Learning Outcome 4: Financial Intermediation

This learning outcome is dedicated to exploring the crucial concept and process of financial intermediation. This is the fundamental mechanism by which funds are efficiently channelled from those economic units that have surplus funds (typically savers or lenders who are deferring current consumption or have accumulated wealth) to those units that have a shortage of funds and need to borrow (typically borrowers or investors who wish to finance consumption, investment in productive assets, or ongoing business operations). We will identify and differentiate between the various types of banking financial institutions (BFIs) and non-banking financial institutions (NBFIs) that perform this vital intermediation role. Furthermore, we will meticulously discuss their distinct, specialized, and often complementary roles in the broader economy, with particular reference to the Zimbabwean context where relevant examples can be drawn to illustrate these concepts. Understanding financial intermediation is absolutely key to understanding how financial systems support and facilitate economic activity, capital formation, risk management, and overall economic growth and development.

The Concept of Financial Intermediation

Financial intermediation is the core economic process performed by specialized financial institutions (both banks and non-banks) that act as intermediaries (or "middlemen" or "conduits") to facilitate the efficient and effective flow of funds between:

• Surplus Units (Net Savers or Lenders): These are economic entities – such as individual households, businesses that have retained profits, or even governments running budget surpluses at certain times – that have more income than their current expenditure on consumption and direct investment. This results in surplus funds or savings which they wish to place somewhere safe, liquid, and ideally, where they can earn a return.
• Deficit Units (Net Borrowers or Spenders/Investors): These are economic entities – such as individual households wishing to finance consumption (e.g., buying a car or appliances) or acquire assets (e.g., a house), businesses needing to finance investment in new projects, expansion, or working capital, or governments running budget deficits – that have expenditure needs that exceed their current income or internally generated funds. They are looking to borrow funds to finance this deficit or investment.

In essence, financial intermediation is about bridging the gap between those economic units that have an excess of money (savings) and those that have a shortage of money relative to their spending or investment plans. By doing so, financial intermediaries enable a much larger volume of productive investment, consumption smoothing, and overall economic activity than would be possible if surplus and deficit units had to find each other directly.

Why is financial intermediation necessary? Why can't surplus units lend directly to deficit units efficiently on a large scale?

While direct lending and borrowing between surplus units and deficit units (a system often called "direct finance" – e.g., one person directly lending money to a friend or family member, or a large, well-known corporation issuing bonds directly to institutional investors or wealthy individuals via organized capital markets) can and does occur, it faces significant challenges, inefficiencies, costs, and risks, especially for the vast majority of smaller or less sophisticated participants in the economy. These challenges include:

• Information Asymmetry and High Search Costs:
  • Savers (lenders) often lack the detailed information, expertise, or resources to accurately identify and assess the creditworthiness (i.e., the ability and willingness to repay) of potential borrowers. This information asymmetry (where borrowers know more about their own financial situation and riskiness than lenders do) can lead to problems like adverse selection (where lenders are more likely to attract high-risk borrowers) and moral hazard (where borrowers, once they have the funds, might engage in riskier behavior than promised).
  • Similarly, borrowers may not know where to find willing lenders who can provide funds on suitable terms (amount, maturity, interest rate).
  • The costs of searching for a suitable counterparty (a lender or a borrower) can be very high in terms of time, effort, and resources.
• Mismatch of Scale (Amount or Denomination):
  • Individual savers often have relatively small amounts of surplus funds available to lend at any given time.
  • Conversely, borrowers, especially businesses undertaking large investment projects (e.g., building a new factory, developing a mine, constructing a shopping mall) or governments financing infrastructure, may require very substantial sums of money.
  • It is extremely difficult and costly to aggregate many small savings from diverse individuals to meet the large funding needs of a single borrower without an intermediary to perform this "denomination intermediation."
• Mismatch of Maturity Preferences (Time Horizon):
  • Savers (lenders, especially individual households) often prefer to keep their funds relatively liquid and accessible for short periods. They may want to be able to withdraw their savings on demand or at short notice in case of emergencies, unforeseen opportunities, or changing needs.
  • Borrowers, on the other hand, especially those financing long-term productive investments (like infrastructure projects, machinery, or housing), often require funds for much longer terms, sometimes spanning many years or even decades, to match the productive life of the assets being financed.
  • Financial intermediaries help to reconcile these conflicting maturity preferences through "maturity transformation."
• Risk Aversion and Lack of Diversification for Individual Lenders:
  • Individual savers are typically risk-averse and may be unwilling or unable to bear the entire risk of a single borrower defaulting on a loan. Lending a large portion of one's savings to a single individual or business is a highly concentrated and risky strategy.
  • It is difficult for individual lenders to achieve adequate diversification of their lending portfolio (i.e., lending small amounts to many different borrowers) to reduce their overall risk exposure.
• High Transaction Costs for Direct Finance:
  • The various costs associated with direct finance – such as searching for a counterparty, conducting due diligence and credit assessment, negotiating the complex terms of the loan (interest rate, repayment schedule, collateral requirements, covenants), drafting legally sound loan contracts, monitoring the borrower's performance and compliance with loan terms over the life of the loan, and enforcing repayment in case of default (which can involve costly legal proceedings) – can be prohibitively high for most individual savers and small borrowers.

