Financial Intermediaries

The financial intermediaries do more than simply transfer money and securities between firms and savers - they literally create new financial products.

The financial intermediaries do more than simply transfer money and securities between firms and savers - they literally create new financial products. Since the intermediaries are generally large, they gain economies of scale in analyzing the creditworthiness of potential borrowers, in processing and collecting loans, and in pooling risks and thus helping individual savers diversify. Further, a system of specialized intermediaries can enable savings to do more than just draw interest. For example, individuals can put money into banks and get both interest income and a convenient way of making payments (checking), or put money into life insurance companies and get both interest income and protection for their beneficiaries.

Here are the major classes of intermediaries:

1. Commercial banks, which are the traditional financial "department store", serve a wide variety of savers and those with needs for funds. Historically, the commercial banks were the major institutions which handled checking accounts and through which the Federal Reserve System expanded or contracted the money supply. Today, however, several other institutions also provide checking services and significantly influence the effective money supply. Conversely, commercial banks are providing an ever-widening range of services, including stock brokerage services and insurance. Note that commercial banks are quite different from investment banks. Commercial banks lend money, whereas investment banks help companies raise capital from other parties.

2. Savings and loan associations (S&Ls), which have traditionally served individual savers and residential and commercial mortgage borrowers, take the funds of many small savers and then lend this money to home buyers and other types of borrowers.

3. Mutual savings banks, which are similar to S&Ls, operate primarily in the northeastern states, accept savings primarily from individuals, and lend mainly on a long-term basis to home buyers and consumers.

4. Credit unions are cooperative associations whose members have a common bond, such as being employees of the same firm. Members' savings are loaned only to other members, generally for auto purchases, home improvements, and the like. Credit unions often are the cheapest source of funds available to individual borrowers.

5. Pension funds are retirement plans funded by corporations or government agencies for their workers and administered primarily by the trust departments of commercial banks or by life insurance companies. Pension funds invest primarily in bonds, stocks, mortgages, and real estate.

6. Life insurance companies take savings in the form of annual premiums, then invest these funds in stocks, bonds, real estate, and mortgages, and finally make payments to the beneficiaries of the insured parties.

7. Mutual funds are corporations which accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units. These organizations pool funds and thus reduce risks by diversification. They also achieve economies of scale, which lower the costs of analyzing securities, managing portfolios, and buying and selling securities.