FINANCIAL INTERMEDIATION or INDIRECT FINANCE is the process of obtaining funds or investing funds through third-party institutions like banks and mutual funds. As a source of funds for American businesses, indirect finance is far more common than direct finance. For every dollar that firms raise by borrowing directly from households or selling stocks directly to households, they raise about $20 through indirect finance in ways of bank loans, selling bonds and stocks to mutual funds, pension funds, insurance companies, etc.
“Funds are usually transferred from surplus to deficit units via financial institutions which act as intermediaries, borrowing from surplus units to lend deficit units. This process is called intermediation or indirect financing” (Valentine et al, 2006, pp.4).
In indirect finance, two financial assets are created. For an example investor deposits funds in a bank and the depositor has a legal claim on the bank for the deposited money or bond issued. Firstly, a financial asset is created for the legal claim that the investor have on the bank. On the other hand, the bank lends these funds to borrowers, who inturn build a legal obligation to the bank to repay the funds. Secondly, the bank holds a financial asset in its name in the form of a loan or some kind of financial instruments such as commercial bills.
(Viney, 2007, pp. 20)
Types of financial institutions:
1. Depository institutions (BANKS, CREDIT UNIONS, SAVINGS & LOAN ASSOCIATIONS)
They mainly raise their funds through deposits and invest those deposits as loans.
2. Insurance companies
They charge premiums from policy-holders, and pay compensation to policy-holders if certain events occur (e.g., Accidents, theft, Natural disasters). They try to create profit by investing those funds in securities and real estate.
3. Pension funds
They raise funds by charging subscription from their members (current workers) and make payments to retired workers. Usually they also invest their funds in securities and real estate.
4. Securities firms
Financial Institutions such as INVESTMENT BANKS, BROKERS, and MUTUAL-FUND COMPANIES are coming under this category
INVESTMENT BANKS: Usually they don’t hold deposits, or provide loans. Their main function is selling new securities for companies. Underwriters can be recognized as a very good example for investment bank. But main deferent is some time they purchase all the unsold securities.
BROKERS: buy/sell old securities on behalf of individuals.
MUTUAL-FUND COMPANIES: pool the money of small savers (individuals), who buy shares in the fund, and invest that money in stocks, bonds, and/or other assets. These are popular because they allow small savers relatively easy and cheap access and also enable them to reduce risk by holding a diversified portfolio.
Hedge funds: pool the money of a small number of wealthy individuals and institutions and invest in various financial instruments, notably derivatives.
5. Finance companies
Like banks, they use people’s savings to make loans to businesses and households, but instead of holding deposits, they raise the cash to make these loans by selling bonds and commercial paper. They tend to specialize in certain types of loans, e.g., automobile (GMAC) or mortgage loans.
6. Government-sponsored enterprises (federal credit agencies)
Some of these provide loans directly, such as to farmers and home buyers.
Some, such as the Federal National Mortgage Association (FNMA, “Fannie Mae”), guarantee or buy up private loans, notably mortgage and student loans.
Some, such as the Social Security Administration, administer social insurance programs.
According to Viney(2007), the nature of these financial intermediaries can be described through the range of functions provided by financial intermediaries in indirect financing.
1) Asset transformation
2) Maturity transformation
3) Credit risk diversification
4) Liquidity transformation
5) Economies of scale
All the functions mentioned above, are advantageous for those who invests in indirect finance.
This gives customers a broad range of financial products. According to Viney (2007), the return on a small amount of money investment would be not worth for investing. At the indirect finance, the intermediaries collect deposits from depositors, pool them and invest them by way of loans, bank overdrafts, credit cards, mortgage loans and term loans.
Savers have different preferences. For an example one saver’s preference would be deposit money for a short time and withdraw them when ever they need. Another saver’s choice would be deposit on a long term basis. Here the financial intermediaries manage both types of deposits and provide loans accordingly (Viney, 2007).
Credit risk diversification
“Credit risk transformation is derived from the contractual agreements of intermediation” Normally the financial intermediaries like banks have good credit rating than the borrowers. Managing of the deposits is also an advantage of credit risk transformation. (Viney, 2007, pp. 20).
