What is Indirect Finance?
The transfer of funds from primary lenders to primary borrowers by converting the borrower’s securities into indirect securities and the lender’s funds into indirect funds is the process of financial intermediation. Financial intermediaries form the basic structure of indirect financing; borrowers access money through them in the form of a loan from the financial markets. For example, a business borrows money from a bank, rather than directly from investors. The bank charges the company interest on the loan, thereby paying interest to its own investors and depositors.
Direct vs. Indirect Financing
Financing consists of the act of providing funds for business activities, making important purchases or investing in other firms. Companies do this through different methods, such as through equity financing, credit arrangements or by purchasing or issuing securities, in the form of stocks and bonds.
These are all different forms of direct financing. A business is not entitled to pay any interest rate in these cases. These transactions take place through the financial markets, where investors lend their money directly to borrowers. Brokers, dealers and investment banks play important roles here.
In the indirect financing mode, financial intermediaries play a critical role. They purchase direct claims with a specific set of parametres from borrowers and then convert them into direct claims, with a different set of parameters, to be sold to the lenders.
Also, in direct financing, there is involvement of one financial instrument between the lender and borrower, while in indirect financing, there are two instruments involved; one between lenders and financial intermediaries and the other between financial intermediaries and borrowers.
Why do Businesses Choose Indirect Financing?
As the financial intermediaries take on the responsibility of approaching investors and performing the due-diligence process, indirect financing is often the quicker way for businesses to raise money. In many countries, indirect financing takes a front seat, as compared to direct financing methods, since financial intermediaries are very efficient in reducing the information costs associated with lending. This is done through economies of scale and expertise. They can quickly curb the problems associated with asymmetric information; that too at a lower cost.
They also provide critical financial services, such as:
· Denomination and Maturity Transformation
Suppose a company wants to raise $500 million, which is not possible from retail investors. A bank, on the other hand, will raise this amount by accumulating savings of thousands of depositors and will issue a loan to the company. In this way, banks help in denomination transformation. That is, they take the help of small and medium-sized deposits to raise large sums of money for companies.
Next, a bank can confidently issue long-term loans. On reaching their maturity date, deposits will either get renewed or be replaced by a different deposit scheme. They offer maturity transformation. By providing both these benefits, they offer a company sustainable liquidity.
· Risk Diversification
Financial intermediaries have greater expertise and invest in multiple loans. Whatever money we put into the banks, they deploy across a huge section of borrowers. Pooled funds are diversified into many different instruments. This diversifies the associated risk. Intermediaries like mutual funds and commercial banks have the resources to employ risk management experts who look into the risk and return ratio of alternative investments and take appropriate action. Banks take losses from defaulted loans and still guarantee deposits back.
These factors are both pros and cons of indirect financing. The magnitude of transaction costs, such as brokerage commissions, are reduced on a per unit scale, but obviously this will happen till a certain point only, after which fixed costs will be incurred again. The single most prominent disadvantage is that financial intermediaries offer a spread, which is usually avoided in direct financing.
Who are Financial Intermediaries?
Financial intermediaries pool savings and investments of thousands of customers to lend money to or invest in companies or individuals and earn returns. The profit is the difference between what they earn through their asset lending and what they pay as liabilities. While the loans, stocks and bonds are assets, the deposits and other payment obligations are liabilities.
Broadly, these institutions can be categorized into three branches:
1. Depository Institutions
They take deposits in the form of savings and investments, and give them to borrowers in the form of loans. They include commercial banks, like Bank of America or Citibank. Credit unions, like the State Employee Credit Union or the Allegacy Federal Credit Union, fall under this category too. Other examples including Savings and Loan (S&L) Associations and Mutual Savings Funds. The Piedmont Federal Savings and Loan Association is an example of a depository institution.
While commercial banks raise funds primarily through savings deposits, issuing checkable deposits and time deposits, credit unions deal with deposits in the form of shares. The holders of these share accounts are typically members or employees of an organisation.
2. Contractual Savings Institutions
These institutions gain funds at periodic intervals, based on a contract, which specifies the conditions or events in which a payout will be necessitated. Insurance companies fall under this category. These can be life insurance companies like MetLife or Prudential Life Insurance. Other examples include pension funds or government retirement funds. Fire and casualty insurance companies, like State Farm insurance, also qualify for this category.
Insurance companies gain funds through the premiums paid by policyholders, in order to keep their policies active. They buy corporate bonds and mortgages. Pension funds provide retirement benefits in the form of annuity. They also invest in corporate bonds and stocks.
3. Investment Intermediaries
These typically include mutual funds and finance companies. Finance companies lend money to people for buying consumer durables. They sell commercial papers and issue stocks or bonds to raise funds. Mutual funds also issue and sell their company’s shares; the proceeds of which are then invested in a diversified portfolio of securities. There are stock mutual funds, corporate bond funds, mortgage-backed securities funds and money market mutual funds. Hedge funds too fall under this category, open to a limited number of accredited investors.
Commercial banks have been the largest sources of indirect financing till now. In recent years though, hedge funds and insurance companies have gained popularity too. Together they represent a huge percentage of sources of external funds for companies worldwide. They help many small and medium-sized organisations flourish. These companies do not issue marketable debt and equity securities like big companies, who have greater access to the financial markets for issuing of bonds, stocks and commercial papers.
