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2.5. Financial intermediaries: classification and relationship

2.5.1. Introduction

As expressed earlier, financial institutions exist primarily because of the conflict between lenders' and borrowers' requirements in terms of deal size, term to maturity, quality, price and liquidity. They issue financial liabilities (indirect securities or claims on themselves, such as deposits) that are acceptable as financial assets to the ultimate lenders, and use the funds so obtained to acquire claims that reflect the requirements of the borrowers (primary securities = debt and shares).

In so doing they facilitate the flow of funds from surplus to deficit economic units. As noted, the banks also have the unique ability to acquire financial claims first and thereby increase the financial liabilities in the system, i.e. to create money.

Many different types of institutions perform the intermediation function. In terms of the fundamental function of intermediation, there is little distinction between banks, finance houses, insurance companies, unit trusts or any other type of intermediary. The distinguishing characteristics lie in the nature of the claims (indirect securities) and services offered to lenders and in the nature of the claims on (primary securities) and services offered to the borrowers. In these respects there are wide differences between intermediaries.

a classification of financial intermediaries

Figure 4: a classification of financial intermediaries

Generally, financial institutions tend to be more specialized on the liability side of their balance sheets. Given this, it would be fitting to classify them according to the nature of the indirect securities they issue.

In addition, in most financial systems there are entities that are closely related to financial intermediaries. They are generally small players in the financial system, but in some systems they can be large (such as vehicle finance companies). These intermediaries we call quasi-financial intermediaries (QFIs).

2.5.2. Classification of financial intermediaries

Classification of financial intermediaries

Given the existence of QFIs, it is logical to divide financial intermediaries into two broad categories: mainstream financial intermediaries (MFIs) and QFIs. It is then reasonable to classify the MFIs into deposit and non-deposit intermediaries. While the former category is straightforward, the second category may be split up in various ways. A sensible split is into three categories: contractual intermediaries (CIs), collective investment schemes (also known as "portfolio intermediaries") (CISs) and alternative investments (AIs). This classification is presented in Figure 4.

Under the category deposit intermediaries a central bank and the private sector banks are always present. In many countries other deposit-taking intermediaries are established for various reasons, such as mutual banks, rural banks, savings and loan intermediaries, a Post Office Bank and so on.

The category contractual intermediaries (CIs) is reserved for those intermediaries that offer contractual savings (and other like) facilities: the insurers and the retirement funds.

The category collective investment schemes (CISs) applies to securities unit trusts, property unit trusts, and exchange traded funds (ETFs). The latter have become popular indeed over the past decade. Some countries also have other CISs such as participation bond schemes (PBSs).

In many countries another category of financial intermediary has emerged over the past number of years: alternative investments comprised of private equity funds and hedge funds.

No two countries have the same quasi-financial intermediaries. Some have finance companies, investment trusts, SPVs, credit unions, DFIs, micro-lenders, credit unions, and so on, while others have just one or two of them.

Box 1 presents a summary the categories and the intermediaries that are common to most countries. 2.5.3 Relationships of financial intermediaries

It is appropriate at this stage to show the relationship of the financial intermediaries to one another. This is portrayed in Figure 58.

It will be seen that the private sector banks intermediate between all the ultimate lenders and borrowers and take deposits from all the other intermediaries9. The lines between the banks and the central bank represent the reserve requirement and the borrowed reserves of the banks from the central bank (which is provided at the KIR). The lines between the banks represent the bank-to-bank interbank market.

The CIs and the CISs take funds mainly from the household sector and invest these in the primary securities of the ultimate borrowers and the indirect securities of the banks and the QFIs (the latter is small, however). The QFIs are also funded from the banks through the purchase of their securities and lend to certain of the ultimate borrowers (mainly the household and corporate sectors).

relationship of financial intermediaries

Figure 5: relationship of financial intermediaries

We have portrayed the AIs as issuing liabilities (= participation interests) to all the ultimate lenders. This is only partly correct; they also take in funds from the retirement funds.

The central bank is funded by its issue of bank notes and coins, by the deposits of government and the banks, and by the issue of its own securities (the latter mainly for monetary policy reasons), and its assets are made up of various domestic securities (through the accommodation system) and foreign securities (i.e. foreign exchange reserves).

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