How do financial intermediaries help resolve these issues and add value to the economy?

Financial institutions, acting as specialized intermediaries, have evolved to overcome these challenges and make the process of channelling funds from surplus units to deficit units much more efficient, less costly, and less risky for both parties. They do this by performing several crucial value-adding functions:

• Aggregating Funds (Pooling of Savings / Denomination Intermediation): They collect or pool together relatively small amounts of savings from a large number of individual depositors or investors. By aggregating these funds, they can make much larger loans or investments than individual savers could fund on their own, thus overcoming the scale mismatch and enabling the financing of large-scale projects.
• Maturity Transformation (Reconciling Time Preferences): As mentioned, they transform the maturity structure of funds. They typically accept relatively short-term liabilities (e.g., demand deposits from savers which are highly liquid and can be withdrawn on demand or at short notice) and use these funds to provide longer-term assets (e.g., mortgages that may have a 20-30 year term, or business loans for several years). In doing so, financial intermediaries take on and manage the associated liquidity risk and interest rate risk. This transformation is vital for financing long-term capital formation and economic growth.
• Risk Diversification and Risk Transformation (Managing and Spreading Risk):
  • Diversification: By lending to a wide and diverse portfolio of numerous borrowers, financial intermediaries can spread and diversify credit risk.
  • Risk Assessment and Management (Transformation): Financial intermediaries develop specialized expertise for assessing and managing credit risk. They transform higher individual risk into a lower, diversified risk profile for savers.
• Reducing Transaction Costs (Achieving Economies of Scale and Scope): Financial intermediaries achieve significant economies of scale in processing transactions, gathering information, and monitoring loans, making lending and borrowing more efficient and less costly.
• Providing Liquidity and Payment Services (Enhancing Utility of Money): Many intermediaries, especially commercial banks, offer accounts with varying liquidity and facilitate payments, enhancing the utility of savings.
• Facilitating the Efficient Allocation of Capital: By assessing risks and channelling savings, intermediaries direct funds towards their most productive uses, promoting economic growth.
• Providing Financial Advice and Other Services: Many intermediaries also provide valuable financial advice and related services.

In essence, financial intermediation is a vital economic function that reduces information and transaction costs, manages and transforms risks, reconciles conflicting needs of savers and borrowers, enhances the efficiency of capital markets, promotes investment and economic growth, and provides valuable services to both savers and borrowers. A well-developed and efficient financial intermediation sector is a hallmark of a modern, prosperous economy.

1. List of Banking Financial Institutions

Banking Financial Institutions (BFIs), often simply referred to as "banks," are typically defined as those financial institutions that are legally authorized by the relevant national regulatory authority (in Zimbabwe, this is primarily the Reserve Bank of Zimbabwe - RBZ) to perform two core and distinguishing functions: (1) Accepting deposits from the public that are withdrawable on demand or after a certain specified period or notice. (2) Using these mobilised deposits, along with other sources of funds, to make loans, extend various forms of credit, and undertake investments.

