An institution or an individual that acts as a link between the parties of a financial transaction is known as a financial intermediary. A mutual fund, investment bank, commercial bank, or pension fund are examples of financial intermediaries. Usually, in debt markets, one of the two parties involved is a lender and the other is a borrower. In equity markets, however, companies don’t lend money or shares to the other party. The shares are purchased and the companies are not obligated to repay the invested amount, thus introducing a certain risk factor.
Each type of financial intermediary serves a specific purpose in the financial ecosystem. Let us look at some examples.
A bank connects a lender and a borrower. The lender deposits their money with the bank in exchange for interest while the bank loans out that money to the borrower at a higher rate. An NBFC, or a Non-Banking Financial Company also offers loans to borrowers but at a relatively higher interest rate. An Asset Management Company (AMC) offer mutual funds that pool money from various investors and invest the sum into financial instruments like equity, debt, bonds, etc.
Similarly, an insurance company provides health or term life insurance against premiums paid by investors. The Indian share market encompasses several popular financial intermediaries in capital markets like broking firms and the stock exchanges themselves. Ventura, a leading brokerage organisation that offers one of the best trading platforms in India, is a popular financial intermediary. They facilitate the purchase and sale of shares for a brokerage or commission.
The functions of financial intermediaries vary depending on the type of institution. In addition to the examples mentioned above, pension funds, credit unions, and building societies are also financial intermediaries.
The primary role of financial intermediaries is to connect the two parties and ensure a seamless and efficient transaction. They help with investment avenues, offering loans, asset storage, or other financial services.
As financial intermediaries pool sums of money from multiple sources (small investors), they achieve economies of scale in their operations. It enables the institutions to help individuals invest in a range of financial instruments at a relatively low cost.
Managing and transforming risk is one of the key functions of financial intermediaries in capital markets. For instance, banks assume the risk of defaults from their borrowers while insurance companies absorb the risk of unfortunate events through their insurance policies.
Capital markets often witness a gap in information between the investor and the companies. Financial intermediaries play a crucial role in assessing the risk, and credibility of the borrower, and ensuring the funds are allocated to the right financial instruments.
Financial intermediaries contribute significantly to increasing market liquidity by offering a secondary market for various instruments. This allows investors to explore avenues, buy and sell with ease, thereby fostering a more efficient market.
Thus, the role of financial intermediaries extends beyond simply funding. Risk management, bridging information gaps, offering diverse avenues to invest in and lowering financing costs with economies of scale contribute significantly to a more efficient and lucrative investment ecosystem.
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