Indirect Finance

1. Learning Unit #5
Indirect Finance

2. Objectives of Learning Unit
• Indirect Finance
– How Funds are Transferred?
– How Three Financial Services are Provided?
• Indirect Finance in Action
– Types of Financial Intermediaries
• Why People Use Financial Intermediaries
More Often than Direct Finance?

3. Indirect Finance
(Financial Intermediation)
• Funds are transferred from lenders to
borrowers through financial intermediaries,
which issue own IOUs to lenders and acquire
IOUs issued by borrowers.
• Financial intermediaries: institutions that
borrow funds from savers who have excess of
funds and then make loans to borrowers who
have short of funds.

4. Distinction between Direct Finance
and Indirect Finance
Although both direct finance and indirect finance channel funds
from saver-lenders to borrower-spenders, they are distinguished
in one important aspect:
In the direct finance, there is only one financial instrument
involved between lenders and borrowers where borrowers
directly owe to lenders.
In the indirect finance, there are two financial instruments
involved between lenders and borrowers; one between lenders
and financial intermediaries, and another between financial
intermediaries and borrowers. Thus, borrowers do not directly
owe to lenders, but indirectly through financial intermediaries.

5. How Financial Intermediaries Transfer
Funds
Financial intermediaries pool the funds of many
small savers by issuing own IOUs and lend to
many individual borrowers by acquiring IOUs.

6. How Financial Intermediaries Provide
Three Financial Services
• Risk-sharing
Financial intermediaries have more information & expertise and diversify
into many loans
• Liquidity
Financial intermediaries transform long-term financial instruments (issued
by borrowers) to short-term financial instruments (issued by financial
intermediaries)
• Information
Financial intermediaries gather and process information at low cost
through economies of scale and expertise
Through economies of scale and its expertise, financial intermediaries can
reduce the problems created by asymmetric information at low cost and
quickly (lower transaction costs).

7. Risk Sharing
Financial intermediaries reduce or eliminate the
exposure of savers to risk by
– Pooling funds to share risks among savers.
• Your deposit at a bank is pooled with other deposits, and you share
risk with other depositors.
– Diversifying pooled funds into many different financial
instruments.
• Only a small portion of your deposit goes to a particular borrower.
– transferring risk to the financial intermediaries.
• Your bank takes a loss from a defaulted loan and still guarantees your
deposits.
Ex. If one borrower defaults a loan from your bank, its loss
will be shared by all depositors and the bank (its
shareholders).

8. Liquidity
Financial intermediaries provides liquidity service by
– Diversifying pooled funds into many different financial
instruments with different maturities.
• A bank makes loans to many different borrowers with different
maturities, so always someone pays back to the bank which keeps
funds in vault.
– Pooling funds and maintaining liquidity.
• Your deposit is not locked to any particular borrower. You can get
funds back from the bank before the borrower (of your funds) pays
back to the bank.
• Someone always deposits funds at the bank and the bank does not loan
all of them out, so some funds are kept in the bank in case of
withdrawals.
Ex. Even though cash that you deposited at your bank was
loaned to someone, the bank keeps ample funds in vault to
meet your withdrawal anytime.

9. Information
Financial intermediaries provides information service by
– Collecting information of prospective borrowers
• A bank asks every prospective borrower (applicant) to fill basic financial
information and check credit background (e.g. credit history, credit score).
– Using expertise to sort out good borrowers among risky borrowers.
• A bank hires financial professionals with finance and accounting background
who know how to evaluate applicant’s credit background, and train them to
keep up their expertise.
Ex. When you deposit your funds at a bank, you do not know who is going
to borrow your funds. The bank collects all necessary information and
processes it to make the best decision. Instead of providing borrower’s
information to you to make better decision, the bank makes even better
decision for you!

10. Three Types of
Financial Intermediaries
• Depository Institutions
• Contractual Savings Institutions
• Investment Intermediaries
Although all of these institutions pool funds from many
savers and provide funds to many borrowers, they are
different in terms of what kind of IOUs they can issue to
savers and what kind of IOUs they can acquire from
borrowers.