In indirect financing, the financial intermediaries provide highly or less liquid accounts according to the depositor’s preference (Viney, 2007).
Economies of scale
“Financial and operational benefits gained from organisational size and volume.” For an example, cost of communication is distributed among all the transactions that the intermediary done. (Viney, 2007)
Risk of Indirect Financing
When consider the risk, an advantage of asset transformation is the financial intermediaries involved in indirect finance such as banks have much higher credit ratings than those of their borrowers. This was also supported by Valentine et al (2006).
Another fact related to risk is the risks of a project are spread over a large number of depositors. In case if a depositor invest the whole amount of money on a project which had gone bankrupted, the depositors would have lost all their money they invested. But if they invest through a financial intermediary their return would be less but they are much less likely to lose all the money they invested (Valentine et al, 2006).
The third fact regarding the risk is, the intermediaries involved in indirect investment issue loans to another party after doing a proper credit evaluation. Also they monitor loans which in result lessen the risk of loosing the money deposited (Valentine et al, 2006).
Expected Return of Indirect Financing
The return from indirect financing is earned from its interest rate spread, that is, the difference between their lending and borrowing rates. This spread compensates the Authorized Deposit-taking Institutions (ADIs) for the risks it accepts, one of which is the credit risk posed by its borrowers. ADIs transform the risks faced by depositors (risk transformation) by accepting the credit risk, that is, the risk of loss due to the non-payment of a loan, posed by borrowers. Typically, an ADI sets its base rate called its prime or reference rate and charges each borrower a premium over this rate, depending on the borrower’s risk. Non-performing loans result in a reduction in the ADI’s net-interest income.
Valentine, T. Ford, G. Edwards, V. Sundmacher, M. Copp, R. 2006 Financial Markets and Institutions in Australia, Pearson Education Australia, New South Wales.
Viney, C. 2007 McGrath’s Financial Institutions, Instruments and Markets, McDraw-Hill Australia Pty Limited
Comparing Direct and Indirect Financing based on Historical data
Due to the many and varied forms of both direct and indirect financing it is necessary to identify a simple tool which allows us to analyse the historical yield performance of both financial systems.
The yields of intermediaries’ products are generally linked to a distinguishable rate. A lot of the time this is the Bank Bill Swap Rate (BBSW) or Bank Bills interest rate. BBSW is the midpoint of banks’ bid and offer prices in the transfer of bank bills on the secondary market, and bank bills are products issued by businesses to banks in order to raise funds.
In general, these products mimic the majority of indirect forms of finance. These are also very closely linked to the Reserve Bank’s overnight cash rate. To illustrate the performance of indirect financing products the closing yields for each week over the past ten years has been used.
The yields of issued securities (direct financing) are driven by the market forces. Furthermore, there are many different products with stark differences. This makes it quite difficult to model the yield performance of the securities market, however, Commonwealth bonds are securities issued by the government to raise funds. They are widely considered to be extremely low risk and as a result they are usually in high demand. The RBA holds the greatest proportion of these securities, as it is how the RBA influences interest rates through supply and demand. The method for calculating the effective yields on Commonwealth bonds has changed somewhat over time; however since July 1982 the tender system has been in operation (Viney, 2007). This is a system whereby investors bid for a price on the government securities, effectively setting the yield. These bids are allocated in order of lowest yields. Because of this external factor of bidding by investors, the yields set are generally comparable (or at least correlated) with the yields of other products in the securities market. Therefore, a time-series graph of commonwealth bond yields will give an indication of past direct financing performance. The closing yields for 5 and 10 year commonwealth bonds over the past ten years have been used.
It is obvious to see that there are two distinctly correlated movement patterns: the direct and the indirect financial products. To an extent, all items on the graph tend to move in a similar direction, demonstrating the shared link with economic movements. However, in some locations the intermediated products move in conflicting directions. It is the aim of this analysis to explain these differences and hence re-iterate the theoretical facts detailed earlier.
For simplicity’s sake, the analysis will be of just 90 day bill rates vs 10 year bonds, including the overnight cash rate.
