Theissueofnewfinancialinstrumentsgeneratesaflowoffundsthroughtheprimarymarketsfromthe provideroffundstotheuserofthosefunds.Thisflowcanoccurintwoways:
• Thefundsmayflowthroughadirectrelationshipfromtheprovideroffundstotheuseroffunds.
• Theflowoffundsmayoccurthroughafinancialintermediarysuchasabank.
Withinthefinancialmarkets,eachformoffinancialflowisanimportantsourceoffinance.
Direct finance
Whenfundsareraisedintheprimarymarketsusingdirect finance,thecontractualagreementisbetween theprovideroffundsandtheuseroffunds.Thefundsarenotprovidedbyafinancialinstitution.The relationshipsthatexistbetweensaversandtheusersoffundsintheprovisionofdirectfinanceare showninFigure1.4.
Securities financial assets that are traded in a formal secondary market (e.g.
stock exchange)
Direct finance funding obtained directly from the money markets and capital markets
Financial instruments Suppliers of funds
(surplus units) Users of funds
(deficit units) provide funds
Brokers and dealers
Figure 1.4 Direct financial flows
The‘brokersanddealers’includedinFigure1.4mayactasagentsthroughwhichtheinstructions oftheprovidersoffundsandusersofthefundsarecarriedout.
Thebroker does not provide the finance, but receives a fee or commission for arranging the transactionbetweenthetwoparties.Thebrokerhasnorightstothebenefitsthatmayflowfromthe purchaseofthesecurity.Itisnotnecessaryforabrokerordealertobeinvolvedatallinthetransaction.
Aninvestorseekingtopurchasesharesinacompanywillgenerallyarrangethetransactionthrough a stockbroker. The stockbroker acts only as an agent to the transaction and, on behalf of a client, facilitatesthedirectpurchaseorsaleofsharesbyaccessingtheelectronicsharetradingsystemsofthe stockexchange.
Examples of direct financing include share issues, corporate bonds and government securities.
Thesesecuritiesarediscussedfurtherinvariouschaptersofthetext.
The benefits and disadvantages of direct finance
Direct finance is generally available only to corporations and government authorities that have establishedagoodcredit rating.Acreditratingisanassessmentofthecreditworthinessofanissuerof
Broker an agent who carries out the instructions of a client Dealer makes a market in a security by quoting both buy (bid) and sell (offer) prices Credit rating the assessment by a credit rating agency of the creditworthiness of an obligor to a financial obligation
paper.Asthecontractualrelationshipindirectfinanceisdirectlybetweentheprovideroffundsandthe issuerofpaper,theriskthattheissuermaydefaultisanimportantconsideration.Therefore,borrowers thatdonothaveanestablishedgoodcreditratinggenerallyarenotabletoborrowdirect.Thecredit ratingprocessisdiscussedinChapter11.
Themainadvantagesofdirectfinanceareasfollows:
• It removes the cost of a financial intermediary. If a borrower obtains a loan from a financial institution, the borrower will pay a profit margin to the intermediary. Should a corporation or government authority have an investment-grade credit rating (e.g. Standard & Poor’s BBB and above),itmaywellbeabletoraisefundsdirectlyfromthedomesticorinternationalmarketsata lowertotalcostthanborrowingthroughabank.
• Itallowsaborrowertodiversifyfundingsourcesbyaccessingboththedomesticandinternational moneyandcapitalmarkets.Thisreducestheriskofexposuretoasinglefundingsourceormarket.
• Itenablesgreaterflexibilityinthetypesoffundinginstrumentsusedtomeetdifferentfinancing needs.Moresophisticatedfundingstrategiesmaybeusedtoraisefunds.Forexample,acorporation mayobtainaUSdollar(USD)loanintheinternationalcapitalmarketsandthenuseUSDexport incometorepaytheloan.
• An organisation may enhance its international profile by carrying out transactions in the internationalfinancialmarkets.Anincreasedprofileinthefinancialmarketsmaybebeneficialin establishingareputationinthemarketsforthefirm’sgoodsandservices.
