Why Banks Are Financial Intermediaries
Households and businesses may have funds they want to hold safely and access conveniently, while other households and businesses need financing for purchases or investment. Banks connect these needs through services that include accepting funds, supporting payments, and making or arranging loans. Their role is not just to pass a particular saver’s money directly to a particular borrower: banks assess credit, combine funding from different sources, and offer financial claims with different terms.
This tutorial focuses on those economic functions. The word intermediation describes how a financial institution connects those who supply funds with those who demand financing. It does not, by itself, describe the accounting mechanics of how a bank loan affects deposits. Those mechanics are a separate topic.
Accepting Funds and Providing Payment Services
A customer may place funds in a bank account to keep them accessible, receive income, or make payments. In return, the account provides a claim on the bank: subject to the account’s terms, the customer can withdraw funds or instruct the bank to make a payment. Accounts may differ in access conditions, interest paid, and fees.
Payment services make bank accounts useful for everyday transactions. For example, a business may receive customer payments into an account and use that account to pay employees and suppliers. The bank supplies a way to hold and transfer funds; the customer receives a service as well as a place to keep an account balance. The specific instruments and steps used to process payments are distinct from the broad intermediary role described here.
Funds placed with a bank may also contribute to the bank’s overall funding. The bank does not generally treat each customer’s deposit as a labeled packet reserved for a particular loan. It manages its funding and financing decisions as part of the institution’s wider activities. This distinction matters: describing banks as intermediaries does not imply a one-to-one match between one depositor and one borrower.
Worked Example: Connecting Business Accounts and Financing
Hypothetical scenario. A regional bank has 120 small-business customers. During a month, customers deposit a total of $480,000. A bakery requests $72,000 to buy an oven and refrigeration equipment. The bank approves the loan after reviewing the bakery’s projected cash flows and credit history. The bakery also uses its account to pay suppliers.
Method. Separate the bank’s funding, payment, and financing functions; do not assume that one customer’s deposit is directly assigned to the bakery.
Funding function. The bank has received $480,000 in deposits across its customer base. The bakery’s requested loan is $72,000, so the request is \(72{,}000/480{,}000=0.15\), or 15% of that month’s deposit total. This comparison describes scale; it does not establish that the bank sets aside exactly 15% of those deposits for the bakery.
Credit-allocation function. The bank decides whether to approve the $72,000 request based on its assessment of repayment prospects and other lending considerations. The decision is about the bakery’s financing request, not about identifying a specific depositor whose money will be lent.
Payment function. The bakery uses its bank account to pay suppliers. The account and payment service help it carry out transactions, in addition to the loan supporting its equipment purchase.
Check. The bank’s three distinct roles in the scenario are accepting funds, assessing and providing financing, and supporting payments. The 15% calculation compares totals only; treating it as a direct depositor-to-borrower match is the mistake this method avoids.
Channeling Financing to Borrowers
Banks channel financing by deciding which applicants to lend to, how much to lend, and on what terms. A bank can gather information, evaluate repayment capacity, and monitor a loan after it is made. These activities address information problems: borrowers often know more about their own plans and circumstances than lenders do, while lenders may find it costly to assess each borrower. The earlier material on information problems in financial intermediation covers why screening and monitoring matter.
Bank financing can support household purchases, such as a home or vehicle, and business activity, such as equipment purchases, inventory, or expansion. The bank’s decision is not simply whether funds are available in the abstract. It also involves the expected return, the possibility of nonpayment, the terms of funding, and the bank’s ability to manage the resulting risks.
Borrowers can also obtain financing directly from savers by issuing claims to them. With direct finance, the borrower raises funds from the ultimate provider of funds without a bank acting as the intermediary between them. With bank intermediation, the bank stands between fund providers and borrowers: customers hold claims on the bank, while borrowers owe obligations to the bank. The terms of those two relationships need not be identical.
