Question

Why do we call a bank a financial intermediary?

Short answer

We call a bank a financial intermediary because it connects borrowers and savers in an economy, channeling funds between them and efficiently allocating resources. Banks perform this role by accepting deposits, providing loans, facilitating payments, pooling resources, conducting maturity transformation, and managing risk. By linking savers and borrowers, banks play a fundamental role in the efficient functioning of the financial system.

Step-by-step solution

Definition of a Financial Intermediary

A financial intermediary is an institution that connects borrowers and savers within an economy by channeling funds between them. These institutions facilitate the flow of money and the efficient allocation of resources, enabling both parties to achieve their financial goals.

Functions of a Bank

In order to understand why a bank is called a financial intermediary, let's discuss the main functions of a bank: 1. Accept deposits: Banks accept deposits from individuals and businesses who want to save their money and earn interest on it. This makes banks a primary source of funds. 2. Provide loans: With the money deposited by savers, banks provide loans to individuals and businesses who need to borrow funds for various purposes, such as buying a house, starting a business, or paying for education. 3. Facilitate payments: Banks provide a means for transferring money between individuals and businesses, such as through checks, wire transfers, or electronic payment systems.

Connecting Savers and Borrowers

As a financial intermediary, a bank connects savers and borrowers in the following ways: 1. Pooling resources: By gathering deposits from many savers, banks aggregate a large pool of funds that can be lent to borrowers. This process transforms fragmented, small deposits into substantial loans. 2. Maturity transformation: Banks take short-term deposits that savers can access anytime and use those funds to provide longer-term loans to borrowers. This process is called maturity transformation, as banks match the different needs of savers and borrowers in terms of the time horizon of their financial goals. 3. Risk management: Banks carefully assess the credit risk of borrowers and manage their loan portfolio to minimize potential losses. They also diversify their investments to reduce the impact of any single borrower's default on the overall portfolio. In conclusion, we call a bank a financial intermediary because it fulfills the crucial role of connecting borrowers and savers in an economy. Through accepting deposits, providing loans, and facilitating payments, banks channel funds between these two groups and help to allocate resources efficiently.