11. Depository Institutions
Depository institutions: Accept deposits from savers
and make loans to borrowers.
• Commercial Banks:
Ex. Bank of America, Wachovia bank
• Savings & Loan (S&L) Associations and Mutual Savings
Banks:
Ex. Piedmont Federal Savings & Loan Association, Washington Mutual
• Credit Unions:
Ex. State Employee Credit Union, Allegacy Federal Credit Union

12. Commercial Banks
• Commercial banks raise funds primarily by issuing checkable
deposits, saving deposits, and time deposits (CDs).
• They use funds to make commercial loans (to businesses),
consumer loans (to households), and mortgage loans, and to
buy U.S. government securities and municipal bonds.
Do you have bank accounts? What kind of accounts do you
have at your bank? Did you borrow from your bank? What
kind of loans did you borrow? Auto loan, mortgage loan,
student loan, or credit card loan?

13. Savings & Loan Associations (S&Ls) and
Mutual Savings Banks
• Savings & Loan Associations and Mutual Saving
Banks obtain funds primarily through saving deposits
(called shares) and time and checkable deposits.
– Many S&Ls are mutual, that is, owned by depositors
(holders of share accounts) of the S&Ls.
• Traditionally, these institutions mostly made
mortgage loans, but nowadays they can make same
types of loans as commercial banks.
• Mutual savings banks mainly locate in Northeast.

14. Credit Unions
• Credit unions are organized around a particular group,
employees of a particular firm or organization.
– Only if you are a member of organization, you can join a credit union
and receive its financial services.
– Ex. Sate Employees Credit Union accepts only employees of North
Carolina state government.
– Ex. Allegacy Federal Credit Union accepts only employees of RJ
Reynolds Tobacco Company and its affiliates.
• They acquire funds from deposits (called shares) and primarily
make consumer loans to its members.
– Credit unions are mutual, that is, owned by depositors (holders of share
accounts) of the credit unions. As a result, credit unions are not-for-
profit and return all profits to its members in form of higher interest
rates on deposits and lower interest rates on loans.

15. Contractual Savings Institutions
Contractual Savings Institutions: Acquire funds at
periodic intervals on a contractual basis and pay out an
amount if an event specified on the contract occurs.
• Life Insurance Companies
Ex. MetLife, Prudential Life Insurance
• Fire and Casualty Insurance Companies
Ex. State Farm insurance, Allstate Insurance
• Pension Funds and Government Retirement Funds
Ex. California Public Employees’ retirement System

16. Life Insurance Companies
• Life insurance companies insure people against financial
hazards following a death and sell annuities (annual income
payments upon retirement).
• They acquire funds from the premiums that people pay to keep
their policies in force.
• They use funds mainly to buy corporate bonds and mortgages.
They also purchase stocks, but restricted in the amount.
Under what circumstances will they pay benefits? Under what
circumstances won’t they pay benefits?

17. Fire and Casualty Insurance Companies
• Fire and casualty insurance companies insure their policy-
holders against loss from theft, fire, and accidents.
• Like life insurance companies, they receive funds through
premiums. They pay out benefits upon property damages due
to theft, fire, or accident.
• They tend to hold municipal bonds, corporate bonds,
government securities, and stocks.
How did Hurricane Katrina affect these companies? How
about floods and tornadoes in mid-West? Or, an earthquake
and wild fires in California?

18. Pension Funds and Government
Retirement Funds
• Private pension funds and state and local retirement funds
provide retirement income in the form of annuities.
• Funds are acquired by contributions from employers and
employees.
• Funds are used to acquire corporate bonds and stocks.
Do you work? Does your employer offer a retirement saving
plan? Do you know 401(k)? How about IRA (individual
retirement account)? Do you know the largest retirement
funds in the U.S. that almost everyone is forced to join?

19. More on Pension Funds
• Pension funds are either
– Defined-contribution plan: the benefits are determined by the
contributions into the plan and their earnings (uncertain).
– Defined-benefit plan: the benefits are set in advance.
• Defined-benefit plan may be
– Fully funded: the contributions into the plan and their earnings are
sufficient to pay out the defined benefits.
– Underfunded: the contributions and their earnings are not sufficient.
• Pension Benefit Guarantee Corporation (Penny Benny):
insures pension benefits up to a limit ($47,000 per year per
person) if a company is unable to meet its pension obligations.
– Penny Benny had only $23 billion of assets in 2004. When United
Airline filed for chapter 11 bankruptcy in 2005, it took over $6.6
billion of liabilities of pension benefits.
– Does Penny Benny have enough funds? If it runs out of funds, who is
going to pay? Tax-payers!

20. More on Government Retirement Funds
• Social securities are the largest retirement funds in the U.S.
that everyone is forced to join and contribute.
• Social securities are basically defined-benefit plans, but the
federal government changes benefits if necessary.
Does the social securities have enough funds? Do you think
everyone contribute enough to guarantee its defined benefits
(fully funded)? If not (if it is underfunded), who is going to
pay? Should social security be privatized?

