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Role of Financial Intermediaries in The 21st Century

http://www.indianmba.com/occasional_papers/op125/op125.html

Abstract Financial Intermediaries are performing various roles in addition to what they used to do earlier by innovating and upgrading themselves in many ways. Some of the important roles they are expected to perform in the 21st century is to help in the reduction of Poverty, Restructuring of firms in distress, Markets for firm's Assets and so on. Keywords Financial Intermediary/ Types of Financial Intermediary/ Need for financial intermediary/ Roles performed by financial intermediary/ Financial Intermediary for Poverty Reduction/ Markets for Firm's Assets/ Pension Funds Introduction The term financial intermediary may refer to an institution, firm or individual who performs intermediation between two or more parties in a financial context. Typically the first party is a provider of a product or service and the second party is a consumer or customer. Financial intermediaries are banking and non-banking institutions which transfer funds from economic agents with surplus funds (surplus units) to economic agents (deficit units) that would like to utilize those funds. FIs are basically two types: Bank Financial Intermediaries, BFIs (Central banks and Commercial banks) and Non-Bank Financial Intermediaries, NBFIs (insurance companies, mutual trust funds, investment companies, pensions funds, discount houses and bureaux de change). Financial intermediaries can be:

Banks; Building Societies; Credit Unions; Financial adviser or broker; Insurance Companies; Life Insurance Companies; Mutual Funds; or

Pension Funds.

The borrower who borrows money from the Financial Intermediaries/Institutions pays higher amount of interest than that received by the actual lender and the difference between the Interest paid and Interest earned is the Financial Intermediaries/Institutions profit. Financial Intermediaries are broadly classified into two major categories: 1) Fee-based or Advisory Financial Intermediaries 2) Asset Based Financial Intermediaries. Fee Based/Advisory Financial Intermediaries: These Financial Intermediaries/ Institutions offer advisory financial services and charge a fee accordingly for the services rendered. Their services include: i. Issue Management ii. Underwriting iii. Portfolio Management iv. Corporate Counseling v. Stock Broking vi. Syndicated Credit vii. Arranging Foreign Collaboration Services viii. Mergers and Acquisitions ix. Debentive Trusteeship x. Capital Restructuring ASSET-BASED Financial Intermediaries: These Financial Intermediaries/Institutions finance the specific requirements of their clientele. The required infra-structure, in the form of required asset or finance is provided for rent or interest respectively. Such companies earn their incomes from the interest spread, namely the difference between interest paid and interest earned. The financial institutions may be regulated by various regulatory authorities, or may be required to disclose the qualifications of the person to potential clients. In addition, regulatory authorities may impose specific standards of conduct requirements on financial intermediaries when providing services to investors. Role of Financial Intermediaries for Poverty Reduction Finding innovative ways to provide financial services to the poor so that they can improve their productive capacity and quality of life is the role of the financial intermediaries in the 21st century. Most of the poor live in the rural areas, and are engaged in agricultural activities or a variety of micro-enterprises.

The poor are vulnerable to income fluctuations and hence are exposed to risk. They are unable to access conventional credit and insurance markets to offset this.

Most formal financial institutions do not serve the poor because of perceived high risks, high costs involved in small transactions, perceived low profitability, and most importantly, inability to provide the physical collateral generally required by such institutions. About 95 percent of poor households still have little access to institutional financial services. Most poor and lowincome households continue to rely on meager self-finance or informal sources of finance. Providing efficient micro-finance to the poor is important for many reasons:

Efficient provision of savings, credit and insurance facilities can enable the poor to smoothen their consumption, manage risks better, gradually build assets, develop microenterprises, enhance income earning capacity, and generally enjoy an improved quality of life. Efficient micro-finance services can also contribute to improvement of resource allocation, development of financial markets and system, and ultimately economic growth and development. With improved access to institutional micro-finance, the poor can actively participate in and benefit from development opportunities. The latent capacity of the poor for entrepreneurship would be encouraged with the availability of small-scale loans and would introduce them to the small-enterprise sector. This could allow them to be more self-reliant, create employment opportunities, and, not least, engage women in economically productive activities. Micro-finance activities prove that poor households can and do save rather than borrow, and it is possible to successfully mobilize funds from poor households. Another important fact is that contrary to expectations, the poor are creditworthy and financial services can be provided to the poor on a profitable basis at low transaction costs without having to rely on physical collateral. Finally, micro-finance services contribute to the development of rural financial markets and to strengthening the social and human capital of the poor.

There are many problems that should be resolved for the further development of micro-finance in Poverty Reduction:

Policy environments in many developing countries are not favorable for the sustainable growth of micro-finance. In particular, interest rate ceilings and subsidized credit limit the ability of micro-finance institutions to provide services to the poor. Inappropriate and extensive intervention by governments in micro-finance undermines its efficient operation. Inadequate financial infrastructure is another major problem in the region. Financial infrastructure includes legal, information, and regulatory and supervision systems. In addition, most microfinance institutions do not have adequate capacity to expand the scope and outreach of services on a sustainable basis to potential clients. Specifically, they lack the ability to leverage funds, provide services compatible with the potential clients' characteristics, adequate network and delivery mechanisms, and so forth.

