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A financial intermediary is an institution which facilitates the flow of funds from individuals and entities with a surplus of money to those who are in need of funds. The classic example of a financial intermediary is a bank. The bank accepts deposits from people who have an excess of funds and it makes loans with those same deposits to people who need funds. Other examples of financial intermediaries include brokerages and credit unions.
The financial intermediary essentially acts as a middleman, receiving fees and interest in exchange for the services it offers. While loans could be made directly, the intermediary provides a much safer method of making loans and moving funds from place to place. People with funds on deposit have claims on the bank and the agency which insures it, rather than on individual borrowers, and they receive interest in exchange for their deposits, which provides an incentive to deposit and make those funds available.
Financial intermediaries are able to diversify their risks because they work with more people and institutions than a single person could. This increases safety as well. If one person makes a loan to another and the borrower cannot repay it, the lender is exposed to substantial risk. On the other hand, if a bank makes a pool of loans with the money invested in it and one of these loans goes bad, the effect on investors is negligible. Thus, using a financial intermediary reduces financial risks considerably.
These financial institutions make the financial markets function. Many people and companies need to borrow money at some point, and such institutions provide access to funds which can be borrowed along with loan servicing. Likewise, people with extra money want to invest it, and financial intermediaries provide a safe location for investments. The facilitation of loans opens up the credit market, allowing businesses to expand and to borrow to make investments in their future.
In order to act as a financial intermediary, a financial institution is required to comply with a number of laws. These laws are designed to protect consumers and to provide standards of practice which are observed by the industry as a whole to streamline financial transactions and related activities. Many nations also require institutions to carry insurance to protect their members. In the event of a collapse, people with funds on deposit will not lose them, because the insurance will pay out on their claims.