Sunday, July 5, 2009

Banks as financial intermediaries

Financial markets links savers and borrowers. This link is accomplished through either direct finance or indirect finance. Direct finance occurs when savers lend funds directly to borrowers. For example, if you ask a classmate to loan you money to buy a new car and she agrees, you are engaging in direct finance. No third party matched you (the borrower) with your classmate (the lender). In fact, however, direct finance most often involves the assistance of third party, such as a broker, who brings buyer and seller together. When IBM issues new bond, it uses the services of various specialists in the financial markets. The exact procedure need not concern us here; simply note that the ultimate buyers of the IBM bonds will usually engage the services of a broker to arrange the sale. This is one way financial markets facilitate direct finance.
In contrast, indirect finance involves a particular type of middleman a third party who stands between the borrower and the lender. This middleman is called financial intermediary, and his or her role is to accumulate funds from various savers and lend those funds to borrowers. Banks are financial intermediaries because they accept deposits and lend those funds to borrowers. Credit union and savings and loan associations also are financial intermediaries. Less obviously, life insurance companies and pensions accumulate savings and lend those funds to borrowers, thus performing the role of financial intermediaries.
In all these cases, the financial intermediary borrows funds from savers and lends them to borrowers. If you obtain a car loan from a bank, the bank is actually loaning you money that other people have on deposit there. The depositors receive interest from the bank; you pay the bank interest on the loan. The bank is in the middle, earning a profit on the difference (margin) between the rate you pay for the loan and the rate it pays depositors.
There is an important distinction between the function of a financial intermediary and that of a broker. A broker brings together a buyer and a seller of a financial instrument such as a bond, but does not personally issue a bond or otherwise lend to borrower; instead, the broker facilitates the transaction without personally creating a financial instrument. In contrast, a financial intermediary accumulates savers funds and lends them to borrowers by making a loan from itself. Thus, a bank makes a loan to a borrower instead of merely introducing the borrower to one or more depositors and brokering a loan between the two.
Thus, banks and other financial intermediaries are a special kind of middleman. They profit on the difference between the interest rate they pay on deposit and the interest rate they collect on loans. Their function is to repackage depositors' savings into loans to borrowers in the same way a retailer might purchase produce in bulk from produce dealers and repackage it for sale at the supermarket produce counter.
With direct finance, the final lender (here Ross Perot) provide funds directly to the borrower (AT&T). In this case, the role of financial markets is to facilitate the transaction, and Ross Perot will probably rely on a broker to carry it out. With indirect finance, Ross Perot would deposit money in financial intermediary such as Nations Bank, which in turn would make a loan to AT&T. Note that in this case, the financial intermediary is both a borrower (from depositors) and a lender.

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