Financial Intermediaries as Markets for Firm's Assets

Financial intermediaries appear to have a key role in the restructuring and liquidation of firms in distress. In particular, there is rich evidence that financial intermediaries play an active role in the reallocation of displaced capital, meant both as the piece-meal reallocation of assets (such as the redeployment of individual plants) and, more broadly, as the sale of entire bankrupt corporations to healthy ones. A key part of reorganization under main bank supervision or management is the implementation of a plan of asset sales with proceeds typically used to recover bank loans. In Germany a function of banks during reorganizations is to "use bank contacts to facilitate a merger with another firm as a means of resolving the crisis". Knowing possible synergies among firms, banks can suggest solutions for the efficient reallocation of assets and of corporate control and that in several countries there is widespread anecdotal evidence, though not quantitative one, on this role of banks. Healthy firms search around for the displaced capital of bankrupt firms but matching is imperfect and firms can end up with machines unsuitable for them. Financial intermediaries arise as internal, centralized markets where information on machines and buyers is readily available, allowing displaced capital to migrate towards its most productive uses. Financial intermediaries can perform this role by aggregating the information on firms collected in the credit market. The function of intermediaries as matchmakers between savers and firms in the credit market can support their function as internal markets for assets. Intuitively, by increasing the number of highly productive matches in the credit market, intermediaries increase the share of highly productive second hand users in the decentralized resale market. This improvement in the quality of the decentralized secondary market reduces the incentive of firms to address financial intermediaries for their ability as re-deployers. However, by increasing the number of highly productive matches in the credit market, intermediaries create also wealthy buyers without assets and contribute to decrease the thickness of the decentralized resale market. This makes the decentralized market less appealing and increases the incentive of firms to use intermediaries as resale markets. When the quality improvement in the decentralized market is not too big and the second effect prevails, better matchmaking in the credit market supports the function of intermediaries as internal markets for assets.

Role of Pension Funds as Financial Intermediaries Pension funds may be defined as forms of institutional investor, which collect pool and invest funds contributed by sponsors and beneficiaries to provide for the future pension entitlements of beneficiaries. They thus provide means for individuals to accumulate saving over their working life so as to finance their consumption needs in retirement, either by means of a lump sum or by provision of an annuity, while also supplying funds to end-users such as corporations, other households (via securitized loans) or governments for investment or consumption. We now assess pension funds relative to the various financial functions one by one, in order correctly to identify the role funds play in stimulating change in the financial landscape.

Clearing and settling payments: Pension funds have had an important indirect role in boosting the efficiency of the financial systems, by influencing the structure of securities markets. By demanding liquidity, pension funds help to generate it, firstly by their own activity in arbitrage, trading and diversification, secondly via the fact that liquidity is a form of increasing return to scale, as larger markets in which pension funds are active attract more trading, reducing costs and improving liquidity further. A third effect arises from funds' countervailing power as they press for improvements in market structure and regulation. These include deregulation and reduction in commissions, advanced communication and information systems, reliable clearing and settlements systems, and efficient trading systems, all of which help to ensure that there is efficient arbitrage between securities and scope for diversification. Provision of a mechanism for pooling of funds and subdivision of shares: Pension funds offer much lower costs of diversification by proportional ownership. Pension funds can also offer the possibility of investing in large denomination and indivisible assets such as property which are unavailable to small investors. Furthermore, pension funds reduce the cost of transacting by negotiating lower transactions costs and custodial fees. The direct participation costs to households of acquiring information and knowledge needed to invest in a range of assets, as well as in undertaking complex risk trading and risk management are reduced (although costs of monitoring the asset manager remain). The net effect is that individuals are likely to switch to pension funds from direct holdings of securities and from bank deposits. Provision of ways to transfer economic resources: Pension funds act in an unusual manner in this regard, in that they may increase the volume of saving besides the disposition of household funds. At a micro level, company or other obligatory pension funds can implement enforced saving by deferring wages and salaries, thereby reducing risk of a low replacement ratio. At a macro level, the increase in saving is not usually one-to-one, as increased contractual saving via pension funds is typically partly or wholly offset by declining discretionary saving. Pension funds increase the supply of long term funds to capital markets, and reduce bank deposits, even abstracting from changes in aggregate saving, so long as households do not increase the liquidity of the remainder of their portfolios fully to offset growth of pension assets. Provision of ways to manage uncertainty and control risk: Pension funds provide risk control directly to households via the forms of retirement income insurance they provide, an advantage which largely reflects the unusual (among financial intermediaries) link of pension funds to employers. To assist in undertaking this risk control function they diversify assets as noted above and also act in securities and derivatives markets to hedge and control risk. Providing price information: pension funds seek publication of information from companies directly, and press for market-value based accounting systems. This is of benefit to all users of the market - although it disadvantages banks, which in making

loans tend to rely on private information not available to other investors.

Providing ways to deal with incentive problems: Dealing with incentive problems in equity finance is one of the most crucial aspects of pension funds' activities as financial intermediaries. The basic issue in corporate governance is simply stated. Given the divorce of ownership and control in the modern corporation, principal-agent problems arise, as shareholders cannot perfectly control managers acting on their behalf. Managers, who have superior information about the firm and its prospects and at most a partial link of their compensation to the firms' profitability, may divert funds in various ways away from those who sink equity capital in the firm, notably expropriation or diversion to unattractive projects from a shareholder's point of view. Principal-agent problems in equity finance imply a need for shareholders such as pension funds to exert control over management, while also remaining sufficiently distinct to let them buy and sell shares freely without breaking insider trading rules. If difficulties of corporate governance are not resolved, these market failures in turn also have implications for corporate finance in that equity will be costly and often subject to quantitative restrictions. Effectiveness of corporate governance is typically enhanced by presence of large investors, such as pension funds. They will have the leverage to oblige managers to distribute profits to providers of external finance either directly or via the threat to sell to takeover raiders. They are needed because individual investors may find it difficult to enforce their rights, owing to difficulty of acting in a concerted manner against management and related free rider problems which make it not worthwhile for an individual to collect information and monitor management. Since pension fund stakes are typically limited to 5% of a company, they also avoid the "downside" to dominant investors, who if they own a large proportion of the company may override the interests of minority shareholders and could even reduce measured profitability.