BFIs form the core of the traditional financial system. They are usually subject to more stringent regulation due to their deposit-taking nature, role in the payment system, ability to create money, and systemic importance.

a) Commercial Banks (Retail and Corporate Banks)

Definition and Scope: The most common and diversified type, offering a wide range of services to individuals, SMEs, large corporations, and government entities.

Key Characteristics and Services:

• Extensive Deposit Mobilization: Current accounts, savings accounts, fixed deposit accounts.
• Diverse Lending and Credit Provision Portfolio: Personal loans, mortgages, business loans (working capital, term loans, project finance), overdraft facilities.
• Central Role in Payment System Facilitation: Processing cheques, debit/credit cards, ATMs, EFTs, online/mobile banking, interbank transfers.
• Offering Foreign Exchange (Forex) Services: Buying/selling currencies, international payments, forex accounts, hedging.
• Other Ancillary Services: Safe deposit boxes, financial advisory, bank drafts, guarantees.

Examples in Zimbabwe: CBZ Bank, Stanbic Bank, Standard Chartered Bank, Ecobank, FBC Bank, Nedbank, ZB Bank, BancABC. CABS also operates with a commercial banking license.

b) Merchant Banks (Historically Accepting Houses; or Investment/Corporate Banks)

Definition and Primary Focus: Traditionally focused on sophisticated financial services and advice to corporate clients, governments, and other financial institutions, rather than retail banking. Often fee-based and wholesale transactions.

Key Characteristics and Services (Traditional and Modern Context):

• Limited Deposit-Taking: May accept wholesale deposits.
• Corporate Finance Advisory: Capital structure, raising capital, financial restructuring.
• Underwriting of Securities (Capital Raising): Assisting in issuing shares (IPOs) and bonds.
• Mergers and Acquisitions (M&A) Advisory: Advice and execution for M&A, divestitures, MBOs, LBOs.
• Project Finance Advisory and Arrangement: For large-scale infrastructure and industrial projects.
• Specialized Trade Finance: Facilitating large or complex international trade.
• Investment Management and Private Banking: For institutional clients or HNWIs.

Evolution and Examples in Zimbabwe: Distinction blurred; many commercial banks have merchant/investment banking divisions (e.g., FBC Merchant Bank functions integrated into FBC Holdings). Some boutique firms exist.

c) Building Societies

Definition and Primary Historical Mandate: Originated to help members save money and finance home purchase or construction; promoting thrift and home ownership.

Key Characteristics and Services:

• Core Business (Traditional): Mobilizing retail savings deposits, providing long-term mortgage finance.
• Diversification of Services: May offer current accounts, personal loans, insurance, payment services, SME lending.
• Ownership Structure (Mutual vs. Corporate): Historically mutual (owned by members), but many have demutualized to become corporate entities.

Examples in Zimbabwe: CABS (prominent, also commercial banking license), ZB Building Society, FBC Building Society (parts of larger groups).

d) Savings Banks (e.g., Post Office Savings Banks, Trustee Savings Banks, Community Banks)

Definition and Primary Focus: Primarily focused on encouraging thrift and mobilizing savings, especially from small savers, lower-income individuals, and rural populations. Strong emphasis on financial inclusion.

Key Characteristics and Services:

• Strong Emphasis on Financial Inclusion and Social Mandate: Provide basic, accessible services to the unbanked.
• Product Range: Basic savings accounts, limited lending (small personal loans, microloans), basic payment services.
• Distribution Network and Accessibility: Wide network, sometimes using post office branches; lower minimum balances.
• Ownership and Governance Structure: Can be state-owned, mutually owned, or operated by trusts/foundations.

Example in Zimbabwe: The People's Own Savings Bank (POSB), with a statutory mandate to mobilize savings and provide banking services, particularly to lower/middle-income individuals and communities.

e) Development Banks (or Development Finance Institutions - DFIs)

Definition and Purpose: Specialized institutions (often government-owned or supported) to provide medium and long-term finance, risk mitigation, and advisory services for projects crucial for economic and social development. Focus on areas where commercial banks may hesitate due to high risk, long payback, or lower commercial returns.

