Ch 2: Financial Intermediaries
Plan of the second chapter
2-1: Definition
2-2: Utility of banks
2-3: Functions of financial intermediaries
2-4: Advantages of financial intermediaries
2-5: Money creation
• Cash reserve requirement
• Credit multiplier coefficient
2-6: Accounts
➢ Current account
➢ Time deposit
➢ Call deposit
➢ Savings account Debit card
➢ Credit card
➢ Overdraft
2-7: Desirable way of household saving
2-1: Definition: Financial intermediaries are a group of institutions that provide
financial services as intermediaries for us. These institutions are responsible for
operating a payment system, providing loans, taking deposits, and helping with
investment [Walsh C.E. 2003].
Financial intermediary (institution) performs several different functions. For example,
payment and loan functions at commercial banks allow us to deposit funds and use
checking accounts and debit cards to pay the bills or make purchases. Many banks
are profit-seeking entities with shareholders. They obtain profits by charging more
interest for loans and paying less interest on deposits.
Why do we need a financial intermediary? Why can’t individuals and firm simply borrow
from other individuals and firms when they need to? Lending is most efficiently and
cheaply conducted by specialists [Wright R.2012]. A financial intermediary is
necessary because few businesses can rely on internal finance alone.
2-2: Utility of banks
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An efficient financial institution is absolutely necessary for a country, if it is to progress
economically. The services that an efficient financial institution can render a country
are very valuable. The financial institution can be useful in the following ways:
• The banks create instruments of credit which are very convenient substitutes for
money.
• The banks increase the mobility of capital. They bring the borrowers and the
lenders together. They collect money from savers and give it to users. Thus, they
help the movement of funds from place to place.
• They encourage the habit of savings by providing safe channels of investment.
In the absence of banking facilities, people would just waste their funds.
• By encouraging savings, the banks bring about accumulation of large amount of
capital in the country from small individual savings. In this way, they make the
resources of the country more productive, and thus contribute to the general
prosperity and welfare of the country.
Financial intermediaries (Commercial Banks) provide services as intermediaries for
businesses and consumers. They are responsible for transferring funds from savers to
investors in need of these funds. Their business mainly consists of receiving deposits,
giving loans and financing the trade of a country. They provide short-term credit, i.e.,
lend money for short periods. When banks make loans to firms, the banks will try to
channel financial capital to healthy businesses that have good prospects for repaying
the loans, not to firms that are suffering losses and may be unable to repay [Robert, E.
2012]. The following figure illustrates the position of banks as financial intermediaries,
with deposits flowing into a bank and loans flowing out.
A Financial intermediary is an institution that facilitates the transfer of funds between
lenders and borrowers indirectly. The financial Institutions are given security, if the
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borrower defaults on the loan; the bank would have the right to repossess the warrant
and sell it to recover the sum of it. Banks acts as financial intermediaries because they
stand between savers and borrowers. Borrowers receive loans from banks and repay
the loans with interest. In turn, banks return money to savers in the form of withdrawals,
which also include interest repayments from banks to savers.
Finance may be direct or indirect in form. Direct finance occurs where savers lend to
spenders. Indirect finance, more important quantitatively than direct, involves
intermediaries. Each act of external finance creates a financial asset for the lender and
a financial liability for the borrower. Direct finance creates a single financial asset,
namely the lender’s claim on the borrower. Indirect finance, at least two financial assets
arise; the lender’s claim against the intermediary, and the intermediary’s claim against
the borrower. Self finance doesn’t give rise to any financial asset. A surplus sector,
with saving exceeding its capital formation, will correspondingly increase its financial
assets or decrease its liabilities; verse- versa is correct for the deficit sector.
2-3: Functions of financial intermediaries
It seems likely to focus our attention on the functions of commercial banks they perform
[Pettinger, T. 2001].
I. Pooling the resources of small savers: Many borrowers require large sums, while
many savers offer small sums. Without intermediaries, a borrower for an important
amount would have to find many people willing to lend him that amount. That is
very hard. Banks, for example, pool many small deposits and use to make large
loans. The intermediary must attract many savers, so the soundness of the
institution must be widely believed.
II. Providing safekeeping, accounting, and payment mechanisms for resources:
Banks are an obvious example for the safekeeping of money in accounts, the
records of payments, deposits and withdrawals and the use of debit. Financial
intermediaries can do all of this much more cheaply than anyone.
III. Providing liquidity: Liquidity refers to how easy and cheaply an asset can be
converted to a means of payment. Financial intermediaries make it easy to
transform various assets into a means of payments through checking accounts
and credit cards, etc. Liquidity is the ability to cover assets into spendable form-
money quickly. That could be done through the technique of discount (bills), and
banks hold some funds idle as cash to provide liquidity to depositors.
IV. Diversifying risks: Financial institutions help investors to diversify in ways they
would be unable to do on their own. Banks spread depositor funds over many
types of loans, so the default of any one loan does not put depositor funds in
jeopardy (be in danger).
V. Collecting and processing information: The lack of information on one side creates
problems before the loan is made and after the loan. These problems are huge,
but financial institutions use their size and expertise to minimise them. Basically
the worst candidates (adverse) are more likely to be selected for the transaction.