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FINANCIAL INTERMEDIERIES
http://en.wikipedia.org/wiki/Financial_intermediary

Financial intermediary Financial intermediation consists of channeling funds between surplus and deficit agents. A financial intermediary is a financial institution that connects surplus and deficit agents. The classic example of a financial intermediary is a bank that transforms bank deposits into bank loans.[1] Through the process of financial intermediation, certain assets or liabilities are transformed into different assets or liabilities.[1] As such, financial intermediaries channel funds from people who have extra money (savers) to those who do not have enough money to carry out a desired activity (borrowers).[2] In the U.S., a financial intermediary is typically an institution that facilitates the channeling of funds between lenders and borrowers indirectly. That is, savers (lenders) give funds to an intermediary institution (such as a bank), and that institution gives those funds to spenders (borrowers). This may be in the form of loans or mortgages.[3] Alternatively, they may lend the money directly via the financial markets, which is known as financial disintermediation. Functions performed by financial intermediaries Financial intermediaries provide 3 major functions: 1. Maturity transformation Converting short-term liabilities to long term assets (banks deal with large number of lenders and borrowers, and reconcile their conflicting needs) 2. Risk transformation Converting risky investments into relatively risk-free ones. (lending to multiple borrowers to spread the risk) 3. Convenience denomination Matching small deposits with large loans and large deposits with small loans Advantages of financial intermediaries There are 2 essential advantages from using financial intermediaries:

1. Cost advantage over direct lending/borrowing[citation needed] 2. Market failure protection the conflicting needs of lenders and borrowers are reconciled, preventing[citation needed] market failure The cost advantages of using financial intermediaries include: 1. Reconciling conflicting preferences of lenders and borrowers 2. Risk aversion intermediaries help spread out and decrease the risks 3. Economies of scale using financial intermediaries reduces the costs of lending and borrowing 4. Economies of scope intermediaries concentrate on the demands of the lenders and borrowers and are able to enhance their products and services (use same inputs to produce different outputs) Types of financial intermediaries Financial intermediaries include:

Banks Building societies Credit unions Financial advisers or brokers Insurance companies Collective investment schemes Pension funds

Summary & conclusion Financial institutions (intermediaries) perform the vital role of bringing together those economic agents with surplus funds who want to lend, with those with a shortage of funds who want to borrow. In doing this they offer the major benefits of maturity and risk transformation. It is possible for this to be done by direct contact between the ultimate borrowers, but there are major cost disadvantages of direct finance. Indeed, one explanation of the existence of specialist financial intermediaries is that they have a related (cost) advantage in offering financial services, which not only enables them to make profit, but also raises the overall efficiency of the economy. The other main explanation draws on the analysis of information problems associated with financial markets. #############################################################################

Role of Financial Intermediation Services in the Informal Sector*

I. Introduction

The National Statistical Commission made a series of recommendations in regard to the improvements in the existing statistical system, data collection mechanism, and also the data gaps to be filled-in in formal and informal sectors of the economy. Among the data gaps, the informal sector is one segment on which scanty data are available. According to the UN System of National Accounts (SNA), 1993, the informal sector has broadly been characterised as consisting of units engaged in producing goods and services with the primary objective of generating employment and income to the persons concerned.1 The production units in the informal sector are regarded as household enterprises or equivalently, unincorporated enterprises owned by households. These units are engaged in activities like, manufacturing, construction, trading and repair services, hotels and restaurants, transport, storage and communication, financial intermediation, real estate, renting and business activities, education and other community, social and personal services. All these activities can broadly be grouped as financial and non-financial activities in the informal sector, wherein the financial intermediation services constitute the former while the remaining activities form the nonfinancial sector. The article assesses the role of financial activity in the informal sector as observed through the 55th round of the National Sample Survey Organisation (NSSO) and compares the results with those of National Accounts Statistics, to the extent they are available. Section II presents the salient results of the NSSO survey while a comparison with the estimates presented in National Accounts Statistics is given in Section III. Certain definitions adopted by NSSO are given in Appendix. II. Salient Results of the Survey of NSSO The first ever nation-wide survey on informal sector covering non-agricultural enterprises was conducted by the National Sample Survey Organisation (NSSO) along with the survey of households on employment, unemployment and consumer expenditure in the 55th round during July 1999 to June 2000. The survey covered the non-agricultural enterprises engaged in activities like, (i) manufacturing, (ii) construction, (iii) trading and repair services, (iv) hotels and restaurants, (v) transport, storage and communication, (vi) financial intermediation, (vii) real estate, renting and business activities, (viii) education, (ix) health and social work, and (x) other community, social and personal service activities (excluding domestic services). Information on various characteristics of the enterprises, viz., fixed assets, employment, expenses and receipts, value added, etc., was collected from the enterprises besides the information on workers engaged in these enterprises.

The financial intermediation activities covered in the survey related to financial leasing, hire purchase financing, life insurance agents, non-life insurance agents, administration of financial markets, stock brokers, actuaries, financial advisors, etc., classified under sections 6567 of National Industrial Classification (NIC), 1998. In this survey, all unincorporated proprietary and partnership enterprises were defined as informal sector enterprises.2 All these enterprises are grouped into (a) own account enterprises (OAE), and (b) establishments. The former are those run by household labour, usually without any hired worker employed on fairly regular basis.3 The establishments are those which have got at least one hired worker on a fairly regular basis. The NSSO presented the results against the above mentioned ten activities which had been referred to as tabulation categories. The article considers the enterprises providing service activities in the informal sector, with a special emphasis on financial intermediation services and excludes manufacturing activity of informal sector.

The results of the survey are based on a sample of 6046 villages and 4124 urban blocks. In all, 79,165 enterprises in rural areas and 61,951 enterprises in urban areas, relating to nonmanufacturing activities, were surveyed (Table 1). Of these, only 784 enterprises (254 in rural areas and 530 in urban areas) belonged to financial intermediation services. It was estimated that there were 154.55 lakh and 146.88 lakh enterprises in services activities in rural and urban areas, respectively, in 1999-20004 . Thus it may be seen that there were larger number of service enterprises in all activities together in rural areas (51.3 per cent) than in urban areas. In the case of financial intermediation services, there were more number of enterprises in urban areas (118,586) than in rural areas (41,804) as also in five other activities. Surprisingly, according to the survey, the number of enterprises in rural areas was higher than that in urban areas in respect of transport, storage and communication, construction, health and social work and other community & social service activities.

