The limitations of direct and semidirect finance under certain conditions stimulated the development of indirect finance carried out with the help of financial intermediaries. Financial intermediaries include commercial banks, insurance companies, credit unions, finance companies, savings and loan associations, savings banks, pension funds, mutual funds, and similar organizations. (See Exhibit 2.7. ) Their fundamental role in the financial system is to serve both ultimate lenders and borrowers but in a different way than brokers and dealers do. Financial intermediaries issue securities of their own—often called secondary securities —to ultimate lenders and at the same time accept IOUs from ultimate borrowers— primary securities (see Exhibit 2.8 ).
The secondary securities issued by financial intermediaries include such familiar instruments as checking and savings accounts, life insurance policies, annuities, and shares in a mutual fund. For the most part, these securities share several common characteristics. They generally carry low risk of default. For example, most deposits held in banks and credit unions are insured by an agency of government (in the United States, for amounts up to $100,000). Moreover, the majority of secondary securities can be acquired in small denominations, affordable by savers of limited means. For the most part, secondary securities are liquid and, therefore, can be converted quickly into cash with little risk of significant loss. Financial intermediaries in recent years have tried to make savings as convenient as possible through the mail and by plastic card, computer terminal, and telephone in order to reduce transactions costs to the saver.
Financial intermediaries accept primary securities from those who need credit and, in doing so, take on financial assets that many savers, especially those with limited funds and limited knowledge of the market, would find unacceptable. For example, many large corporations require billions of dollars in credit financing each year—sums that would make it impractical to deal directly with thousands of small savers. By pooling the resources of scores of small savings accounts, however, a large financial intermediary frequently can service the credit needs of several large firms simultaneously. In addition, many primary securities are not readily marketable and carry sizable risk of borrower default—a situation usually not acceptable to the small saver. By issuing its own securities attractive to ultimate lenders (SBUs), and accepting primary securities from ultimate borrowers (DBUs), the financial intermediary acts to satisfy the financial needs of both surplus-and deficit-budget units in the economy.
One of the benefits of the development of efficient financial intermediation (indirect finance) has been to smooth out consumption spending by households and investment spending by businesses over time, despite variations in income, because intermediation makes saving and borrowing easier and safer. Financial intermediation permits a given amount of saving in the global economy to finance a greater amount of investment than probably would have occurred without intermediation.
Interestingly enough, finance theory suggests that in a perfect world with perfect competition and where the public has access to information at little or no cost, financial intermediaries probably would not exist. Rather, it is imperfections in the financial system (where, for example, some groups do not have access to relevant financial information or face prohibitive information costs) that help explain why there are financial intermediaries and why they have grown to be such huge and important institutions within the financial system. Financial intermediaries overcome inefficiencies in the financial marketplace and reduce the cost to society of moving information and wealth among households, businesses, and governments, thereby providing access to economies of scale (information cost savings) that would otherwise not be available to smaller units in the economy. Financial intermediaries improve the real world efficiency of the money and capital markets in allocating the daily flow of capital toward its best possible uses. How well financial intermediaries work is a key determinant of which countries have the largest and strongest economies.