Financial intermediaries play a vital role in building economies. World over, in different economies it is typical to find that the sources of funds and the uses of funds are not one and the same. This process is also so complexly structured that while individual contributions comprise the major source of funds to the market, the utilization of funds is done by different sectors in the economy. Capital formation comprising of Savings and Investment holds the key to this process.
In this causal sequence, Savings play the role of the initiator. The ability of an economy to generate savings depends on the combined abilities of the general public and the government. It is here that the financial system comes into play by converting the savings into productive results.
Significance of Financial Intermediation
The savings process is facilitated by the financial Intermediaries. In simple terms, financial intermediaries perform the function of facilitating supply of funds to the user of funds, by obtaining the same from the depositors or savers of funds. The term ‘financial intermediaries’ includes different institutions like Banks, Insurance companies, Investment companies, Developmental Financial Institutions, Non-banking Finance Companies, Mutual funds, Pension funds etc.
While the role of above institutions is singular with respect to financial intermediation, the functions that are performed by each one of them are different. In a nutshell, these types of intermediation revolve around liquidity position of funds, risks in loans, and pooling of risks to take advantage of economies of scale. To sum up, the function of financial intermediation has arisen out of the need on the part of savers to reach the investors and the inability of investors to find savers.
Developed economic systems may not require the need of full-fledged financial intermediaries, unlike the developing systems. This is due to the fact that the gap between the saver and the investor is absolutely minimal. This is referred to as “financial disintermediation”.
The process of financial disintermediation is best achieved by reducing the cost of funds thereby facilitating direct capital formation, which spurs economic growth. The greatest advantage in this process is the fact that it reduces the time gap between saving of money and utilization.
The process of financial intermediation is always fraught with risks. Risks both for the givers of funds and the takers of funds, besides the risks for financial intermediaries themselves. The risk factor arises in the first place out of the need for the availability of information and in the second place the need for players to be aware of the available information. Consequently, the need for regulations and the role for a regulator are felt.
Financial Intermediation in Indian context
In India, without exception, a single type of intermediary does not perform the task of financial intermediation. Different types of financial intermediaries exist and their functions are discussed below.
Banks: Banks comprise the oldest form of financial intermediaries in India. The Indian financial scene is dotted with a number of banking institutions. All these banks are...