TABLE 1: Number of Enterprises in Services Sector, 1999-2000 - by Type of Activity Type of Activity Number of Enterprises Surveyed Rural Urban Combine d Estimated Number of Enterprises

Rural

Urban

Combined

Construction Trading and Repair

6,003 37,878

3,910 26,872

9,913 1181,368 672,795 1854,163

(6.2)

64,750 8577,793 8794,085 17371,87 (57.6)

Services Hotels and Restaurants Transport, Storage and Communications Financial Intermediation Real Estate, Renting and Business Activities Education Health and Social Work Other Community, Social and Personal Service Activities 10,485 5,798 1,350 1,523 2,816 2,935 2,124 1,984 10,569 254 10,282 530 8,287 7,516

8 15,803 848,222 928,128 1776,350 (5.9)

20,851 2011,949 1924,047 3935,995 (13.1) 784 41,804 118,586 160,390 (0.5)

4,285 200,293 572,388 772,681 3,647 232,104 348,132 580,237 4,800 455,080 330,558 785,637

(2.6) (1.9) (2.6)

16,283 1906,161 999,731 2905,891

(9.6)

All Activities

79,165

61,951 141,116 15454,77 14688,44 30143,22 4 9 3 (51.3) (48.7) (100.0)

Note: Figures in brackets are percentages total of all activities.

It may be seen from Table 2 that value added per worker is the highest in the case of financial intermediation service enterprises (Rs.40,622) followed by health and social work, real estate related services and trading and repair services.5 As expected, the value added per worker in urban areas is more than double than that in rural areas. The value added per worker was the highest in health and social work enterprises (Rs.48,058) in urban areas followed by financial intermediation services (Rs.43,874). In rural areas, value added per worker was maximum for financial service enterprises at Rs.27,590, followed by transport, storage and communications enterprises (Rs.24,803). As against this, it is interesting to see from the table that trading and repair services accounted for 62 per cent of the aggregate value added of all service enterprises in the informal sector, while the financial intermediation activities accounted for less than 1 per cent. Transport, storage and communications activities shared about 11 per cent, while all other activities had small shares ranging from 2 to 8 per cent.

Table 2: Value Added per Worker in Services Sector: Type of Activity Tabulation Category Estimated Aggregate Value Added per Worker (in Rs.) Value Added * (Rs. crore) Rural Construction Trading and Repair Services Hotels and Restaurants Transport, Storage and Communications Financial Intermediation Real Estate, Renting and Business Activities Education Health and Social Work Other Community, Social and Personal Service Activities All Activities 7,395 88,561 10,499 15,316 1,352 5,159 (5.2) (62.2) (7.4) (10.7) (0.9) (3.6) 23,183 18,298 17,170 24,803 27,590 20,841 Urban Combined 33,699 40,598 29,077 33,522 43,874 37,088 27,704 31,180 24,468 29,307 40,622 33,763

3,229 4,495 6,442

(2.3) (3.2) (4.5)

12,176 24,031 8,847

21,823 48,058 21,256

18,565 37,354 13,623

142,448

(100.0)

15,008

33,437

24,242

(*): Estimates are based on Method 2 (product approach).

Among the enterprises rendering financial intermediation services, it was estimated that nearly 74 per cent of them were in urban areas (Table 3). Considering the enterprises by their type, OAEs formed nearly 74 per cent of all financial enterprises in the informal sector. Of the financial enterprises in rural areas, OAEs accounted for about 86 per cent whereas their share in urban areas was 69.3 per cent.

Table 3: Number of Enterprises in Financial Intermediation

Activity, 1999-2000 Number of Enterprises Surveyed Rural Estimated

Own Account Enterprises

181

36,191

Establishments

73

5,613

All Enterprises

254

41,804

Urban

Own Account Enterprises

399

82,238

Establishments

131

36,348

All Enterprises

530

118,586

Combined

Own Account Enterprises

580

118,429

Establishments

204

41,960

All Enterprises

784

160,390

The survey collected data on aggregate value of fixed assets, owned and hired, by the service enterprises in informal sector and these data are given in Table 4. The results indicated that 77.3 per cent of the assets of all service enterprises in rural areas are owned by them while in the urban areas similar share was only 57.1 per cent indicating that enterprises in urban areas prefer to have hired assets like land and buildings. The assets owned by enterprises in financial activity (Rs.1,285 crore), however, held a very small share (0.8 per cent) in assets of all service enterprises. In the case of financial services, about 60 per cent of the assets are owned by the enterprises. However, only 7.1 per cent of the assets (owned and hired) of financial enterprises was held in rural areas and the rest in urban areas. Considering the composition of fixed assets for financial enterprises, land and buildings formed about 54 per cent in rural areas while they formed 77.3 per cent in urban areas (Table 5). The transport equipment had a higher share of 30 per cent in respect of rural financial enterprises as against less than 10 per cent share for urban financial enterprises. Hired assets of the financial enterprises are mostly in the form of land and buildings, perhaps in the form of rented premises for the enterprises. It is true for both rural and urban areas. The details of outstanding loans and interest payable by the service enterprises were also collected in the survey. It was estimated that outstanding debt of Rs.23,998 crore (all activities) was payable as at the end of March 2000 to credit agencies in both organised and unorganised sectors (Table 6).6 Of this total amount, credit payable by the urban enterprises accounted for the largest share of about 82.5 per cent. Of the outstanding debt of the urban enterprises, it was mostly accounted for by the establishments (79.8 per cent). In the case of enterprises in the rural sector, the OAEs accounted for a higher share than that of establishments for all services enterprises. The outstanding debt of financial intermediation enterprises was of a small order at about Rs.204 crore for both rural and urban areas.

