Financial Intermediaries & Institutions: Roles, Types & Functions

TAKEAWAYS:

• Financial intermediaries reduce transaction costs by pooling funds and spreading risk (e.g., banks lending to businesses instead of individuals).
• Depository institutions (banks) and non-depository institutions (insurance, mutual funds) serve distinct but complementary roles in the financial system.
• Regulatory bodies (Nepal Rastra Bank, SEBON) ensure stability and protect investors (e.g., NEPSE’s investor protection rules).
• Disintermediation (bypassing banks via fintech like Khalti) challenges traditional intermediaries but creates new opportunities.
• Risk management (diversification, hedging) is critical—seen in how Ncell uses insurance to cover network outages.
• Exam focus: Define intermediaries, compare types, and analyze case studies (e.g., how a mutual fund invests in NEPSE stocks).

1. What Are Financial Intermediaries?

Financial intermediaries are institutions that facilitate the flow of funds between savers (surplus units) and borrowers (deficit units). They:

• Pool small savings into large loans.
• Provide liquidity (e.g., banks allowing withdrawals).
• Spread risk (e.g., insurance covering multiple policies).

Why do we need them? Without intermediaries, borrowers (e.g., a Kathmandu shop owner) would need to find thousands of individual lenders—a costly, inefficient process. Intermediaries solve this by aggregating funds and specializing in risk assessment.

graph LR
    A["Savers (Households, Firms)"] -->|"Deposit"| B["Financial Intermediary\n(Bank, Insurance, Mutual Fund)"]
    B -->|"Lend as Loan/Investment"| C["Borrowers (Businesses, Govt, Individuals)"]
    B -->|"Pay Interest/Dividends"| A

2. Types of Financial Intermediaries

Intermediaries are classified based on their source of funds and primary function. Below is a comparison table:

Real-World Example:

• Ncell’s Insurance Partnership: Ncell offers mobile insurance (e.g., phone damage coverage) via non-depository intermediaries. When you buy a policy, Ncell acts as an agent for an insurance company (e.g., NIC Asia), pooling premiums to pay claims—spreading risk across thousands of users.

3. How Depository Institutions Work: Banks

Banks are the most common intermediaries. Their core functions:

1. Accept deposits (current, savings, fixed).
2. Grant loans (business, personal, mortgages).
3. Provide payment services (e.g., eSewa, Khalti).

How a Bank Creates Money

When you deposit Rs. 10,000 in Nabil Bank, the bank:

• Keeps 10% (Rs. 1,000) as reserve (required by Nepal Rastra Bank).
• Lends out Rs. 9,000 to a shop owner.
• The shop owner deposits the Rs. 9,000 elsewhere, creating new money in the economy.

Money Multiplier Effect: $$\text{Total Money Created}=\frac{\text{Initial Deposit}}{\text{Reserve Ratio}}$$ For Nepal’s 10% reserve ratio: $$\frac{10,000}{0.10}=\text{Rs. 100,000}$$ (This is why banks are called "money creators.")

Worked Example: Kathmandu Retail Shop Loan Scenario: A shop in Thamel takes a Rs. 500,000 loan from Global IME Bank at 12% annual interest for 3 years.

1. Monthly Installment Calculation: $$\text{EMI}=\frac{P\times r\times (1+r{)}^n}{(1+r{)}^n-1}$$ Where:

   • $P=500,000$
   • $r=\frac{12\%}{12}=0.01$ (monthly rate)
   • $n=36$ (months) $$\text{EMI}=\frac{500,000\times 0.01\times (1.01{)}^{36}}{(1.01{)}^{36}-1}=\text{Rs. 16,275/month}$$

2. Total Interest Paid: $$\text{Total Paid}=16,275\times 36=\text{Rs. 586,000}$$ $$\text{Interest}=586,000-500,000=\text{Rs. 86,000}$$

Why This Matters:

• The bank earns spread (difference between deposit and loan rates).
• The shop uses funds for inventory, boosting Nepal’s GDP.

4. Non-Depository Intermediaries: Insurance and Mutual Funds

A. Insurance Companies (Risk Pooling)

How it works:

1. Policyholders pay premiums (e.g., Rs. 5,000/year for health insurance).
2. The insurer pools funds to pay claims (e.g., Rs. 200,000 to a policyholder after an accident).
3. Law of Large Numbers: More policies = predictable payouts.