Key Characteristics and Services:

• Ownership, Funding, and Mandate: Government-owned (national) or multi-government owned (multilateral). Funding from government, capital subscriptions, concessional loans, or bonds. Clear developmental mandate.
• Sectoral Focus: Priority sectors like agriculture, industry (SMEs), infrastructure (transport, energy, water), housing, export promotion.
• Types of Finance and Support Provided: Long-term loans, equity investments, guarantees, quasi-equity, technical assistance, advisory services.
• Lending Terms and Additionality: May offer concessional terms. Aim to support projects not commercially viable or to "catalyze" private investment ("additionality").

Examples in Zimbabwe: Infrastructure Development Bank of Zimbabwe (IDBZ) (infrastructure focus), Agricultural Finance Corporation (AFC) Commercial Bank (agricultural support, also commercial banking license). Other specialized DFIs or funds for SMEs, youth, women. Regional and international DFIs also operate.

2. Roles of Banking Financial Institutions

Banking financial institutions (BFIs) are pivotal to the modern economy, performing numerous crucial roles.

a) Mobilisation of Savings (Attracting and Pooling Deposits)

A primary role: providing safe, convenient, and interest-bearing avenues for entities to deposit surplus funds. This pools widespread savings into loanable funds for capital formation and encourages a savings culture.

b) Provision of Credit and Finance (Lending and the Process of Credit Creation)

Channeling mobilised funds into productive investments and consumption. They lend to individuals, businesses, and government. Through lending under a fractional reserve system, commercial banks engage in credit creation (money creation), expanding the money supply.

c) Facilitation of the Payments System (Operating the "Financial Plumbing" of the Economy)

Central to the payments system, enabling transactions via cheques, cards, ATMs, EFTs, online/mobile banking, and interbank systems (RTGS, ACHs). Essential for all economic transactions.

d) Maturity Transformation (Bridging Different Time Preferences of Savers and Borrowers)

Bridging mismatched time preferences: accepting short-term, liquid deposits from savers and transforming them into longer-term loans for borrowers. This involves managing liquidity risk and interest rate risk, and is vital for long-term capital formation.

e) Risk Management, Assessment, and Diversification (Risk Transformation and Allocation)

Specializing in identifying, assessing, managing, and transforming financial risks, particularly credit risk. This includes risk assessment (screening, due diligence, monitoring), risk diversification (lending to a diverse portfolio), and risk transformation (absorbing and managing risk on behalf of customers).

f) Agent and Advisory Services (Providing Expertise and Convenience)

Acting as agents for customers (collecting/making payments, trustees, custodians, safe deposit boxes) and providing financial advice (personal financial planning, business cash flow, corporate finance strategies, risk management).

g) Foreign Exchange Services (Facilitating International Trade and Finance)

Vital for international trade and finance: buying/selling foreign currencies, foreign currency accounts, international money transfers, letters of credit, and helping manage exchange rate risk (hedging).

h) Supporting Government Operations and Facilitating Monetary Policy Transmission

Assisting government finances (tax collection, payment disbursements), participating in government securities markets (helping finance deficits), and acting as crucial conduits for monetary policy transmission from the central bank to the economy.

i) Promoting Financial Inclusion and Contributing to Economic Development

Extending formal financial services to unbanked/underbanked populations via mobile/digital banking, agency banking, simplified accounts, and financial literacy. This contributes to poverty reduction, empowerment, and inclusive economic development.

3. Outline of Non-Banking Financial Institutions (NBFIs)

Non-Banking Financial Institutions (NBFIs) provide financial services but generally do not hold full banking licenses and cannot accept demand deposits. They complement banks, cater to niche markets, and contribute to financial innovation and competition.

a) Insurance Companies (Life and Non-Life/General)

Core Function: Risk management and transfer; providing financial protection (indemnification) against specified contingent losses by pooling risks and collecting premiums.