Therearesomedisadvantagesthatmay,attimes,beassociatedwithdirectfinancing.Theseinclude:
• There can be a problem of matching the preferences of lenders and borrowers. For example, a lendermayhaveacertainamountoffundsavailableforinvestment,butthisamountmaynotbe sufficientfortheneedsoftheborrower,whowouldthenneedtoseekoutandenterintofunding arrangementswithadditionalsuppliersoffunds.Theremayalsobeamismatchinthematurity structureofthefundingastheborrowermayneedtoborrowforalongerperiodthantherisk-averse investoriswillingtolend.
• Theliquidityandmarketabilityofadirectfinanceinstrumentmaybeofconcern.Howeasyisitfor theholderofaninstrumentissuedbydirectfinancetosellatalaterdate?Isthereadeepandliquid secondarymarketinthatinstrument?Notallfinancialinstrumentshaveanactivesecondarymarket throughwhichtheymaybesold.
• Thesearchandtransactioncostsassociatedwithadirectissuecanbequitehigh.Thesemightinclude advisoryfees,thecostofpreparingaprospectus,legalfees,taxationadvice,accountingadviceand specificexpertadvice(suchasageologist’sreport).Onverylargedirectfinancetransactionsthe feesandcostsmayrunintomillionsofdollars.
• Itcanbedifficulttoassessthelevelofriskofinvestmentinadirectissue,particularlydefault risk.
Accountingandreportingstandardsmayvarybetweennation-states,andinformationaboutanissuer maybelimitedtotheprospectusandtheissuer’screditrating.
Intermediated finance
The critical difference between direct and intermediated finance can be found in the relationships thatexistbetweenthesaver,theintermediaryandtheuseroffunds.Withintermediated finance,as illustratedinFigure1.5,theintermediaryhasanactiveroleintherelationship.Theintermediary,in providingfinancetodeficitunits,acquirestheownershipofthefinancialinstrumentthatiscreatedas partofthetransaction.Italsoobtainstherightstothebenefitsandrisksassociatedwiththeownership ofthatasset.Thebenefitsincludethereceiptofinterestpaymentsandtherepaymentofprincipal.On theotherhand,asignificantriskacceptedbytheintermediaryisdefaultorcreditrisk—thatis,therisk thattheborrowermaynotmakeallloanrepayments.
Default risk
the risk that a borrower may not meet financial commitments such as loan repayments when they are due
Intermediated finance
financial transaction conducted with a financial intermediary (e.g. bank deposits and bank loans); separate contractual agreements
Inordertobeabletoprovideloanstoitscustomers,anintermediaryobtainsitsfundingfrom savers.Saversreceivefinancialinstrumentsissuedbytheintermediary,suchasatermdepositreceipt issuedbyabank.Acontractualagreementthenexistsbetweenthesaverandtheintermediaryinrelation tothetermdeposit.Theintermediarycreatesaseparatecontractualagreementwiththeborrower(the ultimateuseroffunds).Thesaverhasnoclaimontheincomeorassetsoftheultimateborrower.Those entitlementsresidewiththebankastheintermediary.Thesaveronlyhasaclaimforthepaymentof interestandthereturnofprincipalatmaturityfromthebank.Ontheotherhand,underaseparate loancontract,theintermediaryreliesontheborrowerforrepaymentoftheloan.Failureofthebank torecoverthefundsfromtheborrowerdoesnotchangethecontractualrelationshipthebankhaswith itsdepositor.
The benefits of financial intermediation
Veryoftentheportfoliopreferencesofsaversandborrowersdiffer.Forexample,arisk-averselender maybepreparedtoreceivealowerrateofreturninexchangeformaintainingfundsatcall.Onthe otherhand,aborrowermaybepreparedtopayahigherrateofreturn,butmaywanttohavethefunds availableforanumberofyears.Itislikelythatmanysaversandborrowerswouldfinditdifficulttomeet theirinvestmentandfundingneedsifonlydirectfinancewaspossible.