Transformation, Risk, and the Interest Spread
Banks may offer account holders access to funds on shorter notice than the time a borrower needs to repay a loan. This difference in the timing of claims is one form of maturity transformation. Banks may also provide customers with relatively accessible funds while holding financing that cannot be converted into cash immediately without cost. This is a form of liquidity transformation. These services can be valuable, but the mismatch means a bank must manage the risk that its funding needs and its borrowers’ repayments will not arrive at the same times.
Banks also bear credit risk: a borrower may fail to make a promised payment. The bank’s revenues and costs therefore cannot be summarized by the interest rate charged on loans alone. A simple interest-spread calculation is useful as a starting point, but it is not a complete measure of profit.
For a simplified period, assume a bank earns interest on a loan portfolio and pays interest on its funding. Assume the balances and annual rates remain constant for the period, and ignore fees, operating expenses, taxes, and credit losses. Under these assumptions, the difference between interest income and interest expense is:
If the bank earns a loan rate \(r_L\) on loan amount \(L\), then interest income for one year is \(Lr_L\). If it pays funding rate \(r_F\) on funding amount \(F\), then interest expense for one year is \(Fr_F\). Subtracting the expense from the income gives \(Lr_L-Fr_F\). This is a dollar amount before other costs and losses, not a guarantee of profit.
Worked Example: Calculating a Simplified Interest Spread
Hypothetical assumptions. A bank has $2,000,000 in loans earning a fixed annual interest rate of 8% for one year. It obtains $1,500,000 of funding at an annual rate of 3% and another $500,000 at an annual rate of 4%. Assume all balances remain constant for the full year, interest is calculated as balance multiplied by annual rate, and there are no fees, operating costs, taxes, or credit losses in this calculation.
Method. Calculate interest income and each funding expense separately, then subtract total interest expense. This avoids applying one funding rate to all funding when the rates differ.
Loan interest income. \(2{,}000{,}000 \times 0.08 = \$160{,}000\).
First funding expense. \(1{,}500{,}000 \times 0.03 = \$45{,}000\).
Second funding expense. \(500{,}000 \times 0.04 = \$20{,}000\).
Total interest expense. \(\$45{,}000+\$20{,}000=\$65{,}000\).
Net interest income under the assumptions. \(\$160{,}000-\$65{,}000=\$95{,}000\).
Check. The bank earns $160,000 and pays $65,000, leaving $95,000 before omitted costs and losses. This result is not net profit because the example excludes those other items.
Why Intermediation Can Be Valuable
A bank can reduce the effort required for savers and borrowers to find and evaluate one another. Instead of each saver investigating potential borrowers, the bank can use its expertise and processes to assess many applicants. It can also offer customers a convenient account and payment service while providing borrowers with financing on agreed terms.
These benefits come with trade-offs. Screening and monitoring take resources, and borrowers may still fail to repay. A bank that offers accessible accounts while financing longer-term projects must manage timing and liquidity risks. A high loan interest rate does not automatically mean a loan is attractive: the expected payments must be considered alongside funding costs, expected losses, and operating costs.
The following example isolates one part of that assessment. It uses expected credit loss to compare two hypothetical loans; it does not model a bank’s full pricing decision.
Worked Example: Comparing Two Hypothetical Loan Applicants
Hypothetical assumptions. A bank is considering two one-year loans, each with principal of $10,000. Applicant A’s loan earns 9% interest, and the probability of default during the year is 4%. Applicant B’s loan earns 11% interest, and the probability of default is 8%. If either applicant defaults, assume the bank receives none of the principal or interest. If an applicant does not default, the bank receives principal plus the stated interest at year-end. Treat default as a Bernoulli event with the stated probability for each loan. Ignore funding costs, expenses, and any recovery after default.
Method. For each loan, calculate the nondefault probability, the payment if there is no default, and expected receipt. Subtract the $10,000 principal advanced to find expected gain before omitted costs. This comparison avoids choosing a loan from its interest rate alone.
