Role of Intermidiaries

7/27/2019 Role of Intermidiaries

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ROLE OF INTERMIDIARIESAbstract

Financial Intermediaries are performing various roles in addition to what they used to doearlier by innovating and upgrading themselves in many ways. Some of the important rolesthey are expected to perform in the 21 st 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 whoperforms intermediation between two or more parties in a financial context. Typically thefirst party is a provider of a product or service and the second party is a consumer orcustomer.

Financial intermediaries are banking and non-banking institutions which transfer funds fromeconomic agents with surplus funds (surplus units) to economic agents (deficit units) thatwould 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, discounthouses 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 payshigher amount of interest than that received by the actual lender and the differencebetween the Interest paid and Interest earned is the Financial Intermediaries/Institutionsprofit.

Financial Intermediaries are broadly classified into two major categories:

1) Fee-based or Advisory Financial Intermediaries2) Asset Based Financial Intermediaries .


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Fee Based/Advisory Financial Intermediaries : These Financial Intermediaries/ Institutionsoffer advisory financial services and charge a fee accordingly for the services rendered.

Their services include:

i. Issue Managementii. Underwritingiii. Portfolio Managementiv. Corporate Counselingv. Stock Brokingvi. Syndicated Creditvii. Arranging Foreign Collaboration Servicesviii. Mergers and Acquisitionsix. Debentive Trusteeshipx. Capital Restructuring

ASSET-BASED Financial Intermediaries : These Financial Intermediaries/Institutionsfinance 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 companiesearn their incomes from the interest spread, namely the difference between interest paidand interest earned.

The financial institutions may be regulated by various regulatory authorities, or may berequired to disclose the qualifications of the person to potential clients. In addition,regulatory authorities may impose specific standards of conduct requirements on financialintermediaries 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 the21 st century.

Most of the poor live in the rural areas, and are engaged in agricultural activities or avariety 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, highcosts 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. Mostpoor and low-income households continue to rely on meager self-finance or informal sourcesof 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 tosmoothen their consumption, manage risks better, gradually build assets, develop


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micro-enterprises, enhance income earning capacity, and generally enjoy animproved quality of life.

Efficient micro-finance services can also contribute to improvement of resourceallocation, development of financial markets and system, and ultimately economicgrowth 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 theavailability of small-scale loans and would introduce them to the small-enterprisesector.

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 thanborrow, and it is possible to successfully mobilize funds from poor households.

Another important fact is that contrary to expectations, the poor are creditworthyand financial services can be provided to the poor on a profitable basis at lowtransaction costs without having to rely on physical collateral.

Finally, micro-finance services contribute to the development of rural financialmarkets 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 thesustainable growth of micro-finance. In particular, interest rate ceilings andsubsidized credit limit the ability of micro-finance institutions to provide services tothe poor.

Inappropriate and extensive intervention by governments in micro-financeundermines its efficient operation.

Inadequate financial infrastructure is another major problem in the region. Financialinfrastructure includes legal, information, and regulatory and supervision systems.

In addition, most microfinance institutions do not have adequate capacity to expandthe scope and outreach of services on a sustainable basis to potential clients.Specifically, they lack the ability to leverage funds, provide services compatible withthe 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 liquidationof firms in distress. In particular, there is rich evidence that financial intermediariesplay 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 Germanya function of banks during reorganizations is to "use bank contacts to facilitate amerger with another firm as a means of resolving the crisis". Knowing possiblesynergies among firms, banks can suggest solutions for the efficient reallocation of assets and of corporate control and that in several countries there is widespreadanecdotal evidence, though not quantitative one, on this role of banks. Healthy firmssearch around for the displaced capital of bankrupt firms but matching is imperfect


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and firms can end up with machines unsuitable for them.

