Description
Financial intermediation consists of “channeling funds between surplus and deficit agents”.
Financial Intermediaries
An economic community can prosper only when it is able to employ its resources optimally. However, this does not happen on its own, as all people are not endowed with resources that could be deployed productively. Therefore, the resources are required to be moved from those who have it and made available to those who can make use of it. If this function is not achieved, the economy may stagnate. This aspect brings out the need for financial intermediaries. Need for Financial Intermediation Financial intermediaries play an important economic function by facilitating the productive use of the communities’ surplus money. The continuous use of such resources by an economy will foster greater demand for goods and services and in generation of incomes and employment in an economy. The combined wealth created gets channelized in the form of assistance to entrepreneurial activities, which are undertaken by another set of people who have the necessary inclinations. However the following questions arise: • • • • How does it happen? Will the savers voluntarily pass on their savings to entrepreneurs? If not, what kind of risks do they face? How do they want to protect themselves from such risks?
These questions will get answered only when the process of transfer takes place and the roles played by a third agency, which is known as a financial intermediary, facilitates such transfers. Intermediation and management of risks The need for a financial intermediary arises because the savers would not voluntarily come forward to lend directly fearing certain risks. In the process, intermediaries manage the risks in an effective manner to minimize the chances of loss. The process of transferring the funds from the savers to the entrepreneurs is call intermediation. In essence, intermediation is the management of risks. Such risks are as follows: • Credit Risks: It is the risk of default by the borrower for any reason. It is possible that the business does not generate sufficient income to repay the loan and the borrower is not honest enough to keep his commitment. Credit risk is the most serious risk that any lender faces and individual lenders cannot afford to take such risks. Liquidity Risk: The borrower may have every intention to repay the loan and the business may be doing well too. But there could be occasions where the borrower is not able to withdraw funds from the business when the lender demands repayment or when the repayment is due. There could be many types of temporary problems, that may or may not be in the control of the borrower and which stand in the way of timely repayment of the loan.
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•
Interest Rate Risk: Another risk in lending money is the possibility of loss due to change in the rate of interest in the market. At the time of transaction, the borrower may have agreed to give interest at the prevailing rate of interest, say, 10%. Subsequently, the borrower may ask for a reduction in the rate of interest, since money is available at a cheaper rate from other sources. Conversely, while the interest rate may have gone up in the market, the borrower may refuse to pay a higher rate or repay the loan before the due date, quoting the terms of the original contract. Both these situations are detrimental to the lender and individuals prefer to insulate themselves from such chances or risks of loss due to the change in interest rates.
The risk-averse nature of normal savers and the risks inherent in any entrepreneurial activity necessitates intermediaries who have the ability to insulate the savers from the risks inherent to business. Intermediaries not only manage such risks associated with business, but also generate employment and promote economic welfare by enabling production of goods and services required by the community. Hence, intermediation by the financial intermediaries is also an important economic function. •
Types of Financial Intermediaries
Money needs to be circulated for an economy to be productive. If all savings are hoarded, the surpluses of the community will not be available for investments and this in turn would lead to economic stagnation. Financial intermediaries play an important economic function by facilitating a productive use of the community's surplus money. There are various types of financial intermediaries and their structure comprises of both organized and unorganized sectors. The dominance in terms of financial flows handled by these sectors differs from country to country. In India, the players in the unorganized sector are: • • • • • Money lenders Indigenous bankers Chit funds Nidhis or mutual benefit funds Self Help Groups
In the current scenario, there is no estimate of the volume of business handled by the unorganized sector. While the volume of business handled in the urban sector may be small, their role in rural India is very significant. One of the negative effects of the sway of the unorganized sector is that it reduces the efficacy of a country's monetary policy. A lot of initiatives have been undertaken over the years both by central and state governments to reduce the adverse impact. Some of these initiatives are: • All India Development Financial Institutions [DFIs]
• • • •
State level Financial Corporations [SFCs] Insurance Companies Mutual Funds [MFs] Non Banking Finance Corporations [NBFCs]
All India Development Financial Institutions The following are the various institutions covered under all India DFIs: • • • • Industrial Finance Corporation of India [IFCI] Industrial Development Bank of India [IDBI], which merged with IDBI Bank in 2004 Industrial Credit and Investment Corporation of India [ICICI], which merged with ICICI Bank in 2002 Industrial Investment Bank of India [IIBI]. The former Industrial Reconstruction Corporation of India was converted into Industrial Reconstruction Corp of India [IRCI] and was later converted into IIBI in 1995 Small Industries Development Bank of India [SIDBI], which is a wholly owned subsidiary of IDBI curved out through an act of parliament in 1990.
