Financial intermediation

Also called: Banks as intermediaries · Topic: Banking, Credit Creation and Monetary Policy · NCERT: Class 10, Ch 3 "Money and Credit"

Meaning

Financial intermediation means a bank stands between savers, who have extra money, and borrowers, who need money. The bank pools (collects together) many deposits and lends most of that pool out as loans.

• Why it matters: savers and borrowers don't have to find or trust each other. Many small savings get turned into loans for farms, shops, factories and infrastructure.
• Bank's earning formula: Spread = Loan interest rate − Deposit interest rate. The spread pays the bank's costs and gives it profit.

Explanation

How it works: the NCERT story

• Navdeep has spare money, so he deposits it in a bank.
• Rima runs a bamboo business. Her friends and family cannot lend her all the money she needs.
• The bank lends Rima money from its pool, and Navdeep's deposit is part of that pool.
• Navdeep never meets Rima. The bank links them.

Why the middleman helps

• Risk is taken off the saver
• Navdeep does not have to judge whether Rima can repay.

• The bank checks the borrower and carries the risk that the borrower fails to repay.

• Search costs fall

• Search costs are the time and money spent finding the right partner.

• Savers and borrowers don't need to look for each other. They both go to the bank.

• Many small sums become large loans

• One small deposit cannot fund a big project.
• Thousands of small deposits added together can.

How the bank earns: worked example (illustrative)

• The bank pays depositors 6% a year. It charges borrowers 10% a year.
• It lends out ₹100 crore of deposits:
• Interest earned from borrowers: 10% of ₹100 crore = ₹10 crore
• Interest paid to depositors: 6% of ₹100 crore = ₹6 crore

• Spread = 10% − 6% = 4 percentage points, or ₹4 crore

• This ₹4 crore pays for staff, branches and bad loans. What is left is profit.

More than a middleman: Schumpeter's view

• Economist Joseph Schumpeter said the banker is "not only a middleman". The banker is a "producer" of credit who helps entrepreneurs "transform ideas into reality".
• The chain:
• When a bank gives a loan, the money goes into the borrower's account.
• That account is a new deposit.
• So banks do not just pass money along. They are part of the money-creating system. This is called credit creation.

In India

• Commercial banks carry out financial intermediation. They take deposits from the public and lend part of them. The types are:
• Public sector banks, private sector banks and foreign banks
• Regional Rural Banks (RRBs)

• Small finance banks, which lend mainly to small businesses and low-income groups

• Regulator: the RBI (Reserve Bank of India, 1935) regulates banks, NBFCs (non-banking financial companies), payment systems and all-India financial institutions.

• Payments banks do only half of the job. They can take small deposits and handle payments, but they cannot give loans.
• More private intermediaries:
• The 1991 reforms opened banking to new private players.
• The first new private banks were licensed under RBI guidelines in 1993.
• RBI issued the Guidelines for 'on tap' Licensing of Universal Banks in the Private Sector on 1 August 2016. "On tap" means RBI accepts licence applications at any time, not just in rare rounds [2].

• Private sector banks can have up to 74% foreign investment.

• Intermediation without public deposits: DFIs. Development finance institutions (DFIs) lend long-term money to risky sectors. They do not accept deposits from the public. They raise money from the market, the government and multilateral bodies such as the World Bank [3].

• Examples: IFCI (1948), NABARD (1982), EXIM Bank (1982), NHB (1988), SIDBI (1990) and NaBFID (2021).

• NABARD refinances banks. This means it gives funds to the banks that lend to farmers, which lowers their cost of lending.

• Reaching remote savers: post office schemes such as NSC, Kisan Vikas Patra and Sukanya Samriddhi collect savings in villages that may have no bank branch. This helps financial inclusion (bringing everyone into the formal financial system).

• Old Indian example: in early India, temples lent money to artisans, merchants and local governments. They did not take deposits from the public. A 13th-century inscription from Kodumbalur (Tamil Nadu) records that communities borrowed from a temple and agreed to pay interest.

Don't confuse with

• Credit creation: financial intermediation is the bank passing on savers' money to borrowers. Credit creation is the bank creating new deposits when it gives loans. Schumpeter's "producer" idea links the two.
• Payments bank: it takes deposits but cannot lend, so it is not a full financial intermediary. A commercial bank does both.
• Development finance institution (DFI): it also lends to borrowers, but it does not take public deposits [3]. A commercial bank lends out of public deposits.
• Stock exchange / investment bank: here a company raises money straight from investors by selling shares and bonds, and the investor carries the risk. In bank intermediation, the bank carries the borrower's default risk, not the saver.

Prelims Hooks

• In financial intermediation, banks pool savers' deposits and lend them to borrowers. The saver does not directly bear the borrower's default risk.
• Spread = loan rate − deposit rate. For example, 10% − 6% = 4 percentage points.
• Payments banks can take deposits but cannot lend. Commercial banks do both.
• DFIs do not accept public deposits. They raise funds from markets, the government and multilateral bodies [3].
• Schumpeter called the banker "not only a middleman" but a "producer" of credit.
• Trap: ancient Indian temples lent money (as in the Kodumbalur inscription, 13th century, Tamil Nadu) but did not take public deposits. So they were lenders, not full intermediaries.

Mains Points

• Maturity mismatch in infrastructure lending (GS-III)
• Banks use short-term deposits to fund long-term projects. This creates an asset-liability mismatch (loans are locked up for many years, but depositors can ask for their money back sooner).
• This mismatch contributed to the NPA (non-performing asset, meaning a bad loan) problem of the 2010s.

• NaBFID (2021) raises long-term money and helps build the infrastructure bond market, which takes this load off banks [3][4].

• Intermediation and financial inclusion

• Big commercial banks do not reach every saver and borrower.
• Post offices, RRBs, small finance banks and payments banks widen the reach. NABARD's refinance brings credit to farming and village industries.

• Better intermediation turns idle rural savings into productive loans.

• Banks as growth engines (Schumpeter)

• Banks do more than move savings around. They create credit that pays for new businesses.
• Easier credit supports entrepreneurship. This links to Start-up India and to MSME credit through SIDBI (1990).

Related concepts

• Financial infrastructure
• Financial sector
• Commercial banks
• Private sector banks
• Development finance institution

Read more

• The financial system: banks and other institutions