(This post is a part of the series on Basics of Finance and Investing.)

You and I, as members of the household sector, want to invest our money, whereas the business sector wants to raise money to pay for real assets. Such supply and demand requirements create an atmosphere of synergistic interactions between these two sectors.

Financial intermediary - (1) Banks

The problem is that the size of a typical household investment is too small to meet the need of large businesses. I cannot lend Microsoft enough money to make a whiff of a difference to its finances. But, if funds are pooled together from a large number of households, businesses can then borrow from this substantial pool.

Thus, a financial intermediary can make a profit from the difference between the interest it charges the businesses (borrower) and the interest it pays the households (lender). This is exactly what a bank does. The mismatch of scales between the interests of household and business sectors allow banks to earn by providing a service that indirectly brings them together.

(2) Investment companies

Besides borrowing from banks, businesses also sell stocks and bonds directly to the investors. Here again, the smallness of household assets becomes a problem. An investor cannot often afford the substantial brokerage and trading costs to own a large number of securities from different companies (that is needed to adequately diversify his portfolio).

Investment companies, such as Vanguard, Fidelity and T. Rowe Price, have evolved from these mutual needs to sell and buy company securities. Like banks, they pull together funds from small investors and purchase a variety of securities. Each investor pays for shares of this composite holding, known as a mutual fund, which provides the necessary diversification. Part of the payment goes to the fund operators as management fees.

Investment banks

Unlike the banks and investment companies that serve as intermediaries between investors and businesses, investment banks provide services only to the businesses. Because firms issue stocks and bonds to raise funds, investment bankers such as Merrill Lynch, Goldman Sachs and Smith Barney advice them, for a fee, on the prices they should charge for these securities, prevailing market conditions, appropriate interest rates and so on. They also act as brokers in seeking out investors when new securities are issued.

See related posts:

1. Players in an investing environment
2. What is a "money market"?
3. What is a "market"?
4. What is an "asset"?
5. What is a "bond"?
6. Basics of Finance and Investing