Economic Transactions: Financial Institutions as Intermediaries

Within financial systems there are surplus economic units and deficit economic units. A surplus economic unit, usually represented by individual households, is one that generates more income than expenditures. A deficit economic unit, usually represented by businesses or governments, is one that generates more expenditures than income.

The financial market operates by bringing together surplus economic units and deficit economic units so that they may exchange funds for securities, such as stocks, bonds, or certificates of deposit (CDs), to the benefit of both economic units. Financial institutions act as intermediaries in these transactions by receiving the funds from the surplus economic unit, passing those funds on to the deficit economic unit in exchange for the securities, and finally passing on those securities to the surplus economic unit.

The Roles Financial Institutions Play in Financial Intermediation

Financial institutions, such as banks, investment management companies, or insurance companies, play an important role in financial intermediation. In the course of acting as intermediary, these institutions provide many valuable services. Following are three examples of these services, along with the reasons they are necessary.

1) Financial institutions can combine the funds from many households and use those funds to purchase securities from businesses or governments that require larger amounts of money than the single households could provide.

2) By combining the funds of several households, financial institutions can allow businesses or governments the use of funds for longer periods of time than individual households would, because the withdrawal of funds by a small number of households is covered by the additional funds deposited by other households.

3) Financial institutions are able to predict and absorb credit risks that individual households could not. While a household may not be able to determine whether a business or government will fulfill its obligations, the financial institution can make that determination and has the resources to absorb losses when they occur.

Conclusion

The role of financial institutions as intermediaries in economic transactions is an important one. Without this intermediation, the financial market would suffer, because surplus economic units and deficit economic units would not be able to come together in the necessary manner to exchange funds effectively. Deficit economic units, such as businesses and governments, would suffer and likely lose the ability to operate successfully. Surplus economic units, such as households, would also suffer when the businesses and governments lose this ability. The successful operation of the financial market requires financial institutions to act as intermediaries in economic transactions.

References

Gallagher, T. J., & Andrew, J. D. (2003). "Financial management principles & practice." (3^rd ed.). Upper Saddle River, NJ: Pearson Education, Inc.