2. Financial intermediation.

Financial intermediation is an activity of financial intermediaries. Afinancial intermediary is an institution that links lenders with borrowers,by obtaining deposits from lenders and then re-lending them to borrowers.
The role of financial intermediaries in an economy, such as banks andbuilding societies, is to provide means by which funds can be transferredfrom surplus units in the economy to deficit units. Surplus units are thoseeconomical agents, which have more money, than they need for theirimmediate needs. Deficit units are those, which have less money, than theyneed in order to fund their current activity.

Financial intermediaries help to reconcile different requirements ofborrowers and lenders.

They provide obvious and convenient ways in which a lender can savemoney. Instead of having to find a suitable borrower for his money, thelender can deposit his money with a bank etc. All the lender has to do isdecide for how long he might want to lend money, and what sort of return herequires, and choose a financial intermediary, that offers a financialinstrument of the fitting conditions.

They can package up the amounts lent by savers and lend on to borrowersin bigger amounts.

They provide for a risk reduction. Provided that the financialintermediary is itself financially sound, the lender would not run any riskof losing his investment. Bad debts would be borne by the financialintermediary in its re-lending operations.

They provide a ready source of funds for borrowers. Even when money isin short supply, a borrower will usually find a financial intermediaryprepared to lend some.

Most importantly they provide maturity transformation, ie they bridgeup the gap between the wish of most lenders for liquidity and the desire ofmost borrowers for loan over longer periods. They do this by providinginvestors with financial instruments, which are liquid enough for theinvestors 'needs, and by providing funds to borrowers in a different longer -term form.