Table 4: Aggregate Value of Assets owned by Enterprises in Services Sector (Rs. lakh) Type of Activity Owned Rural Urban Combine d Net Owned addition Hired Net addition

Hired

Net Owned addition

Hired

in last 365 days

in last 365 days

in last 365 days

Own Account Enterprises Financial Intermediation Other Activities 6136 2508 1165 49254 30968 951 55391 33476 2117

253601 797713 0

68070 4461907 450097 7 8

121668 695358 5298690 7

189737

All Activities

254214 800221 6

69235 4466833 453194 1 6

122619 700897 5332166 8

191854

Establishments

Financial Intermediation Other Activities

1714

4808

163

71362 46986

852 73077

51794

1016

108843 262755 0

55891 7819704 638815 7

113462 890813 6650912 3

169353

All Activities

109014 267563 4

56054 7891066 643514 3

114314 898121 6702706 0

170369

All Enterprises

Financial Intermediation Other Activities

7851

7316

1329 120617 77955

1804 128467

85270

3133

362443 106046 9 8

123960 1223728 108891 1 34

235130 158617 1194960 20 2

359090

All Activities

363229 106778 0 4

125289 1235789 109670 8 89

236934 159901 1203487 87 2

362223

TABLE 5: Financial Intermediation Service Enterprises: Composition of Fixed Assets (Rs. lakh) Population Group Owned Assets Rural Urban 4222 (53.8) 93270 (77.3) 241 (3.1) 1020 (0.8) 2363 (30.1) 1025 (13.1) 7851 (100.0) 11748 (9.7) 14578 (12.1) 15604 (12.1) 120617 (100.0) 128467 (100.0) Land & Buildings Plant & Machinery Transport Equipment Others Total

Combined

97492 (75.9)

1261 (1.0)

14110 (11.0)

Hired Assets Rural Urban Combined 7309 77606 84915 0 0 0 0 249 249 7 100 107 7316 77955 85271

Note: Figures in brackets are percentages to total.

TABLE 6: Aggregate Value of Outstanding Loans and Interest Payable of the Services Enterprises (Rs. lakh) Tabulation Category Rural Amount Interest Urban Combined Interest

Amount Interest Amount

Own Account Enterprises

Financial Intermediation

967

153

10634

11221

11602

11374

Other Activities

223279

47915

388617

76341

611894

124256

All Activities

224245

48068

399251

87562

623496

135630

Establishments

Financial Intermediation

2710

677

6120

939

8829

1616

Other Activities

192043

35512

1575422 255129 1767466

290640

All Activities

194753

36189

1581542 256068 1776295

292256

All Enterprises

Financial Intermediation

3677

829

16754

12160

20431

12990

Other Activities

415321

83427

1964039 331470 2379360

414897

All Activities

418998

84256

1980793 343630 2399791

427887

TABLE 7: Financial Intermediation Services: Aggregate Outstanding Loans by Credit Agencies

(Rs. lakh) Credit Agency Rural OAEs Establishment s Total Urban OAEs Establishmen ts Total

Term Lending Institutions

62

62

Government

160

160

73

100

173

Commercial Banks

324

27

351

302

42

344

Co-op. Banks and Societies

31

40

Other Institutional Agencies

125

53

178

154

184

338

Money lenders

123

807

930

1724

1191

2915

Business Partners

18

18

225

511

736

Friends and Relatives

199

208

636

3691

4327

Suppliers/contractors

Others

1787

1787

7457

400

7857

Total

967

2710

3677

10634

6120

16754

Note: OAE - Own Account Enterprises.

It is observed from Table 7 that the financial enterprises in the service sector borrowed from credit agencies in unorganised sector as well besides those in organised sector. In the case of rural enterprises in financial services, the debt of OAEs owed to agencies in organised sector was higher than the debt to moneylenders, relatives and friends in the unorganised sector whereas the establishments in the rural areas borrowed more from credit agencies in the unorganized sector. In the case of these establishments about 66 per cent of debt was not classified under any credit agency. In the case of urban enterprises, debt of both OAEs and establishments owed to money-lenders and friends and relatives accounted for a major share in the total debt. About 70 per cent of total debt of OAEs in urban areas was not classified under any credit agency. An important feature observed for financial enterprises in both rural and urban areas is that they obtained about 45 per cent of their credit from agencies in the unorganised sector, excluding the credit not classified to any agency. It was observed earlier from Table 2 that the value added per worker was the highest in the case of enterprises in financial intermediation services. Combining the enterprises in rural and urban areas and also by their type, value added of the financial enterprises in rural areas was much lower at Rs. 18,337 lakh than that of urban areas (Rs.116,840 lakh) during the period under reference (Table 8). Looking at these enterprises by their type, the aggregate value added of the OAEs at Rs.71,369 lakh, is higher than the value added of establishments (Rs.63,808 lakh). Further, the OAEs accounted for a share of 62 per cent of value added in rural areas as against 51.3 per cent in urban area. The productivity of the workers defined as the value added per worker, in urban areas is higher than that of workers in rural areas in respect of both OAEs and establishments. The value added per worker is, however, marginally higher in establishments than that in OAEs in rural areas while the reverse was the case for urban areas. In the case of urban enterprises, the value added per worker was much higher (at Rs.49,417 crore) in the case of OAEs compared to that (Rs.39,236 lakh) of establishments. The value added per enterprise for establishments in rural areas was higher by nearly four times than that of OAEs. But the value added per enterprise in the case of establishments in urban areas was more than double than that of OAEs (Rs.156,517 as against Rs.72,898). The value added of all enterprises providing financial intermediation services in informal sector was estimated as of the order of Rs.1,352 crore during the period 1999-2000.

TABLE 8: Financial Intermediation Service Enterprises - Aggregate Value Added, Value Added per Enterprise and per Worker Item Own Account Establishmen Enterprises ts All Enterprises

Rural

Aggregate Annual Value Added (Rs. lakh)

11,420

6,918

18,337

Value Added per Worker (Rs.)

27,105

28,428

27,590

Value Added per Enterprise (Rs.)

31,554

123,245

43,865

Urban

Aggregate Annual Value Added (Rs. lakh)

59,949

56,890

116,840

Value Added per Worker (Rs.)

49,417

39,236

43,874

Value Added per Enterprise (Rs.)

72,898

156,517

98,528

Combined

Aggregate Annual Value Added (Rs. lakh)

71,369

63,808

135,177

Value Added per Worker (Rs.)