•
State Level Financial Corporations These are state level bodies that mainly concentrate on industrial development in a state. They are legal bodies created under the State Finance Corporations Act, 1951 and are funded through an issue of shares in which the state governments, banks, financial institutions, and private investors participate. SFCs are also permitted to raise funds through the issue of bonds and debentures. The main focus of SFCs is financing the local industrial units, which are usually small and medium units, situated in backward regions of the state. Insurance Companies Insurance companies concentrate on fulfilling the insurance needs of the community, both for life and non life insurance. With the globalization of the Indian economy, a large number of private players have entered into this field, offering products that allow investors to select the kind of policies to suit their financial planning needs. Many of these organizations are formed as subsidiaries of banks that enable the banks to cross sell insurance products to their existing customers. Banks benefit by way of fee income through referrals and enhanced relationships with insurance companies for their banking needs. Mutual Funds
These organizations satisfy the needs of individual investors through pooling resources from a large number with similar investment goals and risk appetite. The resources collected are invested in the capital market and money market securities and the returns generated are distributed to investors. The fund managers of MFs are specialists in the fields of investment analysis and are able to diversify and even out risks through portfolio mix. MFs offer a wide variety of schemes, such as, growth funds, income funds, balanced funds, money market funds and equity related funds designed to cater to the different needs of investors.
Non Banking Finance Corporations NBFCs are commonly known as finance companies and are corporate bodies, which concentrate mainly on lending activities in a well defined area. The Reserve bank of India [RBI] Amendment Act, 1997 defines an NBFC as a financial institution or non banking institution, which has its principal business of receiving deposits under any scheme or arranging and lending in any manner. There are 4 broad categories of NBFCs: • • • • Finance Companies Leasing Companies Loan finance companies Investment finance companies
doc_431441948.doc
Financial intermediation consists of “channeling funds between surplus and deficit agents”.
Financial Intermediaries
An economic community can prosper only when it is able to employ its resources optimally. However, this does not happen on its own, as all people are not endowed with resources that could be deployed productively. Therefore, the resources are required to be moved from those who have it and made available to those who can make use of it. If this function is not achieved, the economy may stagnate. This aspect brings out the need for financial intermediaries. Need for Financial Intermediation Financial intermediaries play an important economic function by facilitating the productive use of the communities’ surplus money. The continuous use of such resources by an economy will foster greater demand for goods and services and in generation of incomes and employment in an economy. The combined wealth created gets channelized in the form of assistance to entrepreneurial activities, which are undertaken by another set of people who have the necessary inclinations. However the following questions arise: • • • • How does it happen? Will the savers voluntarily pass on their savings to entrepreneurs? If not, what kind of risks do they face? How do they want to protect themselves from such risks?
These questions will get answered only when the process of transfer takes place and the roles played by a third agency, which is known as a financial intermediary, facilitates such transfers. Intermediation and management of risks The need for a financial intermediary arises because the savers would not voluntarily come forward to lend directly fearing certain risks. In the process, intermediaries manage the risks in an effective manner to minimize the chances of loss. The process of transferring the funds from the savers to the entrepreneurs is call intermediation. In essence, intermediation is the management of risks. Such risks are as follows: • Credit Risks: It is the risk of default by the borrower for any reason. It is possible that the business does not generate sufficient income to repay the loan and the borrower is not honest enough to keep his commitment. Credit risk is the most serious risk that any lender faces and individual lenders cannot afford to take such risks. Liquidity Risk: The borrower may have every intention to repay the loan and the business may be doing well too. But there could be occasions where the borrower is not able to withdraw funds from the business when the lender demands repayment or when the repayment is due. There could be many types of temporary problems, that may or may not be in the control of the borrower and which stand in the way of timely repayment of the loan.