Example: NIC Asia’s Motor Insurance

• You pay Rs. 15,000/year for car insurance.
• If 1,000 people buy the policy and only 5% file claims, NIC Asia pays out Rs. 250,000 total, covering costs.

B. Mutual Funds (Diversified Investing)

Mutual funds pool money from investors to buy stocks, bonds, or other assets. In Nepal:

• NMB Mutual Fund offers funds like NMB Equity Fund (invests in NEPSE stocks).
• Advantages:
  • Diversification: Reduces risk (e.g., investing in 50 companies vs. 1).
  • Professional Management: Fund managers pick stocks.
• Disadvantages:
  • Fees (1–2% annual expense ratio).
  • Market Risk: If NEPSE falls, your fund value drops.

Worked Example: Investing in NEPSE via Mutual Fund

• You invest Rs. 100,000 in NMB Equity Fund (expense ratio: 1.5%).
• The fund buys NEPSE stocks (e.g., Ncell, NMB, CG).
• After 1 year, NEPSE rises 15%, but fees reduce returns: $$\text{Return}=(1+0.15)-0.015=13.5\%$$ $$\text{Final Value}=100,000\times 1.135=\text{Rs. 113,500}$$

5. The Role of Regulatory Bodies

Financial intermediaries are regulated to ensure stability and investor protection. Key regulators in Nepal:

Example: NRB’s Role in Bank Stability

• If Global IME Bank has low liquidity, NRB can:
  1. Increase reserve requirements (forcing banks to hold more cash).
  2. Inject liquidity via repo operations (short-term loans to banks).
  3. Impose penalties for risky lending.

6. Disintermediation: The Rise of Fintech

Disintermediation = Bypassing traditional intermediaries (banks) via technology. Examples in Nepal:

1. Khalti/Daraz: Let you pay sellers directly (no bank loan needed).
2. eSewa: Facilitates bill payments without bank accounts.
3. Peer-to-Peer Lending (P2P): Platforms like Kiva Nepal connect lenders and borrowers directly.

Impact:

• Pros: Lower fees, faster transactions, financial inclusion.
• Cons: Less regulation, higher risk of fraud.

In the Real World

1. Ncell’s Insurance Partnership

   • Idea Used: Risk pooling (non-depository intermediary).
   • How: Ncell sells phone insurance via NIC Asia. When you buy a policy, your premium joins a pool that pays claims if your phone is damaged. This spreads risk across millions of users, making payouts affordable.

2. NEPSE’s Mutual Funds (e.g., NMB Equity Fund)

   • Idea Used: Diversified investing (mutual funds).
   • How: If you invest in NMB Equity Fund, your money buys shares of Ncell, NMB, and CG automatically. Instead of betting on one stock, you own a piece of Nepal’s top companies, reducing risk.

3. Pathao’s Loan Services

   • Idea Used: Depository intermediation (bank-like lending).
   • How: Pathao offers instant loans to drivers using digital collateral (e.g., bike value). The app partners with banks (e.g., Nabil) to disburse funds quickly—acting like a microfinance intermediary.

Exam Tip

1. Definitions:

   • Always define intermediaries as "institutions that channel funds from savers to borrowers."
   • For disintermediation, say it’s "the process of removing intermediaries via technology (e.g., Khalti)."

2. Case Study Approach:

   • Banks: Use loan calculations (EMI, interest) with real NPR values.
   • Insurance: Explain risk pooling with premium vs. claim examples.
   • Mutual Funds: Compare NEPSE vs. global markets (e.g., "Why invest in NMB Equity Fund?").

3. Diagrams:

   • Draw the accounting cycle for a bank (deposits → loans → profits).
   • Show a T-account for a bank’s assets/liabilities (e.g., loans as assets, deposits as liabilities).

4. Common Pitfalls:

   • ❌ Saying "banks create money out of thin air." → ✅ Say "banks create money by lending deposits, within reserve limits."
   • ❌ Confusing mutual funds with stocks. → ✅ Emphasize "funds pool money to buy diversified assets."

Final Visual Summary

flowchart TD
    A["Financial Intermediaries"] --> B["Depository\n(Banks)"]
    A --> C["Non-Depository\n(Insurance, Mutual Funds)"]
    B --> D["Accept Deposits\nGrant Loans"]
    C --> E["Pool Risk\nInvest Long-Term"]
    D --> F["Example: Nabil Bank\nLending to Shops"]
    E --> G["Example: NIC Asia\nInsuring Phones"]
    E --> H["Example: NMB Mutual\nInvesting in NEPSE"]