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People who are bad credit risk are more likely to try and get a loan than those who
are good credit risks. Banks, however, are experts at assessing credit risk and
can distinguish the good from the bad. So you lend to the bank, and the bank
lends to those who are good credit risks.
2-4: Money creation
The most important function of commercial bank is the creation of money. Therefore,
money supply by commercial banks is called credit money. Commercial banks create
credit by advancing loans and purchasing securities. They lend money to individuals
and businesses out of deposits accepted from public. However, they required to keep
a certain amount as a reserve with the Central bank for serving the cash requirements
of depositors.
Example1: I have a deposit of £1000 in my bank A, the cash requirement of the Central
bank is 10%. According to this case, the bank A would keep £100 as reserve with the
Central bank and would use the remaining £900 for lending purposes. The bank lends
£900 to a borrower n°1 by opening an account in his name. The bank has issued a
check-book to the borrower to withdraw money. Now, the borrower writes a check of
900 in favour of another person n°2 to settle his debt.
The check is deposited by the person n°2 in his bank B. We know that the cash reserve
ratio (CRR) of the Central bank for bank B is 10%. So, £90 will kept as reserve and the
remaining amount, which is £810, would be used for lending purposes by bank B. The
process of deposits and credit creation continues till the reserves with commercial
banks reduced to zero.
Bank Primary Reserve
deposit requirements Loans
Bank A 1000 100 900
Bank B 900 90 810
Bank C 810 81 729
Bank D 729 72.9 656.1
. . . .
. . . .
Total 10.000 1000 9.000
Credit multiplier coefficient = 1/r, where r = cash reserve requirement or cash reserve
ratio (CRR).Liquidity ratio = 1/ 0.1 = 10
Total credit created = 1000 x 10 =
10.000
9000 + 1000 = 10 000
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It is apparent that the lower the liquidity ratio, the greater the ability of banks to lend,
and to increase the supply of money. This liquidity ratio enables banks to be profitable
because it enables them to lend money to borrowers at interest.
Example 2: The financial intermediary can create money through the process of
making loans. The bank B has received an amount of £10 million as a deposit. It is
required by the central bank to keep £1 million on reserve (10% of total deposits). It
will lend out the remaining £9 million. By loaning out £9 million and charging interest
rate, it will be able to make interest payments to depositors and earn interest income
for itself (bank B). Bank B becomes a financial intermediary between savers and
borrowers; it now has £1 million in reserves and a loan to a borrower H of £9 million.
The T- account (balance sheet) for bank B is shown as follows.
Assets Liabilities
Reserves 1m Deposits 10
m Loan to H 9 m
The borrower H will not be let to walk out of the bank B with £9 m in cash. The bank
issues for borrower H a check for £9 m. Borrower H deposits the loan in his regular
checking account within its bank. This bank must hold 10% of additional deposits as
required reserves. Notice that the money supply is now £19 m: £10 m in deposits in
bank B and £9 m in deposits at H’s bank.
The borrower’ bank must hold 10% as required reserves £900.000 but can lend out
the other 90% (£8.1 m) in a loan to borrower F as it is illustrated in its balance sheet.
Assets Liabilities
Reserves 900,000 Deposits 9
m Loans 8.1 m
If borrower F deposits the loan in its checking account at another bank, the money
supply increased by an additional £8.1 m.
In a system with many banks when all banks loan out their excess reserves (remaining
amount) the money supply will expand. In a multi-system, the amount of money that
the system can create is found by using the money multiplier.
The money multiplier formula is: 1/ reserve requirement
According to the previous example the money multiplier is: 1/10% = 10
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Total change in the M1 money supply is: 1/ 0.1 x 9 m = 10 x 9 = £90 m
We can say that, in this example, the total quantity of money generated in this
economy after all round of lending will be £90 million. The credit creation will depend
on the proportion of reserves that banks are required to hold by the central bank.
The credit creation depends on people depositing the money that they receive in the
financial intermediary. If people instead store their cash in safe-deposit boxes hidden
in their closets (store room), then banks cannot recirculate the money in the form of
loans. Indeed, central banks have an incentive to assure that bank deposits are safe
because if people worry that they may lose their bank deposits, they may start holding
more money in cash, instead of depositing in banks, and the quantity of loans in an
economy will decline.
Commercial banks work with short-term funds. Their working capital consists mainly of
money deposited by customers. If a bank lends such money for long periods or keeps
them blocked in other way, it will be unable to meet the demand of its depositors for
withdrawals of cash, and will be forced to go into liquidation.
If the depositor will withdraw more than the average, there is said to be a run on the
bank. In such cases the bank must secure money by converting the assets held by it
into cash immediately. Assets which can be quickly converted into cash are called
liquid assets. A commercial bank must keep in hand sufficient liquid assets. This is
known as the liquid principle.