Types and Products:

• Life Insurance: Life assurance, annuities, disability/critical illness cover, funeral policies.
• General Insurance (Non-Life/P&C): Property, motor, liability, health (medical aid), marine/aviation/transit, agricultural insurance.

Investment Role: Accumulate large reserves invested in diversified assets (bonds, equities, real estate), making them significant institutional investors.

Examples in Zimbabwe: Old Mutual, Nyaradzo, Zimnat Lion, First Mutual Life, NicozDiamond.

b) Pension Funds (Retirement Funds / Superannuation Funds)

Core Function: Help individuals save and invest systematically for retirement by collecting contributions from employers/employees and managing them in a diversified portfolio to provide retirement income.

Key Characteristics:

• Long-Term Investment Horizon: Allows investment in assets with higher potential returns.
• Major Institutional Investors: Critical for mobilizing long-term savings.
• Types of Pension Schemes: Defined Benefit (DB) – benefit is pre-determined, risk on employer; Defined Contribution (DC) – contribution is fixed, benefit depends on returns, risk on employee (more common now).

Examples in Zimbabwe: Occupational pension funds, National Social Security Authority (NSSA), individual pension plans.

c) Microfinance Institutions (MFIs)

Core Function: Provide financial services (microcredit, savings for MFBs, microinsurance, money transfers, business development) to low-income individuals, micro-entrepreneurs, and informal sector businesses underserved by traditional banks.

Key Characteristics:

• Focus on Financial Inclusion, Poverty Alleviation, Empowerment.
• Innovative Lending Methodologies: Group lending, collateral substitutes, frequent/small repayments, step-up lending.
• Operational Aspects and Sustainability: Higher operating costs; interest rates often higher than banks.
• Regulation in Zimbabwe: Licensed by RBZ as Microfinance Banks (deposit-taking) or Credit-Only MFIs.

Examples in Zimbabwe: EmpowerBank, various other licensed MFBs and credit-only MFIs, NGOs providing microfinance.

d) Asset Management Companies (Investment Management Companies, Fund Managers)

Core Function: Professionally manage investment portfolios (stocks, bonds, real estate) on behalf of clients (individuals, corporations, institutions) to achieve specific investment objectives aligned with risk tolerance and time horizon.

Types of Services and Products Offered:

• Collective Investment Schemes (CIS): Mutual funds/unit trusts (e.g., equity, bond, balanced, money market funds).
• Segregated or Discretionary Mandates: Customized portfolios for large clients.
• Exchange Traded Funds (ETFs): Index-tracking funds traded on exchanges.
• Investment Advisory Services.

Revenue Model: Management fees (% of AUM), performance fees, commissions.

Examples in Zimbabwe: Old Mutual Investment Group, Imara Asset Management, Datvest, Stanbic Investment Management Services.

e) Finance Houses (or Finance Companies) / Leasing Companies

Core Function: Provide finance for the acquisition of specific assets (vehicles, equipment, consumer durables) for borrowers who may not have full upfront cash or prefer not to use bank loans.

• Finance Houses: Focus on consumer credit for durable goods via hire purchase or personal loans.
• Leasing Companies: Finance for businesses/individuals to acquire use of capital equipment via leases (Finance/Capital Lease or Operating Lease).

Key Characteristics: Asset-backed financing, hire purchase and leasing are key products, specialized expertise in assets.

Examples in Zimbabwe: Some commercial banks have leasing arms; specialized independent firms may exist.

f) Stockbroking Firms / Securities Dealers (Broker-Dealers)

Core Function: Intermediaries in financial markets, facilitating buying/selling of securities (shares, bonds) on exchanges (ZSE, VFEX) or OTC markets.

• Brokers (Agents): Execute orders for clients, earn commission.
• Dealers (Market Makers): Trade for own account, provide liquidity.

Key Characteristics and Services: Facilitating trading, investment advisory, research, underwriting support, custody/nominee services.

Regulation: By SECZIM and exchange rules.

