Overview
Finance is the process by which agents in the economy that have a surplus of funds lend those funds to agents who have a shortage. The agents who have a surplus of funds could just save that money by saving it in a safe or proverbially stashing it underneath the mattress. However, this method of saving does not generate any return, and in fact, in the presence of inflation, will lose value over time. Hence, savers are motivated to find other agents in the economy who can find productive uses for the funds for which the saver can pocket a portion of the return.
Financial intermediaries are parties that can bring together the savers and the consumers. That is, the savers give their excess funds to the intermediary, who then finds a consumer or some other agent that can use the money and lends it out to them. The typical example of a financial intermediary is a bank.
Factors the Incentivize Intermediation
As noted above, savers in the economy have a reason to look for ways to invest their money.
- Transaction Costs - some investments have a transaction cost, and in particular, may have large fixed costs. When the assets of several savers is pooled and invested together, this can defray large fixed costs.
- Risk - Many investments have minimum investment amounts that are required in order to make the investment viable. These amounts tend to be high, and would create undiversified risks in an investors portfolio. A financial intermediary is able to pool the resources of several clients, and to spread the risk around, giving savers an easy way to diversify risk.
- Asymmetric Information - banks and other intermediaries, typically have more information about the economy, and the markets in which they invest (home lending for instance) than the average saver. This information helps them make intelligent investment decisions, especially in terms of mitigating risk. (see above) This makes them well suited to invest the savings of savers in the community as an intermediary. (see economics of information for more information)