2-6: Accounts
A bank account is a financial account maintained by a bank for a customer. Bank
accounts may have a positive (credit balance), when the financial institution owes
money to the customer, or negative (debit balance), when the customer owes the
financial institution money. A robber was asked why he robbed banks. “That’s where
the money is”. From the perspective of modern economies, he is wrong because the
majority of money in the economy is not in the form of currency sitting in vaults /drawers
at banks, waiting for a robber to appear [Fisher, R. 2013]. Most money is in the form of
bank accounts, which exist only as electronic records on computers. Banks allow
people and businesses to store this money in either a checking accounts or savings
accounts, and then withdraw this money as needed through the use of a direct
withdrawal, writing a check, or using a debit card. The household can use many
accounts to put its money in banks as deposits:
✓ Current account: It is a deposit account held at a bank or other financial
institutions, for the purpose of security and quickly providing frequent access to
funds on demand. A customer can deposit or withdraw any amount of money any
number of times, subject to availability of funds. Current account is a type of
deposit account maintain by individuals who carry out significantly higher number
of transactions with banks. The current account comes with a check-book; it does
not provide interests and requires a higher minimum balance. Current account
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works best for traders and entrepreneurs who need to access their accounts
frequently.
✓ Time deposit (Term deposit): A time deposit held at a financial institution that
cannot be withdrawn for a present period of time and will induce (cause) penalties
for withdrawals before a certain date. When the term is over it can be withdrawn.
It is an account that the depositor has committed to leaving in the bank for a
certain period of time, in exchange for a higher interest rate; also called certificate
of deposit. Generally, the longer the term the higher the interest rate offered by
the bank.
✓ Call deposit: This account allows the holder an access to his account and the
ability to withdraw his money at any time without having to pay a penalty or inform
the bank in advance of his attention to withdraw his funds. It requires a higher
minimum balance to earn a favorable interest rate.
✓ Savings account: It gets interest but cannot be used directly as money (by
writing a check). That account let customers set aside a portion of their liquid
assets while earning a monetary return. For the bank, money in saving account
may not be called immediately, and it can be lent out with interest.
✓ Debit card is like a check, is an instruction to the user’s bank to transfer money
directly and immediately from your bank account to the seller.
✓ Credit card is not considered money but rather a short term loan from the credit
card company to you. When you make a purchase with a credit card, the credit
card company immediately transfers money from its checking account to the
seller, and at the end of the month the credit card company sends you a bill for
what you have charged that month. Until you pay the credit card bill, you have
effectively borrowed money from the credit card company.
✓ Overdraft: An overdraft occurs when withdrawals from a bank account exceed
the available balance. This gives the account a negative balance and an effect
means the account provider is providing credit. If there is a prior agreement with
the account provider for an overdraft facility, and the amount overdrawn is within
this authorised overdraft, then interest is charged at the agreed rate. If the
balance exceeds the agreed facility then fees may be charged and a higher
interest rate might be applied.
Difference between a current account and savings account
▪ You may need to make multiple payments, receipts (daily transactions) with a
current account, whereas a savings account is a deposit account which allows
limited transactions. It is most suitable for people who are salaried employees or
have a monthly income.
▪ It also earns interest rate, while there is no such earning from a current account.
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▪ When you withdraw more money from the account, than it is there, your account
is said to be overdrawn. In the case of savings account, banks neither offer nor
allow overdraft facilities, whereas this facility is provided with a current account.
▪ The minimum balance required to maintain a savings account is usually low, but
for a current account is much higher in comparison.
2-7: Desirable way of household saving
In Algeria, much real wealth is held by individuals, under their own direct control, in the
form of physical assets like housing, land, and precious metal. We should also include
here net private holdings of foreign currencies. It is quite likely that the full potential
saving of the household sector is not mobilised due to the inadequate development of
financial institutions and instruments consistent with saver’s preferences.
In Algeria, potential saving, in one part is not easily transferred to deficit units. For this
reason, this potential saving may be used for consumption or financed the unorganised
sector. The financial institutions finance a small part of private sector investment. A
major part of investment is financed by own saving (self-finance) and borrowing from
the surplus units where Interest rates are very high. These rates have two
consequences; first, worthwhile productive projects cannot be implemented. Second,
these high rates induce speculative investment (physical assets).
With this general picture in mind, banks do not accept to be established into the rural
areas. However, the absence of banks retards the economic growth in these areas. It
may therefore be desirable, in the interest of financial development to apply some
pressure on the banks to extend their services into such areas. For this reason, several
important changes will be called for in government policies:
➢ The priority should be the widening and deepening of the geographical and
functional scope of the commercial banking system. This system is largely
restricted to urban areas and to the financing of public sector.
➢ Savers are likely to prefer a financial instrument that is simple, does not involve
transaction costs.
➢ The interest rate structure should induce savers to keep their saving in the form
of bank deposits rather than in the form physical assets.
It seems likely that the development of financial institutions and stock markets will play
an important role in facilitating economic growth. It is believed that an extension of the
banking system reduces the cost of intermediation as credit is moved from the
economy’s savers to investors. The establishment of more bank offices in the
countryside is important not only in order to reduce rates of interest but also to spread
banking facilities more widely inside these areas [Goldberg D.2005]. If the
development of the economy is to be accelerated, it is essential that the resources
saved by surplus sector be put to the most productive use. If money is staying idle
(under our bed) then it is not good for the economy.
