KINDS OF FINANCIAL INTERMEDIATION

1-1

One of the pre-conditions for the growth of

economy is growth in the Capital formation.

Capital formation refers to an increase in the stocks of

PHYSIAL CAPITAL/REAL OR PRODUCTIVE ASSETS
of an economy.
The process of Capital formation involves three distinct
yet interdependent activities, viz., Savings, Finance and
Investment.
Banks and FIs are engaged in the process of
chanelising Savings from Surplus entities to Deficit
entities/units and help as a catalyst in the Capital
formation and economic development.
This special role/activity of Banks/FIs is known as
Financial Intermediation.

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1-2

Without FIs

Equity & Debt

Households

Corporations

(net savers)

(net borrowers)
Cash

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FIs Specialness

1-3

Without FIs: Low level of fund flows.

Information and Monitoring costs : Very High

Economies of scale reduce costs for FIs to screen

and monitor borrowers

Less liquidity
Maturity Mismatch
Substantial price risk
High Default Risk/ Credit Risk

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1-4

With FIs

FI

Households
Cash

(Brokers)

FI

Corporations
Equity & Debt

(Asset
Transformers)
Deposits/Insurance
Policies

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1-5
KINDS OF FINANCIAL
INTERMEDIATION
Banks and FIs actually performs various
kinds of intermediation. They are :

Denomination Intermediation
Default-risk Intermediation
Maturity Intermediation
Liquidity Intermediation
Information Intermediation
Time Intermediation
Risk Pooling and Diversification (Economies of
Scale & Scope)

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1-6
Kinds of Financial Intermediation
Contd .
Denomination Intermediation : is a kind that
occurs when small amounts of savings from
individuals and others are collected and pooled so
as to give loans to others. This helps small savers
to generate higher returns and lower risks on their
portfolios.
Default-risk Intermediation : refers to the
willingness of FIs to make loans to risky borrowers
and, at the same time, issue relatively safe and
liquid securities in order to attract loanable funds
from savers who are risk averse. Generally, the
borrowers from an FI is perceived to be more risky
than the FI itself. Thus FIs assumes the
Default/Credit Risk onto itself and shield the
Primary Savers.

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1-7
Kinds of Financial Intermediation
Contd
Maturity Intermediation : refers to the borrowing
of relatively short-term funds from savers, who
often cannot commit their funds over long periods,
and making long-term loans to borrowers who
require a long-term commitment to funds. Thus the
FIs takes over the Maturity Mismatch Risk from
the Primary Savers onto itself and thereby subject
itself to consequent Interest Rate Risk. A Large FI
is better able to bear the risk of mismatching of its
assets and liabilities and manage the consequent
Interest Rate Risk through its superior access to
markets and instruments for hedging the risks of
such loans.

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Kinds of Financial Intermediation

Contd.

1-8

Liquidity Intermediation : refers to issuing

of indirect claims to savers that are highly
liquid while at the same time accepting
relatively less liquid direct claims from
borrowers/investors which may entail
considerable risk of loss and high
transaction costs if these claims are
converted into cash. Thus FIs takes over the
Liquidity & Price Risk from the Primary
savers onto itself.

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1-9
Kinds of Financial Intermediation
Contd .
Information Intermediation : refers to the
process by which FIs substitute their skill in
gathering and processing information from
financial market place for that of the savers who
frequently have neither time nor expertise to stay
abreast of the market developments nor access to
relevant information about market conditions and
investment opportunities. The FIs are perceived to
possess Asymmetric Information which will
facilitate in taking better decisions on the aspect of
routing money to the investors/borrowers.
Information Asymmetry is a situation in which
one party to a transaction is better informed than
the other. This is in fact one of the causes for
existence of a Financial Intermediary.

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1-10
Kinds of Financial Intermediation
Contd .
Inter Generational wealth Transfer or Time
Intermediation : refers to the process by which
FIs, especially Life Insurance Companies and
Pension Funds, provide savers with the ability to
transfer wealth from their youth to old age across
generations. This is of great importance to a
countrys social well-being. For example, pension
funds offer savings plans through which fund
participants accumulate tax exempt savings during
their working years before withdrawing them
during their retirement years. By this act, FIs
assumes on to itself the Longevity Risk (?) and
other financial Risks from that of Primary Savers.

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Kinds of Financial Intermediation

Contd .

1-11

Risk Pooling & Diversification (Economies of Scale &

Economies of Scope) : FIs also engage in risk pooling
and take advantage of Economies of Scale in their
activities. Economies of scale refers to decreasing of costs
of overall operation and performance by virtue of large size
of operations. By deploying resources in loans and other
assets like investments with a wide variety of risk-return
characteristics, the benefits of financial diversification are
achieved, enhancing the safety of funds supplied by
savers. Most small savers cannot adequately diversify their
limited funds among different types of investments.
However, an FI can pool the funds of many small savers
and efficiently diversify, achieving Economies of Scope,
across many different investments, lowering risks of all
savers. Economies of Scope refers to decreasing of costs
of overall operation and performance as well as increasing
the overall revenues by virtue of using/optimising the same
existing resources including human resources (often
underutilised) for various complementary and related
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Risks incurred by FIs while performing1-12

the role of Financial Intermediation

As Banks & FIs perform the various services described above, they
assume many types of risks.
. Specifically, all FIs hold some assets that are potentially subject to
default or credit risk (such as loans, stocks or bonds).
. Further, FIs tend to mismatch the maturities of their Balance Sheet
Assets and Liabilities to a greater or lesser extents and are thus
exposed to interest rate risk.
. Moreover, all FIs are exposed to some degree of liability withdrawal or
liquidity risk, depending on the type of claims they have sold to liability
holders.
. Finally, all FIs are exposed to operating cost risk because the
production of financial services requires the use of real resources and
back-office support systems (labour and technology combined to
provide services).
. Other risks FIs face include Off-Balance-Sheet risk, technology risk,
country or sovereign risk and insolvency risk.
. We shall study all these risks in detail in the next chapter.

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