Intermediaries

A third party offering intermediation

services between two trading parties.
Acts as a conduit (medium) for goods
or services offered by a supplier to a
consumer.
Offer some added value to the
transaction that may not be possible
by direct trading.
Can be a person or organization.
Facilitates contract between two
parties.

 Financial Intermediary
Institution, firm or individual performs
intermediation financial context.
First party is provider of product or
service and second party is
consumer or customer.
Institution acting as middleman
between investors/firms raising funds
is financial institutions. Includes
chartered banks, insurance
companies, investment dealers,
mutual funds, and pension funds.

 Most people do not enter financial

markets directly but use
intermediaries or middlemen.
Commercial banks are most common
financial intermediary.
Money deposited in bank used to
make loans to anyone who needs.
A person could seek out borrowers
himself and bypass the intermediary
and could get higher return.
Financial intermediaries provide
advantages to savers.

 Lending through an intermediary is

less risky. Because it can diversify
lending portfolio. Loans given
mistakenly, offset may be against
sound loans.
A saver could directly make only a few
loans and bad loans would
substantially affect his wealth.
Financial intermediaries acquire
specialist knowledge to predict
borrowers ability to repay. Hence risk
reduced. (Even a specialist may make
some mistakes).

 Availability of liquidity. Liquidity is

ability to convert assets into a money
quickly.
Individual lends money and suddenly
needs cash,
o must either persuade the borrower to
repay quickly, may not be possible, or
o find someone to buy the loan from
him, may be very difficult.
Size of intermediary allows to hold
some funds idle as cash to provide
liquidity to individual depositors.

 They can be a source of shocks to the economy,

bumps may disrupt normal flow of economic life.
Bank debt serves as money, so disruptions to
banks can affect the amount of money in
circulation.
They are tied together through chains of debts
and assets.
Due to linkages, failure of one can weaken others
increasing their chances of failure.
If a key financial intermediary fails, it may cause
other institutions to fail.
May result into financial sector to "seize up" and
stop functioning.
Serious disruption of the financial markets will
disrupt the rest of the economy.

 Types of Intermediaries
Banking and Non-banking institutions
They transfer funds from economic
agents with surplus funds (surplus
units) to economic agents (deficit units)
that would like to utilize those funds.
Bank Financial Intermediaries, BFIs
(Central banks and Commercial banks)
Non-Bank Financial Intermediaries,
NBFIs (insurance companies, mutual
trust funds, investment companies,
pensions funds, discount houses and
bureaux de change).

 Fee Based/Advisory Financial Intermediaries:

Offer advisory financial services and charge
a fee accordingly .Their services include:
Issue Management
Underwriting
Portfolio Management
Corporate Counseling
Stock Broking
Syndicated Credit
Arranging Foreign Collaboration Services
Mergers and Acquisitions
Debentiure Trusteeship
Capital Restructuring

 Asset-Based Financial Intermediaries:

Finance specific requirements of
clients.
Required infra-structure, in the form
of required asset or finance is
provided for rent or interest
respectively.
They earn incomes from interest
spread, (difference between interest
paid and interest earned.)

 Channeling funds between surplus and

deficit agents.
A financial intermediary is
It connects surplus and deficit agents.
Example Bank It transforms deposits into
bank loans.
Certain assets/liabilities transformed into
different assets/ liabilities.
The savers give funds to bank and it gives
those funds to borrowers
loans/mortgages.
Alternatively, savers may lend the money
directly via financial markets, which is
known as financial disintermediation.

 Functions
Maturity transformation-Converting
short-term liabilities to long term
assets. Banks deal with large number
of lenders and borrowers and reconcile
their conflicting needs.
Risk transformation-Converting risky
investments into relatively risk-free
ones. Banks lend to multiple borrowers
to spread the risk.
Convenience denomination-Matching
small deposits with large loans and
large deposits with small loans.

 Advantages of financial
intermediaries
Cost advantage over direct
lending/borrowing
Market failure protection the
conflicting needs of lenders and
borrowers are reconciled, preventing
market failure

Cost advantages of using financial

intermediaries:
Reconciling conflicting preferences of
lenders and borrowers
Risk aversion intermediaries help spread
out and decrease the risks
Economies of scale - reduces the costs of
lending and borrowing
Economies of Scope - Intermediaries
concentrate on the demands of the
lenders and borrowers and are able to
enhance their products and services (use
same inputs to produce different outputs)

Financial intermediaries include:

Banks
Financial Advisors or Brokers
Insurance companies
Collective Investment Schemes

In India, the players in the unorganized

sector are:
Money lenders
Indigenous bankers
Chit funds
Nidhis or mutual benefit funds
Self Help Groups

 No estimate of the volume of business handled

by unorganized sector.
Volume of business handled in urban sector may
be small, their role in rural India is very
significant.
Negative effect unorganized sector - It reduces
efficacy of a country's monetary policy.
Lot of initiatives undertaken Central and State
Governments to reduce the adverse impact.
Some of these initiatives are:
All India Development Financial Institutions [DFIs]
State Level Financial Corporations [SFCs]
Insurance Companies
Mutual Funds [MFs]
Non Banking Finance Corporations [NBFCs]

All India Development Financial Institutions

Various institutions covered under all India DFIs:
Industrial Finance Corporation of India [IFCI]
Industrial Development Bank of India [IDBI], which
merged with IDBI Bank
Industrial Credit and Investment Corporation of
India [ICICI], merged with ICICI Bank in 2002
Industrial Investment Bank of India [IIBI]. The
former Industrial Reconstruction Corporation of
India converted into Industrial Reconstruction
Corp of India [IRCI] & was later converted into IIBI
in 1995
Small Industries Development Bank of India
[SIDBI], which is a wholly owned subsidiary of IDBI
curved out through an act of parliament in 1990.