Applicant A. The probability of no default is \(1-0.04=0.96\). If there is no default, the interest is \(10{,}000 \times 0.09=\$900\), and the total receipt is \(\$10{,}000+\$900=\$10{,}900\). If there is a default, the receipt is $0 under the assumptions. Therefore, expected receipt is \(0.96 \times \$10{,}900 + 0.04 \times \$0=\$10{,}464\). Expected gain before omitted costs is \(\$10{,}464-\$10{,}000=\$464\).
Applicant B. The probability of no default is \(1-0.08=0.92\). If there is no default, the interest is \(10{,}000 \times 0.11=\$1{,}100\), and the total receipt is \(\$10{,}000+\$1{,}100=\$11{,}100\). If there is a default, the receipt is $0. Expected receipt is \(0.92 \times \$11{,}100 + 0.08 \times \$0=\$10{,}212\). Expected gain before omitted costs is \(\$10{,}212-\$10{,}000=\$212\).
Comparison and check. Applicant A has the lower interest rate but the higher expected gain in this simplified model: $464 compared with $212. Each result equals expected receipt minus the $10,000 principal advanced. The comparison does not establish which loan a bank should approve in practice; it omits funding costs, operating costs, and other considerations.
Common Mistakes and Exam Traps
- Assuming a one-to-one depositor-to-borrower match. A bank’s intermediary role does not mean that a particular customer’s deposit is earmarked for a particular borrower. The bank manages funding and financing at the institutional level.
- Calling the interest rate the bank’s profit. Interest income must be considered against funding costs, credit losses, and other costs. The $95,000 in the spread example is before expenses and losses.
- Confusing the purpose of an account with the purpose of a loan. An account can support holding funds and making payments; a loan provides financing under agreed repayment terms. A customer may use both services.
- Choosing a borrower by comparing stated rates alone. A higher rate may come with a greater probability or cost of default. State the assumptions and compare expected outcomes before drawing a conclusion.
- Equating intermediation with money-creation mechanics. Intermediation is about connecting funding and financing needs and managing the associated services and risks. It does not, by itself, specify how a loan is recorded or how deposits change.
Check Your Understanding
For each problem, identify the bank function or calculate the requested quantity from the stated assumptions.
- A hypothetical bank receives $240,000 in deposits from several local businesses. It approves a $36,000 loan to a repair shop and provides the shop with an account used to pay suppliers. What is the loan as a percentage of the deposit total, and why does that percentage not show that particular depositors funded the loan? (Answer: 15%; it is only a comparison of aggregate amounts, not evidence of a one-to-one match.)
- A bank earns 7% on $800,000 of loans for one year and pays 2% on $500,000 of funding and 3% on another $300,000. Assume balances stay constant and ignore all other income and costs. Calculate net interest income. (Answer: $56,000 interest income; $10,000 plus $9,000, or $19,000, interest expense; net interest income of $37,000.)
- A hypothetical business has a bank account for receiving customer payments and asks the same bank for a five-year equipment loan. Name one payment service and one financing service in this scenario, and identify the timing difference that may require the bank to manage risk. (Answer: The account supports receiving and making payments; the five-year loan finances equipment; account funds may be accessible sooner than the loan is repaid.)
- A $5,000 one-year loan earns 10%. The probability of default is 6%; if there is no default, the borrower repays principal plus interest, and if there is default, the bank receives nothing. Treat default as a Bernoulli event and ignore all costs. Calculate expected receipt and expected gain before costs. (Answer: Nondefault probability \(0.94\); full repayment is $5,500; expected receipt is \(0.94 \times \$5{,}500=\$5{,}170\); expected gain is $170.)
- Two $20,000 one-year loan proposals have no recovery in default and no other costs. Loan X earns 8% and has a 3% default probability; Loan Y earns 10% and has a 9% default probability. Assume Bernoulli default outcomes and full repayment of principal plus interest if there is no default. Which has the larger expected gain before costs, and by how much? (Answer: X: \(0.97 \times \$21{,}600-\$20{,}000=\$952\). Y: \(0.91 \times \$22{,}000-\$20{,}000=\$20\). Loan X has the larger expected gain by $932.)