43,666

37,683

40,622

Value Added per Enterprise (Rs.)

60,263

152,066

84,280

Looking at the composition of value added for the financial intermediation services, the net surplus accounted for a major share followed by income in the form of interest in the case of OAEs and emoluments in the case of establishments (Table 9). The emoluments component of value added had a higher share for establishments in the urban areas than that of their counterparts on rural areas. The NSSO also presented, in the report, the data on the estimated number of enterprises, the estimated number of workers, value added per enterprise and value added per worker across major States for different activities including financial intermediation services. These details for financial enterprises are presented in Statements 1 to 4. It was estimated that Tamil Nadu accounted for about 25 per cent of total number of enterprises (160,391) in the financial intermediation services followed by Andhra Pradesh (13 per cent) in both urban and rural areas taken together. While Delhi had maximum number of establishments (13,551), Tamil Nadu had maximum number of OAEs (29,428).The female participation in total employment of enterprises in financial intermediation services, at all India level, is estimated to be 7.2 per cent. This participation rate was the highest in Kerala (39.5 per cent) followed by Maharashtra (22.4 per cent). TABLE 9: Financial Intermediation Service Enterprises - Components of Value Added (Rs. lakh) Type of Enterprise Emoluments Rent Interest Net Surplus Total Value Added

Own Account Enterprises Rural Urban Combined Establishments 65 861 925 143 1,658 1,801 153 11,221 11,374 11,194 45,953 57,147 11,555 59,693 71,248

Rural Urban Combined All Enterprises Rural Urban Combined

1,418 14,889 16,307

387 2,693 3,080

677 939 1,616

4,510 38,462 42,972

6,992 56,983 63,975

1,483 15,750 17,233

530 4,351 4,881

830 12,160 12,990

15,704 84,416 100,119

18,547 116,676 135,223

Note: Estimates presented in this table are derived following income approach (Method 2) and, therefore, differ from those of other Tables 2,8 and10, which are derived based on product approach (difference between receipts and expenditure).

The value added per worker for financial intermediation services was highest in Madhya Pradesh and Punjab considering both types of enterprises together.7 However, Haryana and Rajasthan recorded the maximum value added per worker, in that order, for establishments whereas Punjab and Chandigarh ranked the most for OAEs. It was estimated that the aggregate value added for all financial service enterprises was the highest for Tamil Nadu (Rs.442 crore) followed by Uttar Pradesh (Rs.275 crore). However, in the case of establishments, Uttar Pradesh recorded the maximum value added (Rs.239 crore) followed by Delhi (Rs.226 crore). But in the case of OAEs, Tamil Nadu had the maximum value added at Rs.310 crore. Among the two categories of enterprises, establishments accounted for 30 per cent of value added of all financial enterprises at all-India level.

III Estimates of Value Added based on National Accounts Statistics The CSO publishes regularly the estimates of value added for different industrial activities including services. The estimates for each of these activities are published at disaggregated level into organised and unorganised sectors. The economic units termed as enterprises, in the unorganised sector refer to those enterprises whose activities or collection of data is not regulated under any legal provisions and/or those which do not maintain any regular accounts, as stated earlier. On the other hand, the informal sector is defined to include all unincorporated proprietary and partnership enterprises. In the process, the enterprises run by cooperative societies, trusts, private and public limited companies (non-ASI) are not covered in the informal sector but are included in the unorganised sector.8 The informal sector thus, can be seen as a sub-set of the

unorganised sector. Against this background, an attempt is made in this section to compare the estimates of value added of service enterprises in the informal sector derived from the survey for the year 1999-2000 with those obtained from National Accounts Statistics for the same year. The two sets of estimates are given in Table 10. It may be seen from Table 10, that the estimates of value added obtained from the survey for aggregate of all activities are much lower than those of the NAS, forming about one-third of the latter. In absolute terms, the value added of services activities in the informal sector is estimated at Rs.1,42,448 crore from the NSS Survey, as against Rs. 4,18,048 crore for those services in the unorganised sector from the NAS, for the year 1999-2000. It is observed that the informal sector in different activities accounted with varying shares in unorganised sector; such as 7 to 13 per cent for construction, banking and insurance and real estate related activities; 29 to 49 per cent for trade, transport and communication and community, social and personal services. In the case of hotels and restaurants, informal sector formed 119 per cent of the unorganised sector. It is surprising to see that the value added of hotels and restaurants in the informal sector was higher than that of unorganised segment despite the under coverage of the former than that of the latter. The large difference between the two sets of estimates for most of the service activities could be due to the coverage differences in the two sectors as stated earlier. In the case of financial intermediation activity, the value added of the informal sector was estimated as Rs.1,352 crore as against Rs.10,810 crore estimated by NAS. It is thus estimated that the financial intermediation services in the informal sector formed about one-eighth of the unorganised sector, which formed about 1.2 per cent of the value added of total banking and insurance sector. Table 10: Value Added (net ) of Service Activities Unorganised/Informal Sector, 1999-2000 (Amount in Rs. crore) Activity Unorganised Sector National Accounts Statistics 57,580 (13.8) Informal Sector NSSO Survey Coverage of Informal Sector in Unorganised Sector (per cent) 12.8

Construction

7,395 (5.2)

Trade

180,035 (43.1)

88,561 (62.2)

49.2

Hotels and Restaurants

8,856 (2.1)

10,499 (7.4)

118.6

Transport, Storage and Communication

52,087 (12.4)

15,316 (10.7)

29.4

Banking and Insurance

10,810 (2.6)

1,352 (0.9)

12.5

Real Estate, Ownership of dwellings, and business services 69,423 (16.6) 5,159 (3.6) 7.4

Community, social and personal services

39,257 (9.4)

14,166 (10.0)

36.1

Total

418,048 (100.0)

142,448 (100.0)

34.1

Note: Figures in brackets are percentages to total.

