Why Financial Intermediaries Exist

The essence of financial intermediation is the use of a third party to facilitate the transfer of information or wealth between two others. Financial intermediaries exist because they improve on unintermediated markets in which the ‘ultimate’ parties (such as borrowers and savers, or firms and investors) deal directly with each other without the use of any intermediary. An intermediary might be useful in a situation where investors want information about prospective investment projects, but are placed or or lack the expertise to collect that information themselves. The intermediary might then be able to provide that information at cost lower than that at which the investors could provide it for themselves. This type of intermediary is known as a broker, and there are many different varieties of brokers, including investment analysts, credit-rating agencies, auditing firms, and various other specialist information services. However, many intermediaries also go beyond the mere provision of information and actually invest on behalf of their clients whom they issue with claims against themselves. These intermediaries can be broadly divided into two types — banks and mutual funds — which are distinguishable from each other by the types of liability they issue. These latter intermediaries might also go beyond providing a conduit for borrowers and lenders to trade with each other, and provide the means of payment or a payments system that agents use to make payments to each other (e.g., by issuing currency).