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Chapter 12

The role of financial institutions

Faced with a desire to lend or borrow, there are three choices open to the end-users
of the financial system:

 Lenders and borrowers contact each other directly (inefficient, risky and costly)

 Lenders and borrowers use an organised financial market (e.g. purchase bonds
from company (lend money to the company), redeem company bonds or trade
bonds to another investor)

 Lenders and borrowers use financial institutions as intermediaries (lender
obtains an asset which cannot usually be traded but only returned to the
intermediary, e.g. bank deposit account, pension fund rights)

Intermediation refers to the process whereby potential borrowers are
brought together with potential lenders by a third party, the
intermediary.

Financial intermediaries have a number of important roles:

 Risk reduction (reducing the risk of a single default by lending to a
wide variety of individuals and businesses)

 Aggregation (pooling small deposits to enable larger advances to
be made)

 Maturity transformation (satisfying the different timescale needs of
lenders (generally shorter) and borrowers (generally longer))

 Financial intermediation (bringing together lenders and borrowers)

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