Interestingly, it is observed that in the case of banking and insurance in unorganised sector of NAS, the compensation of employees was estimated as nil while the Survey estimated at 12.7 per cent of value added of the sector under this component. The survey also estimated the other components of value added, viz., rent, interest and net surplus, while the NAS indicated only the operating surplus/mixed income. The NAS, however, showed independently certain amounts on rent, interest and FISIM as property incomes. It may be pointed out here that the financial enterprises in the informal sector reported emoluments, which was not shown for unorganised sector of NAS. It is suggested that the CSO may examine the adoption of the survey estimates for the purpose of national accounts statistics, particularly estimating value added for unorganised part of the financial intermediation services.

Statement 1 : State-Wise Distribution of Estimated Number of Enterprises for

Financial Intermediation Activity State/Union Territory Own Account Enterprises Establishments All Enterprises

Andhra Pradesh Arunachal Pradesh Assam Bihar Goa Gujarat Haryana Himachal Pradesh Jammu and Kashmir Karnataka Kerala Madhya Pradesh Maharashtra Manipur Meghalaya Mizoram Nagaland Orissa Punjab Rajasthan Sikkim

17776 0 4771 2222 0 6311 641 50 34 6997 7343 3682 12792 24 0 0 0 991 866 1286 0

3086 5 0 230 76 5432 177 24 243 3935 2057 58 868 0 0 0 0 317 354 124 0

20862 5 4771 2451 76 11744 819 74 278 10932 9400 3740 13659 24 0 0 0 1308 1221 1410 0

Tamil Nadu Tripura Uttar Pradesh West Bengal A & N. Islands Chandigarh D & Nagar Haveli Daman & Diu Delhi Lakshadweep Pondichery

29428 197 10185 12122 5 111 0 0 217 0 377

10455 0 688 159 0 0 0 0 13551 0 121

39882 197 10873 12282 5 111 0 0 13768 0 499

All India

118428

41960

160391

Statement 2 : State-Wise Distribution of Estimated Number of Workers For Financial Intermediation Activity - By Gender State/Union Territory Male Female Total

Andhra Pradesh Arunachal Pradesh Assam Bihar Goa Gujarat Haryana

40092 48 4372 2578 242 37383 1664

2853 0 399 103 228 1377 0

42945 48 4771 2681 470 38760 1664

Himachal Pradesh Jammu and Kashmir Karnataka Kerala Madhya Pradesh Maharashtra Manipur Meghalaya Mizoram Nagaland Orissa Punjab Rajasthan Sikkim Tamil Nadu Tripura Uttar Pradesh West Bengal A & N. Islands Chandigarh D & Nagar Haveli Daman & Diu Delhi Lakshadweep Pondichery

80 1054 30215 10949 3193 14577 0 0 0 0 2550 1620 1963 0 85921 197 14242 12150 5 140 0 0 41690 0 1100

34 127 1363 4158 605 4208 24 0 0 0 0 325 0 0 7356 0 752 451 0 20 0 0 217 0 147

114 1181 31578 15107 3798 18785 24 0 0 0 2550 1945 1963 0 93277 197 14994 12601 5 160 0 0 41907 0 1247

All India

308025

24747

332772

Statement 3 : Estimated Annual Value Added Per Worker for Financial Intermediation Activity (in Rs.) State/Union Territory Own Account Enterprises Establishments All Enterprises

Andhra Pradesh Arunachal Pradesh Assam Bihar Goa Gujarat Haryana Himachal Pradesh Jammu and Kashmir Karnataka Kerala Madhya Pradesh Maharashtra Manipur Meghalaya Mizoram

30200 0 25657 40700 0 42380 15780 34818 23014 40830 37484 73563 45535 55200 0 0

42118 7959867 0 21570 25846 31057 80894 7935 33897 25214 33538 44130 37048 0 0 0

35537 7959867 25657 37424 25846 33182 55795 19708 33415 31888 35639 72668 43697 55200 0 0

Nagaland Orissa Punjab Rajasthan Sikkim Tamil Nadu Tripura Uttar Pradesh West Bengal A & N. Islands Chandigarh D & Nagar Haveli Daman & Diu Delhi Lakshadweep Pondichery

0 34302 122405 63519 0 53767 14632 34872 28728 93990 99050 0 0 23732 0 32546

0 25988 31949 71940 0 37100 0 36275 22400 0 0 0 0 38140 0 27924

0 29382 72258 65649 0 47415 14632 35307 28488 93990 99050 0 0 38061 0 30152

All India

43666

37683

40622

Statement 4 : Estimated Aggregate Annual Value Added for Enterprises In Financial Intermediation Activity (in Rs. 000) State/Union Territory Own Account Enterprises Establishments All Enterprises

Andhra Pradesh Arunachal Pradesh Assam Bihar Goa Gujarat Haryana Himachal Pradesh Jammu and Kashmir Karnataka Kerala Madhya Pradesh Maharashtra Manipur Meghalaya Mizoram Nagaland Orissa Punjab Rajasthan Sikkim Tamil Nadu Tripura Uttar Pradesh West Bengal

716226 0 122406 90422 0 308247 10120 1745 1205 551038 301554 270880 670081 1311 0 0 0 35695 106059 93149 0 3103737 2876 360654 348252

809892 385417 0 9903 12177 977875 82712 510 38242 455932 236890 5097 150707 0 0 0 0 39210 34439 35717 0 1318960 0 2392650 1971617

1526118 385417 122406 100325 12177 1286122 92832 2255 39447 1006970 538444 275977 820788 1311 0 0 0 74905 140498 128866 0 4422697 2876 2753304 2319869

A & N. Islands Chandigarh D & Nagar Haveli Daman & Diu Delhi Lakshadweep Pondichery

