What is Financial Intermediation?

Financial intermediation is a method for connecting people and institutions that have surplus funds with parties who need funds to continue their activities. One of the simplest examples can be seen at a bank, where savers deposit money and the bank turns around and loans that money to borrowers who need funds for things like buying homes or cars. Using financial intermediation, assets and liabilities can be converted, providing interest and other earnings at every step of the way to keep the financial institution robust.

Banks are not the only institutions able to act as financial intermediaries, although they are among the most common. Brokerage firms, investment companies, and numerous other kinds of financial institutions can engage in financial intermediation. A number of steps can be involved, with parties receiving money from one intermediary and using it for a transaction at another, thus passing the funds down the line.

This process is one of the cornerstones of modern economic activity in many financial markets. It allows people with surplus funds to make money from those funds until they are needed, while also providing credit and liquidity to people who need money. A constant series of transactions also provides financial institutions with profits they can use for maintaining staff and facilities, securing deposits, and paying shareholders, whether they are publicly owned or organized on a credit union basis.

Depending on economic conditions, the volume of financial intermediation can vary. When conditions are tight, surplus funds tend to decline, as people may be forced to rely on reserves to pay for their own activities. Long term investments like certificates of deposit tend to be less appealing as a result of low interest rates, and financial institutions may lack access to a steady supply of surplus funds to loan out. While the number of borrowers may stay the same or even increase, available funds decline, pushing up competition and creating a tightening in the credit market. This can have a ripple effect, unsettling investors and other members of the public.

A number of complex regulations are intended to safeguard financial intermediation activities with the goal of protecting all parties involved. Savers are entitled to accountings of how their money is used, and they generally also earn interest while their funds are used. Borrowers must receive detailed contracts providing information about the terms of the loan and other matters, and must sign to acknowledge understanding and commit to the repayment terms.