Surplus units, deficit units and intermediation

Two kinds of unit

In any period some households, firms and governments spend less than they take in — they are surplus units — and others spend more, and are deficit units. The labels are about this period, not about identity: a household saving for a house is a surplus unit; the same household after it borrows a mortgage is a deficit unit; the federal government is a deficit unit most years and a surplus unit in a few. A financial market exists to move funds from the first group to the second, and to price the claim that comes back the other way.

There are exactly two routes.

Worked example — one surplus, two routes

Halton Dairy Co-op has finished its year with $10,000 it does not need until next spring. Lakehead Robotics, a Thunder Bay automation firm, needs to borrow to build a second assembly line.

Route 1 — direct finance. Halton buys $10,000 of a Lakehead Robotics bond through an investment dealer. The dealer finds the bond, executes the trade and takes a commission. What Halton owns afterward is a claim on Lakehead: Lakehead promises Halton the coupons and the principal. If Lakehead fails, Halton loses. The dealer moved the security; it did not change what the claim is or who it is on. A middleman is not an intermediary unless it transforms the claim.

Route 2 — intermediated finance. Halton deposits the $10,000 at a credit union. The credit union pools it with thousands of other deposits and lends $2,000,000 to Lakehead for five years. What Halton owns now is a claim on the credit union — a deposit, repayable on demand. If Lakehead fails, the credit union absorbs the loss; Halton's deposit is untouched. The credit union has stood between the two units and issued its own claim to one while holding a different claim on the other. That is intermediation.

What the intermediary added

Five things, and the exam asks for them as a list:

1. Pooling. Many small deposits fund one large loan that no single saver could make.
2. Maturity transformation. Halton can withdraw tomorrow; Lakehead repays over five years. The intermediary carries the mismatch, funding a long loan with short deposits.
3. Diversification. Halton's $10,000 is spread across every loan the credit union makes, not tied to one borrower's fortunes.
4. Expertise. The credit union assesses Lakehead's credit, writes the covenants and monitors the loan — work Halton could not do for $10,000.
5. Lower cost. Screening, contracting and collecting are done once for the pool rather than once per saver, so the all-in cost of moving the funds falls.

What the intermediary does not add is a guaranteed return: a deposit's safety comes from the intermediary's own balance sheet and, for eligible deposits, from deposit insurance — not from the act of intermediation. That is the distractor the paper likes.

Classify four flows

Before the questions, sort these. (a) A pension plan buys a new issue of provincial bonds — direct (the claim is on the province). (b) A student's summer earnings sit in a chequing account — intermediated (the claim is on the bank). (c) A dealer sells one investor's shares to another — direct (the dealer executed; no claim changed). (d) A life insurer collects premiums and buys corporate bonds — intermediated (the policyholder's claim is on the insurer). If (c) tempted you, remember that being in the middle of a trade is not the same as standing between the two claims.