485 15773 0 0 5449 0 19568

3134 318862 10963 5511 2258000 95 47283

3619 334635 10963 5511 2263449 95 66851

All India

7136932

28767317

35904249

THE ROLE OF FINANCIAL INTERMEDIATION IN ECONOMIC GROWTH

Nineteenth Century Classical Economists ignored financial intermediation as an important element in explaining economic growth until Bagehot. Bagehot, for the first time, gives explicit examples of how money market developments in England could make capital flow across the country in search of the highest rate of return. However, analysis of Bagehot was incomplete. It was Schumpeter, who put the role of financial intermediation at the center stage of economic development. Curiously, renewed interest in economic growth in the post Second World War saw a development in the literature that completely ignored the role of financial intermediation. For example, Solow-Swan model of development and growth has no role of financial intermediation. For all practical purposes, the economies were seen to be well approximated

by a one good (corn producing corn) model. It took the international financial crisis of Latin America in the early 1980s to force economists to take the role of financial intermediaries seriously. I examine why financial intermediation is important in the tradition of Schumpeter. There are important contributions by banks and other financial intermediaries on the economy. This process can be seen when we examine how the economy is affected when there are banking crises. Latin America provides an extremely fertile test-bed. There are important ways financial intermediaries can contribute to growth by examining the models of new growth theory in the tradition of Arrow-Romer. Elements of these models can be found in the writings of Schumpeter. Current debate about the role of financial intermediation in determining the growth rate misses the central point of Schumpeter. Introduction Classical economists of the Nineteenth Century have paid some attention to the role of financial intermediation in running the wheels of economic growth smoothly. For instance, Bagehot (1873) gives explicit examples of how money market developments in England could make capital flow across the country in search of the highest rate of return. " Political economists say that capital sets towards the most profitable trades, and that it rapidly leaves the less profitable and nonpaying trades. But in ordinary countries this is a slow process, and some persons who want to have ocular demonstration of abstract truths have been inclined to doubt it because they could not see it. In England, however, the process would be visible enough if you could only see the books of the bill brokers and the bankers. Their bill cases as a rule are full of the bills drawn in the most profitable trades, and ceteris paribus and in comparison empty of those drawn in the less profitable. If the iron trade ceases to be as profitable as usual, less iron is sold; the fewer the sales the fewer the 64 ECONOMIC THEORY IN THE LIGHT OF SCHUMPETERS SCIENTIFIC HERITAGE bills; and in consequence the number of iron bills in Lombard Street is diminished. On the other hand, if in consequence of a bad harvest the corn trade becomes on a sudden profitable, immediately `corn bills' are created in great numbers, and if good are discounted in Lombard Street. Thus English capital runs as surely and instantly where it is most wanted, and where there is most to be made of it, as water runs to find its level." (Bagehot, 1873, Chapter I, p. 11-12) Further in his exposition, Bagehot becomes even more explicit about the connection between financial development (and trade) and economic growth. " The `loanable capital,' the lending of which caused the rise of prices, was lent to enable it to augment. The loanable capital lay idle in the banks till some trade started into prosperity, and then was lent in order to develop that trade; that trade caused other secondary developments; those secondary developments enabled more loanable capital to be lent; and that lending caused a tertiary development of trade; and so on through society." (Bagehot, 1873, Chapter VI, p. 52) These references to the connection between finance and economic growth, however explicit, did not have central stage in the thinking of classical economists. It was Schumpeter (1911) who put the role of financial intermediation at the center of economic development. It is

curious to note that even though Schumpeter wrote Theorie der Wirtschaftlichen Entewicklung in 1911. The English translation The Theory of Economic Development did not appear until 1934. The German edition appeared just before the First World War. English speaking economists (such as Schumpeter's contemporary John Maynard Keynes) ignored it because it was written in German and because of the War. By the time the English translation appeared, the two main English speaking intellectual centers of the Western World, England and the United States were in the depth of the worst depression of this century. Thus, politicians and economists alike were in no mood to celebrate contributions of businessmen in economic growth. Keynes contributed to this apathy in Schumpeter indirectly by publishing his influential General Theory in 1936. Economists in studying theories of economic growth in the 1950s showed renewed interest. Robert Solow (1956) and T. Swan (1956) developed a model of economic growth. Solow-Swan model of development and growth has no role of financial intermediation. For all practical purposes, the economies were seen to be well approximated by a one good (corn producing corn) model. The growth model that dominated had only two elements in production: capital and labor. However, when researchers talked about capital, it was understood to be physical capital. Financial capital or human capital played no role. Economists understood right after the development of the Solow-Swan model that the model could not explain large parts of economic growth (the existence of so-called "Solow Residuals"). For example, Arrow (1962) wrote, "It is by now incontrovertible that increases in per capita income cannot be explained simply by increases in the capital-labor ratio." Arrow's motivation was to incorporate knowledge into the model. It would be a quarter of a century before Arrow's idea of "learning by doing" would be incorporated into a serious macroeconomic model (Romer, 1986) in the so-called "new growth theory". It would also be another quarter of a century before economists took Solow Residuals seriously and entertained models that contained financial activities. In 1982, the financial markets around the world were rocked by the deep financial problem in Mexico that led to default of international loans. The default sparked crises in financial markets in other Latin American countries. Eventually the financial crisis stalled the economic growth of these Latin American countries in the whole decade that followed. Between 1960 and 1980, the average growth rate for Latin American countries exceeded 6% per annum. The average growth rate fell to 1.3% per annum during 1981-1990. This has prompted economists to dub the 1980s as the lost decade for Latin America. After the Great Depression, this was the first clear evidence that financial crisis leads to general economic depression. Policy in many countries shifted to reforming (and deregulating) financial institutions. It took the international financial crisis of Latin America in the early 1980s to force economists to take the role of financial intermediaries seriously. THE ROLE OF FINANCIAL INTERMEDIATION IN ECONOMIC GROWTH 65 I examine why financial intermediation is important in the tradition of Schumpeter. There are important contributions by banks and other financial intermediaries on the economy. This process can be seen when we examine how the economy is affected when there are banking crises. Latin America provides an extremely fertile test-bed. There are important ways financial intermediaries can contribute to growth by examining

the models of new growth theory in the tradition of Arrow-Romer. Elements of these models can be found in the writings of Schumpeter. s