Article for ACCA Paper F9 by ACCA F9 Tutor, Sandy Hood
Syllabus Section B Financial Management Environment
2. The nature and role of financial markets and institutions
b. “explain the role of financial intermediaries” (knowledge and comprehension)
In this world of exchange websites and crowd funding it might be tempting to think that banks and other “middlemen” between investors and lenders won’t be needed in the future. Perhaps, but perhaps not. The F9 syllabus expects a comprehension of the role of intermediaries. This is likely to be a ready source of exam questions on this topic.
There are many intermediaries, but as such they tend to perform a similar role. To make this easier to visualise, this article refers to high street banks. High street banks are one type, and fulfil the roles.
We deal with intermediaries in most of our transactions. We want a bag of sugar, we don’t want a crop of sugar. We buy our sugar from the shop rather than from the sugar producer. Along the way there are a series of intermediaries (middle men) between the sugar producer and us. We’re happy to pay our price for a single bag, and we know that the intermediaries have all added their profits onto the sugar between it leaving the sugar producer and when we take it away from the shop. The shop is the final intermediary for us as the end user of the sugar. The shop “breaks the bulk”. In other words it buys say a pallet of 144 bags of sugar, and sells individual bags.
Banks are intermediaries. They carry out similar activities to shops, but for them their borrowers and their savers are both customers. Rather like trying to buy a bag of sugar from a sugar producer, it is tricky finding a borrower who is looking for the money you want to save. It is also difficult trying to find a saver with the same ideas you might have if you want to borrow. Along come the banks and they act as a collector of savings and a source for borrowing.
What might your “ideas” be when you want to borrow?
1. An amount of money (sometimes called volume)
2. A period of time before the money needs repaid (the maturity)
3. How risky you are in terms of your business and what you’ll use the borrowed money for
Will the savers have the same ideas? Probably not.
In general, individuals tend to be the savers and businesses tend to be the borrowers
1. Deposit small amounts of money,
2. Favour liquidity (in other words they want to be able to withdraw the money fairly quickly),
3. Want safe investments where there is little risk
Banks tend to accept savers’ deposits on the basis that they can withdraw them with little or no notice and reward them with low rates of interest for the low level of risk these savers have taken.
Banks tend to lend larger amounts of money to businesses, for longer periods of time and recognise the risk they take making these loans by charging a higher rate of interest.
The intermediation of the bank helps savers to be able to put their money somewhere safe and borrowers to access funds needed to help their businesses grow.
The difference in the ideas of savers and borrowers allows the bank to transform savers’ money into borrowers’ money. What is being transformed?
The bank has a lot of small savings deposits from savers. These small sums added together make a substantial amount in terms of deposits. The sources might vary as one saver withdraws his savings on Wednesday morning and another makes a deposit on Wednesday afternoon, but overall there is a substantial total of funds that has been deposited.
The bank transforms the small volumes of individual savers into larger volumes suitable for borrowers.
The savers want instant or near instant access to their savings. As there are savings going on all the time. Some savers withdrawing on Wednesday and others depositing on Wednesday. There is always some money being saved, irrespective of who is saving. This allows the bank to lend for a long period of time to the borrower.
The bank transforms the maturity.
The bank is seen as a safe place for savers to leave their money. The bank will be there when the saver wants to draw the money out again. It is a low risk. The bank weighs up the requests for money made by borrowers and recognises that each has a risk of non-payment. Banks accept the higher risk when they lend money to borrowers. They can do this because invariably they lend to a lot of different borrowers, a portfolio. If one borrower becomes a bad debt, the profit made on the other borrowers is likely to compensate for any loss. Individual savers are not in a position to provide funds to a portfolio of borrowers and instead accept lower rates from the bank.
The bank transforms risk expectations.
Banks are transformers. They are the middlemen between the savers and the borrowers. Rather like the shop where we buy our sugar, they sweeten up the transaction. By transforming the volume, maturity and risk expectations of savers into those of borrowers they are able to take out a profit. It is similar to the shop buying a pallet of sugar and selling the individual bags.
In December 2009 candidates were asked to discuss the role of financial intermediaries in providing short-term finance for use by business organisations.
The examiner’s report stated that weaker answers discussed the types of short-term finance and what type of organisations provide financial intermediation.
I hope that when this appears in the F9 exam, your answer will focus on the transforming role of financial intermediaries.
Sandy Hood runs a small accountancy training business in West Sussex
Email: firstname.lastname@example.org Web: www.sandyhood.com