The Risk of a Financial Intermediary

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A financial intermediary is a bank, or other deposit taking institution, that accepts deposits from savers, then loans the proceeds to business and consumer borrowers. Banks are called an intermediary because they are between the saver and the borrower. Without the intermediary, savers and borrows would interact directly, as they do in capital markets.

Depositor Confidence

Risks specific to financial intermediaries, such as banks, include the risk of losing depositor confidence and misjudging the credit worthiness of borrowers. It is of the utmost importance that each and every bank be seen by the public as a safe place to deposit money. Failure to do so can, at the extreme, result in public panic and a bank run. Banks must not only manage their business prudently, they have to convince the public that they are doing so. To enhance confidence in the banking industry, the government regulates and oversees their operations. The government has additionally established automatic depositor insurance (up to $250,000 per qualifying account) through the Federal Deposit Insurance Corporation.

Credit Risk

Banks are in the business of taking on risk. When they borrow from a depositor, the depositor needs to be 100 percent confident that they will get their money returned. When a bank loans money, it knows that some of the loans will not be re-paid. Of course, they don't know which ones will go bad in advance. What they do for each loan is a thorough analysis to determine how much risk the bank is taking on that the borrower won't repay the money. The bank then adds a risk premium to the interest rate to compensate themselves. As a simple example, the lowest rate you can borrow money at is with a mortgage. This is because the loan is secured by your house, and also because banks know that people will do everything they can to pay their mortgage to avoid losing their homes. On the other hand, if you borrow money for a cruise on an unsecured basis, the bank is going to charge a higher rate.

More Complex Risks

The major banking crisis in the United States that saw the collapse of Lehman Brothers in 2008 brought to focus other kinds of risks. These include capital adequacy and liquidity management. Capital adequacy is a comparison of a bank's assets to its capital. Liquidity management, when properly done, ensures an organization has realistic cash flow projections for both in and outflows, and the ability to meet all of its obligations on time.

Systemic Risk

Bankers and regulators have always known about and managed these types of risks. What has changed is the realization that the collapse of one bank can cause a chain reaction. Or alternatively, if bankers start believing that one or more banks are "too big to fail" -- meaning, there is no way the government would allow those firms to go bankrupt -- then poor judgment and excess risk taking can result. This can lead to vulnerabilities in the banking system as a whole. As a result, regulators and bankers talk about stress testing, and about the consequences of events on the banking system as a whole, not just an individual bank.

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