Anintermediaryisabletoresolvethisproblemandsatisfythepreferencesofbothparties,andat thesametimemakeaprofit.Anintermediaryisabletotransformshort-termdepositfundsintolonger- termloanfunds.Anessentialeconomicroleofanintermediaryistoresolvetheconflictingpreferences ofsurplusunitsanddeficitunits,andthusencouragebothsavingsandproductivecapitalinvestment.
In carrying out the role of offering instruments with varying financial attributes (risk, return, liquidity,timingofcashflows),intermediariesperformarangeoffunctionsthatareimportanttoboth saversandborrowers.Theseare:
• assettransformation
• maturitytransformation
• creditriskdiversificationandtransformation
• liquiditytransformation
• economiesofscale.
Asset transformation
Financial intermediaries engage inasset transformation by offering their customers a wide range of financialproductsonbothsidesofthebalancesheet,includingdeposit,investmentandloanproducts.
Withoutintermediation,surplusunitsthatcouldgenerateonlysmalllevelsofsavingswouldnot haveanyincentivetosave;andusersoffunds,suchasindividualsandsmallbusinesses,wouldfindthe costofobtainingloanstoogreattobeworthwhile.Intermediariesspecialiseinthegatheringofsavings andcanachieveeconomiesofscaleintheiroperations.Theycanprofitablyreceivesmallamountsfrom manysavers,poolthemintolargeramountsandmakethemavailableasloanstoborrowers.
Financialintermediariesprovidearangeofdepositproductswhichmeetthevaryingpreferences andneedoftheircustomers.Theseincludedemanddepositaccounts,currentaccounts,termdeposits
Asset transformation the ability of financial
intermediaries to provide a range of products that meet customers’ portfolio preferences
Financial instrument Financial instrument
Suppliers of funds
(surplus units) Users of funds
(deficit units)
funds funds
Intermediaries
Figure 1.5 Intermediated financial flows
and cash management trusts. At the same time, financial intermediaries provide a range of loan products,includingoverdraftfacilities,termloans,mortgageloansandcreditcardfacilities.
Maturity transformation
Most frequently, savers prefer great liquidity in their financial assets, while borrowers tend to prefer a longer-term commitment in the funds they borrow. By managing the deposits they receive, intermediariesareabletomakeloansofalonger-termnaturewhilesatisfyingsavers’preferencesfor shorter-termsavings.Thisisreferredtoasmaturity transformation.
Banks provide a good example of the maturity transformation function of intermediaries. The depositstheyreceivearegenerallyquiteshortterminnature(typicallylessthanfiveyears),yetalarge proportionoftheirlendingisforhomeloansthatfrequentlyhaveamaturityof30years.Thebanks thereforehaveamismatchbetweenthetermstomaturityofalargeproportionoftheirsourcesoffunds andtheirloanliabilities.
Financial intermediaries are able to perform such extremes of maturity transformation for two reasons.First,itisunlikelythatallsaverswouldchoosetowithdrawtheirdepositsatthesametime.
Depositwithdrawalsduringanyparticularperiodaregenerallymoreorlessmatchedbynewdeposits.
Second,andmoreimportantly,financialintermediariesthatengageinmaturitytransformationrelyon liability management.
Shouldabank’sdepositbase(liabilities)begintodeclinebelowthelevelnecessarytofundtheir forecastloanportfolio(assets),thenthebankmayadjusttheinterestratesthatitoffersinordertoattract the necessary additional deposits. More probably, the bank will issue further securities (liabilities) directlyintothemoneyorcapitalmarketstoraisetheadditionalfundsrequired.
Credit risk diversification and transformation
Credit risk transformationoccursthroughthecontractualagreementsofintermediation.Asaverhasan agreementwiththefinancialintermediary,andthereforethecreditriskexposureofthesaverislimited totheriskoftheintermediarydefaulting.Thefinancialintermediaryhasaseparateloanagreement withtheborrowerandisexposedtothecreditriskoftheborrower.
