Financial intermediation is a very well-known process that most of us are familiar with. When a primary lender transfers his funds to the primary borrower, financial intermediation happens. But this process essentially requires two conditions. During financial intermediation, the borrower’s securities convert into indirect securities, and the lender’s funds convert into an indirect fund. Financial intermediaries are considered as the backbone in forming the basic structure of indirect financing. Here, the person borrowing the money access financial help through them as a loan from the financial market.
What is indirect finance?
Indirect finance represents a process when borrowers borrow funds indirectly from the financial market (such as banks) rather than directly from investors.
The list of financial intermediaries providing indirect financing is:
- Building societies
- Collective investment schemes
- Cooperative societies
- Credit unions
- Financial advisers or brokers
- Insurance companies
- Mutual savings banks
- Pension funds
- Savings banks
- Stock exchanges
For instance, a small business entity doesn’t approach any investor directly. Instead, the well-known source of borrowing money is a loan from a bank. Bank provides a loan to the business and charges a particular amount as interest. Bank uses this interest to pay its own interest amount to the investors and common depositors.
Direct vs. Indirect finance
What is the Difference Between Direct and Indirect Financing?
While direct financing borrows money directly from the lender, indirect financing implies borrowing money using intermediaries. There is only one financial instrument between the borrower and the lender in direct financing, while indirect financing consists of two different instruments.
What does the word ‘financing’ mean? Financing is basically putting your money as a fund for business entities, investing in any other firm, or simply putting your money for important business purchases. Financing can be of two types: direct and indirect financing. Equity financing, purchase of securities, or credit arrangements in bonds and stocks are commonly seen activities in financing. These methods are considered as a few forms of direct financing.
In direct financing, a business is not adhered to pay any interest rate. In these methods, generally, the investor lends his money directly to the borrowers with brokers, dealers, or even investment banks.
Indirect financing by financial intermediaries is the most important concept when you opt for indirect financing. These intermediaries play key roles in purchasing direct claims from the borrower, along with a particular set of parameters. Then they convert these direct claims with a different set of parameters to propose the lender for selling purposes. This is the most common indirect financing example seen across businesses.
The main difference between these two types of financing is the number of financial instruments involved. In direct financing, there is only one financial instrument between the borrower and the lender. But in the presence of intermediaries, indirect financing consists of two different instruments. The first is between the lenders and the intermediaries, and the second one is between the intermediaries and the borrowers.
Indirect finance example: Client deposits funds into checking account in the bank. Bank uses the money to make a loan to a fellow student.
Advantages of Indirect Financing For Businesses
The effective participation of financial intermediaries in indirect financing has made its way to popularity across businesses. The intermediaries take all the responsibilities, from approaching the investors to checking and completing the required process. In this way, businesses can raise more money in lesser time with no direct involvement. The financial intermediaries have been working very efficiently in reducing the information cost related to money lending. They are also very quick with the asymmetrical information problem at a meager cost. Economies of scale and expertise are crucial to make it cost-effective. Not only that, the intermediaries provide critical financial services as well. Indirect financing advantages include the following:
1. Maturity Transformation and Denomination
When a company wants to raise a whopping amount of money, for example, $400 million or more, it is impossible to get help from retail investors. In these cases, the bank appears as a savior by sanctioning a loan for the company. The bank can issue the loan by accumulating the savings money of thousands of small and medium deposits and issue a massive loan for the company,
That’s not all. The bank can also issue a confidential long-term loan. Once these reach their maturity date, two things can happen to the deposit; they can get renewed, or a different scheme will replace them. These processes are very beneficial for businesses to get sustainable liquidity.
2. Risk Diversification:
Financial intermediaries are experts considering their investment in multiple loans at the same time. The money that the depositors put into the bank can be deployed across a huge portion of the borrowers. Pooled funds diversify associated risk as they are put into many different instruments. Popular financial intermediaries such as mutual funds or commercial banks usually have risk management experts as they are very resourceful. The risk management team looks after the risk and return ratio of alternative investments and suggests necessary actions. This is why banks can guarantee a safe deposit and always return the depositor’s money even when it has to go through a loss.
Although these factors are considered the advantages of indirect financing, these can turn into disadvantages. There are several high-scale costs, such as brokerage commission. These costs can be reduced on a per-unit scale but only at a certain point. After that, the fixed costs will be active again. The biggest disadvantage of indirect financing is the spread offered by the intermediaries.
All You Need to Know About Financial Intermediaries
The intermediaries’ main work is to invest the savings and investments of their customers and lend money to individuals or invest in companies to get returns. The difference between their earnings through asset lending and their payback to the customers as liabilities is their profit. In their case, the assets are the loans, bonds, or stocks, and the liabilities are the customer deposits and any other form of the invested money. There are generally three branches of this institution. They are as follows.
- Depository institutions
The popular depository institutions are commercial banks, credit unions, savings and loan associations,s and mutual funds. These institutions generally take their customers’ deposits as savings or investments and lend them to the borrower. The most commonly viewed intermediary, the commercial banks, raises the loan amount through savings or issuing checkable deposits and time deposits. On the other hand, credit unions are all about deposits in the form of shares. Typically, these shareholders are the member or employees of an organization.
The primary way in which commercial banks can raise funds is through saving deposits, time deposits, checkable deposits, and credit union deals, including shares as deposits. Generally, employees or members of an organization hold these share accounts.
- Contractual Savings Institutions
The most familiar contractual savings institutions are life insurance companies, pension funds, or retirement funds provided by the government. These type of intermediaries get their hands on funds at periodic intervals. Working entirely based on a contract, these institutions work under a specific list of conditions. The contract includes certain events when the payroll will be necessitated. Whereas the insurance companies get the fund through premiums paid by the policyholders, pension funds work with retirement benefits in an annuity. Both insurance companies and pension funds invest in corporate mortgages, bonds, and stocks. Policyholders are required to pay a premium to the insurance companies to keep their policies running. These premiums act as funds for insurance companies. These policyholders also buy mortgages and bonds. Retirement benefits are reaped from pension funds as an annuity. Some policyholders invest in stocks and bonds as well.
- Investment Intermediaries
Mutual funds and finance companies fall under this category. These entities issue and sell their company’s share and later invest the proceeds in a different, diversified portfolio of securities. The funds include corporate bond fund, stock mutual fund, money market mutual fund, and mortgage-backed security fund. The hedge fund, which is only accessible to accredited investors, is also included in this category.
Although the commercial bank always has the edges for being the largest indirect investment source, hedge funds and insurance companies are not far behind. These three, altogether, are being the largest source of financial help for businesses across the globe. Small and medium-sized businesses are becoming a major source of the economy with these indirect finance methods. In the absence of huge marketable debt and equity security clauses, these intermediaries rule it for indirect finance.