As shown in Graph 1 and 2 you can see the difference in variability. This is possibly a result of the link between government bonds and the more dynamic securities market as opposed to the intermediated market characterised by the BBSW. The driving forces for the BBSW are largely the RBA’s overnight cash rate, and the market’s speculation of cash-rate movement. The cash rate, being determined by monetary policy, means that the BBSW is not directly linked to overseas market movements or those of other (namely securities) markets in Australia (of course those movements will ultimately affect the BBSW indirectly however).
Government Bond yields, however are not only affected by the cash rate and investor speculation (to a greater extent), but they are also exposed directly to overseas market movements (mainly from America). These are the main contributing factors which will cause Commonwealth Bond yields to move in different directions to the BBSW yields. It should be noted that with the ever increasing supply and demand for non-government bonds, the yields from Commonwealth Bonds as a measure of direct financing could be skewed because of a lack of liquidity.
Generally speaking, one would expect the bonds rate to be slightly above the cash rate and BBSW to reflect the higher returns received with the higher risk. However, due to events affecting the factors mentioned above, this is often not the case. In the following section this will be outlined in certain examples over the past 10 years.
From mid 2000 to early 2001 it can be seen that the bond rate dropped below the cash rate. This is better illustrated with a yield spread curve, which is a graph of the difference between the bond rate and the cash rate.
Here it can be seen that there is a “negative yield curve”. Traditionally speaking this is usually taken as a prediction that monetary policy is contracting, and the cash rate and domestic rates will most likely be decreasing soon. It is also a rather pessimistic view- predicting that the economic outlook is poor (RBA, 2001). For the period of mid 2000 to early 2001 this was certainly the case, and then from late 2002 to late 2003 there was a “positive yield curve”. This traditionally indicates that monetary policy is expansionary, and domestic rates are low, a prediction that domestic rates and cash rates will soon be increasing.
In June 2003 US equity valuations dropped, bringing down the yields on US bonds, which intrinsically lowered Australian bond yields (RBA, 2003). This obvious had an effect on domestic rates as well, but it was a less dramatic impact as you can see. This is a clear example of the global economy having a greater effect on direct financing as opposed to indirect.
Not long after, in early 2005 the curve was once again inverted. Traditionally, this goes presents the indication that the economy is slowing, moderating inflation and easing monetary policy. However, in this case the decrease in bond rates is the result of the link with American bond rates. They remained unusually low, putting downward pressure on Australian bond rates (RBA, 2006). The booming Australian economy and subsequently inflation rates required higher cash rates than in America. Once again, this demonstrates the exposure of bond rates to the structural forces affecting global markets.
In the middle of 2007 the US experienced the credit crunch, which translated into the global economy. With the short supply of offshore short term funds for Australian banks, the banks were forced to borrow domestically, increasing the short term interest rates here in Australia. This particular example is a demonstration of how the global market can sometimes affect both the indirect and direct markets in the same way. In the following months (leading up to now), the bill rate / cash rate spread remained high, reflecting the ongoing speculation of risk underlying short-term funding. With the calming of the global credit crunch and Australia’s high inflation, it could be predicted that the traditional theories of the yield curve will once again prevail and the bond rates will push beyond the cash rate as the cash rate and linked bill rate comes back down.
The above analysis shows that the traditional theories do apply for some of the time, but the demands of such a dynamic and sensitive world economy mean that these theories need to be consistently adjusted and added to in order to keep up. The disruption of these theories also means that the traditional comparison of the risk, nature and rate of return of direct vs indirect financing will need to take into account many different market factors as well. The aforementioned aspects of comparison such as liquidity, maturity, diversification etc are most likely going to be the main driving forces in deciding which financial system to use.
As the cost of borrowing increases, there is a tendency for businesses to borrow directly, rather than indirectly to cut out the cost of the fees associated with intermediation. This graph shows an increasing growth in non-government issued securities, with a contributing factor potentially being the increases in interest rates during that time. Another major reason is most likely the continuation of businesses tending to direct financing as technology grows and makes direct financing easier.