Explain the Main Reasons Why Financial Markets and Financial Intermediaries Exist.

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A financial intermediary, by definition, is responsible for the process of transferring money from economic agents with a surplus of funds to economic agents with a deficit of funds, and is known as financial intermediation. This is achieved by means of a financial security, such as stocks and bonds. The mechanism that allows the trade of such financial securities is known as a financial market. Financial markets aim to facilitate the raising of capital, as well as the transfer of risk between economic agents and also international trade. Typically, the borrower will issue a receipt, or financial security, to the lender that promises to pay back the capital gained. Securities such as these can be freely bought or sold within financial markets. The lender should expect some sort of capital gains from these securities in the form of dividends or interest on the amount invested initially.

As previously mentioned, financial intermediaries exist primarily to transfer funds from economic agents with a surplus of funds, i.e. those with incomes greater than expenditure, to those agents that have a deficit of funds, or those with incomes less than their expenditure. Banks, insurance companies and pension funds are examples of financial intermediaries. An example of an economic agent could be an individual willing to invest, or a company, institution or even the government. The transfer of funds between these economic agents occurs in one of two ways. The first process is known as direct finance. This means that the transfer of funds from economic agents with surplus funds, such as savers and lenders, to those with a deficit, or borrowers, occurs via financial markets such as the stock exchange. The second process is known as indirect finance, which means that the transfer of funds between economic agents does not occur directly from lenders to borrows, but via a financial intermediary or “middle-man”. Borrowers and lenders tend not to engage in financial transactions by themselves typically, however. This is because financial markets are able to provide economic agents with a fair price mechanism and evaluation of the asset to be traded. This characteristic of financial markets is referred to as the pricing function. Also, financial markets are thoroughly regulated. Economic agents with a surplus of funds, or issuers of financial securities, are therefore able to assess whether or not engaging in particular activities within the marketplace is putting the value of their assets at risk. This is known as the discipline function.

Financial intermediaries exist because financial markets alone cannot ensure the transfer of funds between economic agents easily. There are two main barriers that can be identified with the direct finance process. The first is that it is difficult, time-consuming (and therefore expensive) to match the complex needs of both the economic agents with surplus funds and those with a deficit of funds. The other barrier is dissimilar financial intentions of the borrowers and lenders. In order to be willing to trade, lenders insist on the minimisation of risk and overall costs incurred, as well as requiring the maximum returns on investment possible and to be able to convert a financial security into cash easily, which is known as liquidity. Minimisation of risk is achieved via what is known as asset securitisation. Similarly the borrower has a typical set of requirements when trading on the financial market. The borrower will want the funds at a specified date, for an agreed period of time, which is usually long term. Also, the borrower requires the investment lowest possible cost, such as having the lowest interest rate, or giving away the least amount of equity possible. Financial intermediaries have advantages over direct finance, but inevitably there are additional costs to the borrowers and lenders that are not associated with direct finance as previously mentioned. These costs...
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