What is financial intermediation? It's a very important part of how financial institutions operate and perform their day to day functions. Financial organizations need to bring together individuals and organizations who have the same needs either to lend money or borrow money.
The businesses and individuals can be segmented into three categories according their financial position.
1. The surplus sector
The savers, the people with a positive cash flow - they have more money then they need and they wish lend their surplus funds to someone to make extra income.
2. The deficit sector
The exact opposite to the 'surplus sector' these people do not cover their outgoings and need to borrow to fund the deficit.
3. The balanced sector
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The people in the balanced sector meet their outgoings with an equal income - they cover their bills and do not need to borrow, however they do not have surplus income to lend.
As cash flow fluctuates most people and business are never in the 'balanced sector' - most will be in the surplus (cash rich) or deficit sector (cash poor). It is more common to move from one position to the other on a regular basis.
The difficulty for the surplus and the deficit sector is finding each other and reaching a suitable agreement on how to lend. This problem is the basis of what banks and other financial intermediaries do - they bring the cash rich lenders to the cash poor borrowers.
The banks and financial institutions link the surplus sector to the deficit sector, they can however borrow money in their own name and lend it direct to the deficit sector and make a margin on the interest rate at which it borrows.
When the bank borrows in its own name it acts as the principal. The amount it borrows is a debit and becomes part of the banks liabilities. The bank makes its margin by the spread between the rate of interest it borrowed the money and the rate of interest it lent the money.
The risk to the bank is the debtor on the surplus sector may renege on the deal and not pay the money bank.
The customers in the surplus and deficit sector can be categorised as Individuals, business, companies, government and public sector bodies and other banks.
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