Financial intermediaries arise as internal, centralized markets where information onmachines and buyers is readily available, allowing displaced capital to migratetowards its most productive uses. Financial intermediaries can perform this role byaggregating the information on firms collected in the credit market. The function of

intermediaries as matchmakers between savers and firms in the credit market cansupport their function as internal markets for assets. Intuitively, by increasing thenumber of highly productive matches in the credit market, intermediaries increasethe share of highly productive second hand users in the decentralized resale market.This improvement in the quality of the decentralized secondary market reduces theincentive of firms to address financial intermediaries for their ability as re-deployers.However, by increasing the number of highly productive matches in the creditmarket, intermediaries create also wealthy buyers without assets and contribute todecrease the thickness of the decentralized resale market. This makes thedecentralized market less appealing and increases the incentive of firms to useintermediaries as resale markets. When the quality improvement in the decentralizedmarket is not too big and the second effect prevails, better matchmaking in thecredit 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 andinvest funds contributed by sponsors and beneficiaries to provide for the future pensionentitlements of beneficiaries. They thus provide means for individuals to accumulate savingover their working life so as to finance their consumption needs in retirement, either bymeans of a lump sum or by provision of an annuity, while also supplying funds to end-userssuch as corporations, other households (via securitized loans) or governments forinvestment or consumption.

We now assess pension funds relative to the various financial functions one by one, in ordercorrectly to identify the role funds play in stimulating change in the financial landscape.

Clearing and settling payments: Pension funds have had an important indirectrole in boosting the efficiency of the financial systems, by influencing the structure of securities markets. By demanding liquidity, pension funds help to generate it, firstlyby their own activity in arbitrage, trading and diversification, secondly via the factthat liquidity is a form of increasing return to scale, as larger markets in whichpension funds are active attract more trading, reducing costs and improving liquidityfurther. A third effect arises from funds' countervailing power as they press forimprovements in market structure and regulation. These include deregulation andreduction 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 fordiversification.

Provision of a mechanism for pooling of funds and subdivision of shares: Pension funds offer much lower costs of diversification by proportionalownership. Pension funds can also offer the possibility of investing in largedenomination and indivisible assets such as property which are unavailable to smallinvestors. Furthermore, pension funds reduce the cost of transacting by negotiatinglower transactions costs and custodial fees. The direct participation costs to


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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 arereduced (although costs of monitoring the asset manager remain). The net effect isthat individuals are likely to switch to pension funds from direct holdings of securitiesand from bank deposits.

Provision of ways to transfer economic resources: Pension funds act in anunusual manner in this regard, in that they may increase the volume of savingbesides the disposition of household funds. At a micro level, company or otherobligatory pension funds can implement enforced saving by deferring wages andsalaries, thereby reducing risk of a low replacement ratio. At a macro level, theincrease in saving is not usually one-to-one, as increased contractual saving viapension funds is typically partly or wholly offset by declining discretionarysaving. Pension funds increase the supply of long term funds to capital markets, and reducebank deposits, even abstracting from changes in aggregate saving, so long ashouseholds do not increase the liquidity of the remainder of their portfolios fully tooffset growth of pension assets.

Provision of ways to manage uncertainty and control risk: Pension fundsprovide risk control directly to households via the forms of retirement incomeinsurance they provide, an advantage which largely reflects the unusual (amongfinancial intermediaries) link of pension funds to employers. To assist in undertakingthis risk control function they diversify assets as noted above and also act insecurities and derivatives markets to hedge and control risk.

Providing price information: pension funds seek publication of information fromcompanies 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 makingloans tend to rely on private information not available to other investors.

Providing ways to deal with incentive problems: Dealing with incentiveproblems in equity finance is one of the most crucial aspects of pension funds'activities as financial intermediaries. The basic issue in corporate governance issimply stated. Given the divorce of ownership and control in the modern corporation,principal-agent problems arise, as shareholders cannot perfectly control managersacting on their behalf. Managers, who have superior information about the firm andits 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 equitycapital in the firm, notably expropriation or diversion to unattractive projects from ashareholder's point of view. Principal-agent problems in equity finance imply a needfor shareholders such as pension funds to exert control over management, while alsoremaining sufficiently distinct to let them buy and sell shares freely without breakinginsider trading rules. If difficulties of corporate governance are not resolved, thesemarket failures in turn also have implications for corporate finance in that equity willbe costly and often subject to quantitative restrictions. Effectiveness of corporategovernance is typically enhanced by presence of large investors, such as pensionfunds. They will have the leverage to oblige managers to distribute profits toproviders of external finance either directly or via the threat to sell to takeoverraiders. They are needed because individual investors may find it difficult to enforcetheir rights, owing to difficulty of acting in a concerted manner against managementand related free rider problems which make it not worthwhile for an individual tocollect information and monitor management. Since pension fund stakes are typically


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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.

Documents

Role of Intermidiaries