Financial intermediaries

With advances in computer technology, one can transfer money instantly, anywhere in the word, you can trade your funds across major stock exchanges online, you can use your credit card across the globe and so on. Lending and borrowing of money is made simple by financial institutions called financial intermediaries. Financial intermediaries such commercial banks, credit unions and brokerage funds carryout these transactions on your behalf. A financial intermediary is a financial institution that borrows from savers and lend to individuals or firms that need resources for investment. The investments made by financial intermediaries can be in loan and/or securities. Basic role of financial intermediaries is transforming financial assets that are less desirable for a large part of the public into other financial asset, which is preferred more by the public. This transformation involves at least four economical functions: providing maturity intermediation, risk reduction via diversifications, reducing the costs of contracting and information processing and providing a payment mechanism.

 

Without financial intermediation we must not have seen revolution in financial services in past couple of decades. Financial intermediation is responsible for creation of institutional investors in financial market. Modern world would not have been so modern without financial intermediaries. Financial intermediation has won savers confidence by protecting their asset while providing efficient services to help manage their asset. On contrary, with pool of household savings from savers, they emerged as one large lender who can lend money to businesses and various other borrowers. Financial intermediaries are vital part of our economic system and they help to maintain constant flow of money in economy.

 

If there were no intermediaries, individual savers would have to directly purchase the securities of borrowers. There would have been incompatibility of the maturity needs of lenders and borrowers since most savers want to lend funds at short maturity, while borrowers want to borrow at longer maturities. It would have been difficult to match small amounts of individual savings to the larger loan amounts desired by borrowers. This would have cause borrowing more difficult and more tedious. Financial intermediaries perform important function of maturity intermediation to make investment from savers and money borrowing for borrowers seamless. Maturity intermediation involves a financial intermediary issuing liabilities against it that have maturity different from the assets it acquires with the fund raised. An example is a commercial bank that issues certificate of deposit and invests in assets with a longer maturity than those liabilities. Maturity intermediation offers more choice concerning maturity for their investments to investors and reduces cost of long term borrowing for borrowers. Financial intermediaries issue their own debt claims to the saver in forms more attractive to savers, and in turn, lend to borrowers on terms satisfactory to the borrowers.

 

Financial intermediaries bears risk on behalf of investors by investigating their savings across various sectors of business. They transform risk-by-risk spreading and risk pooling; they can spread risk across a range of institution. In turn institutions can pool risk by spreading investment across firms and various projects. Diversification allows a financial intermediary to allocate assets and bear risk more efficiently. Financial intermediaries do risk screening, risk monitoring and risk evaluation; it is more efficient for institution to screen investment opportunity on behalf of individuals than for all individuals to screen the risk. It helps individual saver to save time and money and offers low risk investment opportunity. One of the common example of this function is; a dollar deposited in a checking or savings account, it is not redeemed at less than a dollar but in turn one get paid interest on it over period of time. Therefore without financial intermediaries it would really have been difficult for individual investor to screen prospect borrower or investment opportunity, which would have discouraged individual savers from lending money and would have affected economical developments.

 

Financial intermediaries provide convenient and safe way to store finds and creates standardized forms of securities. It also facilitates easy exchange of funds. Due to high volume it is able to bear transaction and information search cost on behave of savers. Therefore, individual saver enjoys financial services that enable them to deposit and withdraw funds without negotiation whereas borrower avoids having to deal with individual investors. Since it has information available for both lenders and borrowers, it minimizes information cost for analyzing their data. Without financial intermediaries lenders and borrowers would have to pay higher transactional and information costs.

 

            Modern world would not have been so efficient, aggresive and progressive without financial intermediation.

 

Functions of investment banker

 

 

When corporation sells new securities to raise funds, the offering is called a primary issue. The agent responsible for finding buyers for these securities is called the investment banker. The investment banker purchase primary issue from corporation and arranges immediate resell of these securities to the investors. Merrill Lynch & Co., Goldman Sachs are some examples of well-known investment banking firms. Broadly investment bankers (investment banking firms) perform three functions: Investigation, Analysis and Research (Origination), Underwriting (Public Cash offerings) and Distribution. Most of time a single investor banker performs all functions, however some investment bankers are specialized in certain functional areas only.

 

Investigation, Analysis and Research (Origination):            Origination includes the subsidiary operations of discovery, investigation, and negotiation. Discovery is the finding of a prospective issue of securities; investigation is the testing of the investment credit of the prospective security issuer, and the intrinsic soundness of the issue; negotiation is the determination of the amount, the price, and the terms of the proposed issue. Investigation usually involves an analysis of the financial history of the corporation by accountants, investigation of legal factors, a survey of its physical property by engineers, and in-depth review of operations. The purpose of investigation and analysis is to determine whether a proposed issue has sufficient merit to be offered to investment community. In other words, function of investment banking is careful analysis of the soundness and reliability of the corporation whose securities are seeking the investment market. The task of investigation and analyzing the numerous factors, which govern the value of investment securities, varies considerably with the different types of issuing bodies.

 

Underwriting (Public Cash offerings): When a corporation wishes to issue new securities and sell them to the public, it makes an arrangement with an investment banker whereby the investment banker agrees to purchase the entire issue at a set price, known as underwriting. Underwriting also refers to the guarantee by the investment banker that the issuer will receive a certain minimum amount of cash for their new securities. The investment banker buys a new security issue, pays the issuer, and markets the securities. The underwriter’s compensation is the difference between the price at which the securities sold to the public, and the price paid to the company for the securities. Underwriting can be done either through negotiations between underwriter and the issuing company (called negotiated underwriting) or by competitive bidding. A negotiated underwriting is a negotiated agreed arrangement between the issuing firm and its investment banker. Most large corporations work with investment bankers with whom they have long-term relationship. In competitive bidding, the firm awards offering to investment banker that bid the highest price.

 

In certain cases, for large or risky issues a number of investment bankers get together as a group, they are referred to as syndicate. A syndicate is a temporary association of investment bankers brought together for the purpose of selling new securities. One investment banker is selected to manage the syndicate called the originating house, which does underwriting of the major amount of the issue. There are two types of underwriting syndicates, divided and undivided. In a divided syndicate, each member group has liability of selling a portion of offerings assigned to them. However, in undivided syndicate, each member group is liable for unsold securities up to the amount of its percentage participation irrespective of the number of securities that group has sold.

 

Distribution: Another function of investment banker it to market the security issues. The investment banker acts as a specialist to distribute securities efficiently for the corporation. It can be very expensive and ineffective for a corporation to sell an issue by establishing marking and selling organization by its own. Investment banker has established marketing and sales network to distribute securities. For a reputed invest banker, with its past history of selecting good companies and pricing securities builds a broad client base over time, and further increases the efficiency with which securities can be sold.

 

            Invest banker offers security to both corporation issuing securities and investors buying securities. For corporations investment banker offers definite price guaranty on a certain date for securities to offer. The corporation runs no risk of the uncertainties of the market and do not have to spend on resources with which it is not equipped with.

To the investor, the responsible investment banker offers protection against unsafe securities. The offering of a few unsound issues can caused serious loss to its reputation, and hence loss of business. Therefore, investment banker play very important role in issuing new security offerings.