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Most people do not enter financial markets directly but use intermediaries or middlemen. Commercial banks are the financial intermediary we meet most often in macroeconomics, but mutual funds, pension funds, credit unions, savings and loan associations, and to some extent insurance companies are also important financial intermediaries.1 When people deposit money in a bank, the bank uses the funds to make loans to home buyers for mortgages, to students so they can pay for their education, to business to finance inventories, and to anyone else who needs to borrow. A person who has extra money could, of course, seek out borrowers himself and bypass the intermediary. By eliminating the middleman, the saver could get a higher return. Why, then, do so many people use financial intermediaries?

Financial intermediaries provide two important advantages to savers. First, lending through an intermediary is usually less risky than lending directly. The major reason for reduced risk is that a financial intermediary can diversify. It makes a great many loans, and even though some of those loans will be mistakes, the losses will be largely offset by loans that are sound. In contrast, an average saver could directly make only a few loans, and any bad loans would substantially affect his wealth. Because an intermediary can put its "eggs" in many "baskets," it insures its depositors from substantial losses.

Another reason financial intermediaries reduce risk is that by making many loans, they learn how to better predict which of the people who want to borrow money will be able to repay. Someone who does not specialize in this lending may be a poor judge of which loans are worth making and which are not, though even a specialist will make some mistakes.

A second advantage financial intermediaries give savers is liquidity. Liquidity is the ability to convert assets into a spendable form--money--quickly. A house is an illiquid asset; selling one can take a great deal of time. If an individual saver has lent money directly to another person, the loan can also be an illiquid asset. If the lender suddenly needs cash, he must either persuade the borrower to repay quickly, which may not be possible, or he must find someone else who will buy the loan from him, which may be very difficult. Although the intermediary may use its funds to make illiquid loans, its size allows it to hold some funds idle as cash to provide liquidity to individual depositors. Only when a great many depositors want to withdraw deposits at the same time, which happens when there is a "run" on the institution, will the financial intermediary be unable to provide liquidity. Unless it can obtain help from the government or other institutions, it will be forced to suspend payments to depositors.

In addition to lending money to individuals and groups, there are other ways in which banks are part of financial markets. Banks borrow and lend funds among themselves in the federal-funds market. They buy and sell foreign exchange. They buy and sell government and commercial debt. And finally, one form of bank debt serves as money in modern economies, and banks create this debt as a result of their financial transactions.

Economists are concerned that financial intermediaries can be a source of shocks to the economy, bumps that can disrupt the normal flow of economic life. This concern arises for at least two reasons. First, bank debt serves as money, so disruptions to banks can affect the amount of money in circulation. We explore this idea in later chapters. Second, financial intermediaries are tied together through chains of debts and assets. Because of these linkages, the failure of one financial intermediary can weaken others, increasing their chances of failure. As a result, there is the possibility that if a key financial intermediary fails, that failure can create a domino effect that could cause other financial institutions to fail, ultimately causing the financial sector to "seize up" and stop functioning. Serious disruption of the financial markets will disrupt the rest of the economy. We will develop this idea a bit further in later sections of this chapter.

The government plays several roles in financial markets.

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1. Many financial intermediaries, including many or most savings banks, savings and loan associations, and credit unions, plus some of insurance companies were established as not as profit-maximizing institution, but as mutual aid or charitable institutions. Access to financial markets was considered necessary for economic advancement.

Copyright Robert Schenk