•
•
Interest Rate Risk: Another risk in lending money is the possibility of loss due to change in the rate of interest in the market. At the time of transaction, the borrower may have agreed to give interest at the prevailing rate of interest, say, 10%. Subsequently, the borrower may ask for a reduction in the rate of interest, since money is available at a cheaper rate from other sources. Conversely, while the interest rate may have gone up in the market, the borrower may refuse to pay a higher rate or repay the loan before the due date, quoting the terms of the original contract. Both these situations are detrimental to the lender and individuals prefer to insulate themselves from such chances or risks of loss due to the change in interest rates.
The risk-averse nature of normal savers and the risks inherent in any entrepreneurial activity necessitates intermediaries who have the ability to insulate the savers from the risks inherent to business. Intermediaries not only manage such risks associated with business, but also generate employment and promote economic welfare by enabling production of goods and services required by the community. Hence, intermediation by the financial intermediaries is also an important economic function. •
Types of Financial Intermediaries
Money needs to be circulated for an economy to be productive. If all savings are hoarded, the surpluses of the community will not be available for investments and this in turn would lead to economic stagnation. Financial intermediaries play an important economic function by facilitating a productive use of the community's surplus money. There are various types of financial intermediaries and their structure comprises of both organized and unorganized sectors. The dominance in terms of financial flows handled by these sectors differs from country to country. In India, the players in the unorganized sector are: • • • • • Money lenders Indigenous bankers Chit funds Nidhis or mutual benefit funds Self Help Groups
In the current scenario, there is no estimate of the volume of business handled by the unorganized sector. While the volume of business handled in the urban sector may be small, their role in rural India is very significant. One of the negative effects of the sway of the unorganized sector is that it reduces the efficacy of a country's monetary policy. A lot of initiatives have been undertaken over the years both by central and state governments to reduce the adverse impact. Some of these initiatives are: • All India Development Financial Institutions [DFIs]
• • • •
State level Financial Corporations [SFCs] Insurance Companies Mutual Funds [MFs] Non Banking Finance Corporations [NBFCs]
All India Development Financial Institutions The following are the various institutions covered under all India DFIs: • • • • Industrial Finance Corporation of India [IFCI] Industrial Development Bank of India [IDBI], which merged with IDBI Bank in 2004 Industrial Credit and Investment Corporation of India [ICICI], which merged with ICICI Bank in 2002 Industrial Investment Bank of India [IIBI]. The former Industrial Reconstruction Corporation of India was converted into Industrial Reconstruction Corp of India [IRCI] and was later converted into IIBI in 1995 Small Industries Development Bank of India [SIDBI], which is a wholly owned subsidiary of IDBI curved out through an act of parliament in 1990.
•
State Level Financial Corporations These are state level bodies that mainly concentrate on industrial development in a state. They are legal bodies created under the State Finance Corporations Act, 1951 and are funded through an issue of shares in which the state governments, banks, financial institutions, and private investors participate. SFCs are also permitted to raise funds through the issue of bonds and debentures. The main focus of SFCs is financing the local industrial units, which are usually small and medium units, situated in backward regions of the state. Insurance Companies Insurance companies concentrate on fulfilling the insurance needs of the community, both for life and non life insurance. With the globalization of the Indian economy, a large number of private players have entered into this field, offering products that allow investors to select the kind of policies to suit their financial planning needs. Many of these organizations are formed as subsidiaries of banks that enable the banks to cross sell insurance products to their existing customers. Banks benefit by way of fee income through referrals and enhanced relationships with insurance companies for their banking needs. Mutual Funds
These organizations satisfy the needs of individual investors through pooling resources from a large number with similar investment goals and risk appetite. The resources collected are invested in the capital market and money market securities and the returns generated are distributed to investors. The fund managers of MFs are specialists in the fields of investment analysis and are able to diversify and even out risks through portfolio mix. MFs offer a wide variety of schemes, such as, growth funds, income funds, balanced funds, money market funds and equity related funds designed to cater to the different needs of investors.
Non Banking Finance Corporations NBFCs are commonly known as finance companies and are corporate bodies, which concentrate mainly on lending activities in a well defined area. The Reserve bank of India [RBI] Amendment Act, 1997 defines an NBFC as a financial institution or non banking institution, which has its principal business of receiving deposits under any scheme or arranging and lending in any manner. There are 4 broad categories of NBFCs: • • • • Finance Companies Leasing Companies Loan finance companies Investment finance companies
doc_431441948.doc