Examples in Zimbabwe: EFE Securities, Imara Edwards Securities, Lynton-Edwards, Morgan & Co., Old Mutual Securities.

g) Venture Capital (VC) and Private Equity (PE) Firms

Core Function: Provide risk capital (equity, debt, hybrid) to private companies not listed on public exchanges.

• Venture Capital (VC): Invest in startups, early-stage, high-growth potential, often tech-driven businesses. High risk, high potential return.
• Private Equity (PE): Invest in broader range of private companies for growth, restructuring, buyouts (MBOs, LBOs), taking public companies private.

Key Characteristics: High-risk/return, illiquid, long-term horizon, active involvement/value addition, specific exit strategies (IPO, sale, secondary buyout). Funding from institutional investors and HNWIs via limited partnership funds.

Development in Zimbabwe: Relatively less developed but growing area, important for innovation and SME growth.

h) Credit Unions / Savings and Credit Co-operative Societies (SACCOs)

Core Function: Member-owned, democratically controlled financial cooperatives formed by groups with a common bond (employment, profession, community). Focus on serving members' financial needs.

Key Characteristics and Services:

• Cooperative Principles: Voluntary membership, democratic control, member economic participation.
• Primary Purpose (Thrift and Credit): Encourage savings, provide loans to members at fair rates.
• Surplus Distribution: Returned to members (dividends, interest rebates) or used to improve services.
• Range of Services: Savings, loans, basic insurance, payment services, financial counselling.
• Financial Inclusion and Community Development: Serve those underserved by banks, focus on local community.

Regulation: Subject to cooperative legislation, may be supervised by relevant government agency or central bank.

4. Roles of Non-Banking Financial Institutions (NBFIs)

NBFIs complement banks and play crucial, diverse roles in the financial system, contributing to its depth, efficiency, innovation, and resilience.

a) Mobilisation of Long-Term and Contractual Savings

Pension funds and life insurance companies mobilize long-term contractual savings, accumulating vast pools of funds invested in long-term assets (bonds, equities, real estate, infrastructure). This "patient capital" is crucial for financing long-term economic development.

b) Provision of Specialised Financial Services and Products (Catering to Niche Markets)

NBFIs offer specialized services and cater to niche markets often not adequately addressed by banks: insurance (risk management), MFIs (financial access for low-income), leasing/finance houses (asset finance), VC/PE firms (risk capital for innovation/growth), asset managers (investment products).

c) Development and Deepening of Capital Markets

NBFIs like pension funds, insurance companies, and asset managers are significant participants in capital markets, contributing to increased liquidity, depth, improved price discovery, and market efficiency. They create demand for shares and bonds, facilitating capital raising for companies and governments.

d) Enhancing Financial Inclusion (Extending Reach of Financial Services)

Many NBFIs (MFIs, SACCOs, some insurance companies, mobile money operators) extend financial services to underserved populations, promoting financial inclusion, empowering individuals, and contributing to poverty reduction.

e) Specialized Risk Management and Mitigation Solutions (Beyond Traditional Banking Risks)

Insurance companies specialize in managing a wide array of pure risks (life, health, property, liability, business interruption), allowing individuals and businesses to operate with greater financial security and promoting economic resilience.

f) Promoting Competition, Innovation, and Efficiency in the Broader Financial Sector

NBFIs increase competition, leading to improved services, lower costs, and greater innovation (e.g., fintech solutions) in the financial sector, benefiting consumers and businesses.

g) Channelling Funds to Niche Markets, Specialized Needs, and Underserved Sectors

NBFIs direct funds to niche markets or sectors often overlooked by banks: VC firms (startups), PE firms (private company growth/restructuring), specialized finance companies (factoring, equipment finance), social impact funds, crowdfunding platforms.

h) Facilitating Infrastructure Development and Other Long-Term, Large-Scale Investments

Long-term funds mobilized by NBFIs (pension funds, life insurers) are well-suited for financing large-scale, long-gestation infrastructure projects (transport, energy, water, telecom) through infrastructure bonds, funds, or PPPs, critical for sustainable economic growth.