Financial Intermediation

Financial intermediaries are firms that pool the savings or investments of many people and lend or invest the money to other companies or people to earn a return. Financial intermediaries include banks, investment companies, insurance companies, and pension funds. Banks lend the money of depositors to businesses and others, and pay depositors interest or provide them with valuable services, such as checking and electronic funds transfers. Investment companies allow small retail investors to pool their money together to reduce the diversifiable risks of investments and to profit from the expertise of professional money managers. Insurance companies pool the premiums of the insured to pay for the losses of a few of the insured, thereby preventing a financial catastrophe for the sufferers. Pension funds pool the contributions of workers to invest for greater returns, so that a pension income can be provided to the workers after they retire.

The assets and liabilities of financial intermediaries are primarily financial instruments. Loans, stocks, bonds, and other investments are their assets while the deposits and payment obligations, such as the insurance company's obligation to pay for a loss or the pension funds obligation to pay retirees an income, are their liabilities.

Financial intermediaries make a profit from the difference from what they earn on their assets and what they pay in liabilities. So why don't people loan their money directly and earn all of the interest instead of getting only a portion? Or why doesn't a business simply sell stock or bonds directly to the public to save on the investment banking fee or on interest rates that would probably be less than what a bank would charge?

One reason is because financial intermediaries provide valuable services that cannot be obtained by direct lending or investing. Banks, for instance, offer depositors safety for their funds. They have vaults for the safekeeping of cash and other valuables and deposits are insured by the government. Banks also provide payment services that reduce the hassle of paying bills and also provide a record of those payments. Insurance companies provide financial protection in case of a loss, even if that loss is much greater than the premiums paid by the insured.

Another major reason for using financial intermediaries is because they reduce the risk of information asymmetry, where the receiver of the funds knows more about their financial condition and their intentions than do the giver of those funds. Financial intermediaries have expertise in assessing the risk of the applicant for funds that reduces adverse selection and moral hazard. They have easy access to various databases that provide information on both individuals and businesses, and they have expertise in doing their own research and monitoring.

Internal Financing, Indirect Finance, and Direct Finance

Sources of funding for businesses can be categorized as either internal or external financing. External finance can be further categorized as either indirect or direct financing. Direct finance is the financing obtained by selling stocks and bonds directly to the public in the financial markets. Direct finance provides the lowest cost of funds from external sources, but it requires a company that is well established with an appreciable income and substantial assets; otherwise, investors would be reluctant to lend or invest in the company due to the lack of information and assets.

Indirect finance is the financing obtained from financial intermediaries. Financial intermediaries can lend or invest money in smaller businesses because they can do a better job of investigating the company, assessing its risks, and securing assets for collateral against loans. Indirect financing costs more than direct financing, but financial intermediaries can invest or lend money to businesses that would otherwise not be able to get external financing.

However, most businesses, especially many small businesses, cannot obtain any form of external financing. They have to rely entirely on internal financing, which is the money obtained either from the business owners or from the income earned by the business.

According to some recent statistics, more than 80% of all financing in most countries is internal. This is because most businesses don't have substantial net worth or assets, and so it is difficult to offset the risk that information asymmetry presents, even for financial intermediaries.