Financial Intermediaries Explained: Meaning, Function, and Examples

What Is a Financial Intermediary?

A financial intermediary is an entity that acts as the middleman between two parties in a financial transaction, such as a commercial bank, investment bank, mutual fund, or pension fund.

Financial intermediaries offer a number of benefits to the average consumer, including safety, liquidity, and economies of scale involved in banking and asset management. Although in certain areas, such as investing, advances in technology threaten to eliminate the financial intermediary, disintermediation is much less of a threat in other areas of finance, including banking and insurance.

The Mechanics of Financial Intermediaries

A non-bank financial intermediary does not accept deposits from the general public. The intermediary might offer factoring, leasing, insurance, or other financial services. Many intermediaries take part in securities exchanges and utilize long-term plans for managing and growing their funds. The overall economic stability of a country may be shown through the activities of financial intermediaries and the growth of the financial services industry.

Financial intermediaries transfer funds from those with extra capital to those who need it. The process creates efficient markets and lowers the cost of conducting business. For example, a financial advisor connects with clients through purchasing insurance, stocks, bonds, real estate, and other assets.

Banks link borrowers and lenders by sourcing capital from financial institutions and the Federal Reserve. Insurance companies collect premiums for policies and provide policy benefits. A pension fund collects funds on behalf of members and distributes payments to pensioners.

Exploring Different Types of Financial Intermediaries

Mutual funds provide active management of capital pooled by shareholders. The fund manager connects with shareholders through purchasing stock in companies he anticipates may outperform the market. By doing so, the manager provides shareholders with assets, companies with capital, and the market with liquidity.

Understanding the Advantages of Financial Intermediaries

Savers can pool funds through intermediaries to make large investments, benefiting the invested entity. At the same time, financial intermediaries pool risk by spreading funds across a diverse range of investments and loans. Loans benefit households and countries by enabling them to spend more money than they have at the current time. 

Financial intermediaries help cut costs in several areas. They use economies of scale to assess credit profiles and manage records cost-effectively. Last, they reduce the costs of the many financial transactions an individual investor would otherwise have to make if the financial intermediary did not exist.

Real-World Example of Financial Intermediary

In July 2016, the European Commission took on two new financial instruments for European Structural and Investment (ESI) fund investments. The goal was to create easier access to funding for startups and urban development project promoters. Loans, equity, guarantees, and other financial instruments attract greater public and private funding sources that may be reinvested over many cycles, as compared to receiving grants.

One of the instruments, a co-investment facility, was to provide funding for startups to develop their business models and attract additional financial support through a collective investment plan managed by one main financial intermediary. The European Commission projected the total public and private resource investment at approximately €15 million (approximately $17.75 million) per small- and medium-sized enterprise.

The Bottom Line

Financial intermediaries are banks, investment funds, and insurance companies that play a crucial role in connecting borrowers and lenders by facilitating efficient financial transactions. These entities provide benefits such as risk pooling, cost reduction, and access to economies of scale, thereby reducing the financial burden on individual investors and borrowers.

Despite advances in technology and the threat of disintermediation, financial intermediaries continue to be vital in sectors like banking and insurance due to the complex nature of financial transactions. Financial intermediaries not only streamline the movement of funds but also significantly contribute to the overall economic stability by enabling capital allocation across various sectors.