 State Level Financial Corporations

Mainly concentrate on industrial
development in a state.
Legal bodies created under the State
Finance Corporations Act, 1951 and funded
through issue of shares in which the state
governments, banks, financial institutions
and private investors participate.
Also permitted to raise funds through the
issue of bonds and debentures.
Main focus of SFCs financing local
industrial units, which are usually small
and medium units, situated in backward
regions of the state.

 Insurance Companies
Insurance companies fulfill insurance needs of
the community, both for life and non life
insurance.
With globalization large number of private
players have entered into this field, offering
products that allow investors to select the kind
of policies to suit their financial planning
needs.
Many of these are formed as subsidiaries of
banks that enable the banks to cross sell
insurance products to their existing customers.
Banks benefit by way of fee income through
referrals and enhanced relationships with
insurance companies for their banking needs.

 Mutual Funds
Satisfy needs of individual investors through
pooling resources from a large number with
similar investment goals and risk appetite.
Resources collected are invested in capital
market and money market securities and
returns generated distributed to investors.
MFs fund managers - specialists in investment
analysis, able to diversify and even out risks
through portfolio mix.
MFs offer wide variety of schemes - growth
funds, income funds, balanced funds, money
market funds and equity related funds
designed to cater to the different needs of
investors.

 Non Banking Finance Corporations

NBFCs commonly known as finance companies
are corporate bodies
Concentrate mainly on lending activities in well
defined area.
The RBI Amendment Act, 1997 defines - NBFC financial institution or non banking institution,
which has its principal business of receiving
deposits under any scheme or arranging and
lending in any manner.
There are 4 broad categories of NBFCs:
Finance Companies
Leasing Companies
Loan finance companies
Investment finance companies

 Financial adviser
Professional renders financial services to
individuals, businesses and governments.
Involves investment advice, may include pension
planning, and/or advice on life insurance, other
insurances as income protection insurance, critical
illness insurance, mortgages
Many FA receive commission for the various
financial products that they broker, although "feebased" planning is becoming increasingly popular in
financial services industry.
There are two types of financial advisers - "feebased" and "fee-only" advisers. Fee-based advisers
often charge asset based fees but may also collect
commissions. Fee-only advisers do not collect
commissions or referral fees paid by other product
or service providers.

 Broker
Arranges transactions between a
buyer & seller and gets commission
when the deal is executed.
Acts as a seller or as a buyer
becomes a principal party to the
deal. The agent is one who acts on
behalf of a principal.

 Collective Investment Scheme

Investing money with others to participate
in a wider range of investments than
feasible for most individual investors and
share the costs and benefits of it.
They are often referred to as mutual
funds, investment funds, managed
funds, or simply funds. They occupy
substantial portion of all trading on major
stock exchanges. Funds are often selected
on the basis of specified investment aims,
their past investment performance and
other factors such as fees.

 The Net Asset Value or NAV is the value

of a scheme's assets less the value of its
liabilities.
Open-end fund is equitably divided into
shares which vary in price in direct
proportion to the variation in value of the
fund's net asset value.
New shares or units are created to match
the prevailing share price each time money
is invested; each time shares are redeemed,
the assets sold match the prevailing share
price. In this way there is no supply or
demand created for shares and they remain
a direct reflection of the underlying assets.

 Closed-end fund issues a limited number

of shares (or units) in an IPO or through
private placement.
If shares are issued through IPO, they are
then traded on exchange or directly through
fund manager to create a secondary market
subject to market forces.
If demand for the shares is high, they may
trade at a premium to net asset value. If
demand is low they may trade at a discount
to net asset value. Further share (or unit)
offerings may be made by the scheme if
demand is high although this may affect the
share price.

Alpha, Beta, R-squared & standard

deviation
For analyzing investment
performance, statistical measures
are often used to compare 'funds'.
These statistical measures are often
reduced to a single figure
representing an aspect of past
performance:

 Alpha represents the fund's return when

benchmarks return is 0. This shows the
fund's performance relative to the
benchmark & can demonstrate value
added by the fund manager. The higher
the 'alpha' the better the manager. Alpha
investment strategies tend to favour stock
selection methods to achieve growth.
Beta represents an estimate of how much
the fund will move if its benchmark moves
by 1 unit. This shows the fund's sensitivity
to changes in the market. Beta investment
strategies tend to favour asset allocation
models to achieve outperformance.

 R-squared is a measure of the

association between a fund and its
benchmark. Values are between 0 and
1. Perfect correlation is indicated by 1,
and 0 indicates no correlation. This
measure is useful in determining if the
fund manager is adding value in their
investment choices or acting as a closet
tracker mirroring the market and
making little difference. For example, an
index fund will have an R-squared with
its benchmark index very close to 1,
indicating close to perfect correlation.

 Standard deviation is a measure of

volatility of the fund's performance
over a period of time. The higher the
figure the greater the variability of
the fund's performance. High
historical volatility may indicate high
future volatility, and therefore
increased investment risk in a fund.

 Types of risk
Depending on the nature of the investment, the
type of 'investment risk' will vary.
A common concern is that of losing the money
invested, i.e., capital. This risk is referred to as
capital risk.
If investments are held in another currency there
is a risk that currency movements alone may
affect the value. This is referred to as currency
risk.
Many forms of investment may not be readily
salable on the open market (e.g. commercial
property) or the market has a small capacity and
investments may take time to sell. Assets that
are easily sold are termed liquid therefore this
type of risk is termed liquidity risk.