What it means
Without intermediaries, a saver wanting to lend $10,000 would have to find a borrower, judge their creditworthiness, negotiate terms and chase repayment personally. An intermediary pools thousands of small deposits, spreads them across many borrowers, absorbs the credit assessment work and offers the saver instant access to money that is actually lent out for years.
Economists call these functions size transformation, risk transformation and maturity transformation. For businesses this matters because intermediaries determine both the availability and the price of funding.
The margin the intermediary needs, plus its costs and expected losses, sits on top of what savers are paid, which is why a bank paying 2% on deposits will not lend at 3%. Knowing the components of that margin makes it easier to argue about your own rate.
Intermediation also happens outside banking. An insurer collects premiums from many policyholders and pays the few who claim, a pension fund gathers contributions and invests them in companies and governments, and a fund manager pools money from small investors to buy assets none of them could afford individually.
Each is standing between a source of money and a use of it. The nuance is that intermediation can be bypassed, and increasingly is.
A large company can issue bonds directly to investors, and a small one can borrow from a peer-to-peer platform that matches lenders and borrowers without taking the credit risk itself. Cutting out the intermediary usually lowers the margin paid but moves risk and administration back onto the parties themselves.
In practice
Real-world examples.
Example
A pension fund collects $18,000,000 of contributions a year from 4,000 members and invests it across bonds, shares and property. No individual member could build that spread of holdings alone, which is the intermediation benefit in plain form.
Example
A small builder borrows $120,000 through a peer-to-peer platform at 9%, funded by several hundred individual lenders. The platform takes a 1% arrangement fee and services the loan, but the lenders, not the platform, carry the risk of default.
Example
An insurer collects $40,000,000 of motor premiums and pays $31,000,000 in claims, using the gap plus investment returns on the reserves to cover costs and profit. It is intermediating between policyholders who have money now and those who will need it after an accident.
Formula
Calculation
Gross Interest Spread = (Loans x lending rate) - (Deposits x deposit rate)
Consider a small building society with the following position:
Loan book: $70,000,000 at an average lending rate of 6.5%
Deposits: $80,000,000 at an average deposit rate of 2%
Interest earned = $70,000,000 x 6.5% = $4,550,000
Interest paid = $80,000,000 x 2% = $1,600,000
Gross spread = $4,550,000 - $1,600,000 = $2,950,000
Expressed against the loan book, that is $2,950,000 / $70,000,000, or about 4.2%. From this the society must pay staff, premises, technology and expected bad debts, so a bad debt charge of 1% on the loan book, $700,000, would take a quarter of the spread before a single overhead is covered.Case study
Seen in the real world.
Merrow Union is a fictional credit union invented to illustrate intermediation. It served a single city, took $80,000,000 of member deposits at 2% and lent $70,000,000 to members at an average 6.5%, producing a gross spread of $2,950,000.
The illustrative board reviewed where that spread went and found $1,400,000 in staff and branch costs, $700,000 in bad debts and $450,000 in technology and compliance, leaving $400,000 to build reserves. Members had assumed the margin was profit; in reality it was the cost of the service plus a thin cushion.
Merrow used the analysis to make two changes: it tightened lending criteria on its highest-loss product, cutting expected bad debts, and it moved routine transactions online to reduce branch costs. In this fictional case the deposit rate was then raised to 2.4%, passing part of the improvement back to members, which was the whole point of the exercise.
Watch out
Common mistakes.
- Assuming the intermediary's margin is pure profit. Most of it covers operating costs, bad debts and the capital the institution must hold against its lending.
- Thinking peer-to-peer platforms are the same as banks. Many platforms match lenders and borrowers without taking the credit risk themselves, so the lender bears the loss if a borrower defaults.
- Believing your deposit sits waiting in a vault. Intermediaries lend most of it out, which is precisely how they generate the interest they pay you.
Questions
People also ask.
Why not borrow directly from investors and skip the intermediary?
Large companies do exactly that by issuing bonds, but it requires scale, disclosure and a credit rating that smaller businesses rarely have.
Is an insurance broker a financial intermediary?
In a broad sense yes, though brokers arrange contracts rather than transforming savings into loans, so they are usually described as intermediaries in the distribution sense.
What is disintermediation?
It is the process of cutting the middle party out, for example when savers buy government bonds directly instead of leaving money on deposit with a bank.
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