Financialintermediarieshavetwoadvantagesovermostindividualsaversinmanaginginvestments.
First,intermediariesspecialiseinmakingloansandthereforedevelopanexpertiseinassessingtherisk ofpotentialborrowers.Thisexpertisecomesfromthetechnicalskillsoftheemployeesandsystemsin assessingandmonitoringloanapplications,andalsofromtheinformationthatisacquiredthrough priordealingswiththeborrower.
Liquidity transformation
Savers generally prefer more, rather than less, liquidity in their investments. One reason for this is thatthetimingofasaver’sincomeandexpenditureflowswillnotperfectlycoincide.Therearetimes when income is higher than expenditure and savings are available for investment purposes. On the otherhand,therearetimeswhenexpenditureexceedsincome.Inordertotryandmanagethistiming problem,saverswilltendtoholdatleastsomeoftheirfinancialassetsinaveryliquidformthatcan easilybeconvertedtocash.
Liquidity transformationismeasuredbytheabilitytoconvertfinancialassetsintocashatsomething closetothecurrentmarketpriceofthefinancialinstrument.However,liquidityhasanotherdimension:
thetransactioncostsassociatedwithacquiringanddisposingofthefinancialasset.Transactioncosts canoftenbequitehigh.However,afinancialintermediarymayhavethecapacitytolowertransaction feesbyspreadingfixedcostsacrossalargenumberoftransactions.Thetimeinvolvedincarryingouta transactionmayalsobeanimportantcomponentofthetotaltransactioncost.
Many intermediaries provide highly liquid accounts in which individuals may store some of theirwealth.Forexample,ademand(at-call)accountwithabankrepresentscompleteliquidity.The depositorhastherighttowithdrawfundswithoutnotice.Thereiszeroriskthatthevalueoftheasset, whenitisconvertedintocash,willbelessthanthevalueofthedepositinthedemandaccount.In addition,thetransactioncostsassociatedwithconvertingthecreditbalanceintocasharelimitedto
Maturity transformation financial intermediaries offer products with a range of terms to maturity
Liability management when banks actively manage their sources of funds (liabilities) in order to meet future loan demands (assets)
Credit risk transformation a saver’s credit risk exposure is limited to the intermediary; the intermediary is exposed to the credit risk of the ultimate borrower
Liquidity transformation measured by the ability of a saver to convert a financial instrument into cash
transactionfeesimposedbythebank.Intermediariessuchascommercialbankscanofferhighlyliquid assetstosavers,whichtheultimateusersoffundswouldbemostunlikelytobeabletodo.
Banks have further extended liquidity arrangements by adopting systems such as electronic networks:automatictellermachines(ATMs)andelectronicfundstransferatpointofsale(EFTPOS) arrangements.
Economies of scale
Financial intermediaries gain considerableeconomies of scale due to their size and the volume of business transacted, and therefore have the resources to develop cost-efficient distribution systems.
Banksmaintainextensivebranchnetworksastheirprimarydistributionmechanism.Atthesametime theyalsoprovideextensivetechnology-baseddistributionsystemssuchasATMs,EFTPOS,telephone bankingandinternetbanking.
The cost of the sophisticated computer and communication systems required to support such distributionnetworksisspreadoverthemillionsoftransactionsprocessed.
Intermediaries also obtain cost advantages through effective knowledge management and the accumulation of financial, economic and legal expertise. For example, a bank will typically use standardiseddocumentationforitsdepositandlendingproducts.Thebankknowsthatthesedocuments willcomplywithregulatoryandlegalrequirements.Othercostadvantagesincludeareductioninsearch costsforbothsaversandborrowers;thatis,saversdonotneedtoinvestigatethecreditworthinessofthe ultimateborrower.Theintermediarywillhavethatdataavailablebeforemakingaloandecision.
Inacompetitivemarket,financialintermediariesshouldpassonefficiencygainsintheformof reducedinterestmarginsandfees.