21. Investment Intermediaries
All other types of financial intermediaries,
including
• Finance Companies
Ex. GMAC (General Motors Acceptance Company)
• Mutual Funds
Ex. Vanguard S&P 500 Funds, Fidelity Magellan Funds

22. Finance Companies
• Finance companies make loans to consumers who
purchase particular durables.
Ex. Automobiles (GMAC loans buyers of GM cars).
– Many large consumer durable companies have own finance
company subsidiaries to help sell their products.
– Have you seen a commercial on TV like “Buy now and no
need to pay until 2010” or “2.9% finance on select
models”.
• They raise funds by selling commercial paper and by
issuing stocks and bonds.

23. Mutual Funds
• Mutual funds acquire funds by issuing and selling
own shares to many individuals and use the proceeds
to purchase diversified portfolios of stocks and
bonds.
– Mutual funds issues own shares, so they are corporations,
and holders of those shares are owners of the mutual funds.
– As owners of mutual funds, holders of mutual funds’ shares
are entitled to assets and earnings of the mutual funds
which consist of portfolio of other companies’ stocks.
– Each holder of mutual funds’ shares owns a portion of
mutual funds, which is a diversified portfolio of other
companies’ stocks.

24. Benefits of Mutual Funds
• Mutual funds provide three financial services to
savers at ease
– By purchasing shares of mutual funds, savers can have a
well-diversified portfolio (diversification without
purchasing one stock by stock)!
– The value (market price) of shares of mutual funds is
determined by the value of the mutual funds’ holdings of
securities. You can sell shares back to mutual funs any
time (liquidity).
– Because they are shares, mutual funds are usually sold by
security dealers, and often operated by brokerage firms.

25. Types of Mutual Funds
There are thousands of mutual funds traded in financial markets.
Each mutual fund has a set investment objective.
• Stock mutual funds: purchase stocks of corporations.
– Index funds: Ex. S&P 500 funds
– Sector funds: corporations in a particular industry.
Ex. Technology funds
– Size-based funds: based on sizes of corporations.
Ex. Large-cap/mid-cap/small-cap funds
– Strategy-based funds: based on appreciation of stock prices
or dividend incomes. Ex. Growth funds, value funds
– International funds: based on locations of corporations. Ex.
Global funds, emerging market funds, Japan funds

26. Types of Mutual Funds
• Bond mutual funds
– Corporate bond funds
– Municipal (tax exempt) bond funds: purchase only state
and local government bonds to get a benefit of federal
income tax exempted
– Mortgage-backed securities funds: purchase bonds backed
by pool of mortgage loans
– U.S. Government securities funds: safest and most liquid

27. Money Market Mutual Funds
• Money market mutual funds use funds to
purchase money market instruments, in
particular, U.S. Treasury securities.
– They are very liquid and safe.
– They allow holders of mutual funds to write
checks against the value of their shareholdings like
checking accounts at banks.

28. Hedge Funds
• Hedge funds are private investment funds open to a limited
number of accredited savers (know investment and have at least
$1 million), often require a very large initial investment, and
usually require each saver to keep it for at least one year.
– Because they are not open to the general public, they do not
need to follow the government regulations covering activities
of mutual funds, brokerage firms, or investment advisors.
– Although they are structured in the same way as mutual
funds (pooled funds by issuing shares), they differ from
mutual funds in flexibility of investment strategies.
– They use advanced investment strategy, purchase many
different types of assets (both financial and commodity), and
engage in many different financial markets (beyond three
basic financial markets).

29. Hedge Funds as Risk Taker
• Hedge funds differ from other financial intermediaries in a
way that they are usually not intended to provide three
financial services as other financial intermediaries do.
– Unlike their name, most hedge funds’ objective is to
maximize returns, so they tend to take excessive risk rather
than reducing (hedging) risk.
– Because of requirement on long-term investment, they are
not liquid at all.
– Hedge funds’ activities are so secretive that the
government regulators or savers do not know much about
how they operate.

30. Primary Assets and Liabilities of Financial
Intermediaries
Primary liabilities
are IOUs issued
by financial
intermediaries to
savers (to raise
funds), while
primary assets are
IOUs acquired
by financial
intermediaries
from borrowers
(though lending
funds).

31. Sizes of Financial Intermediaries
Commercial
banks are
foremost the
largest financial
intermediaries,
but mutual funds,
pension funds,
and life insurance
companies grew
significantly
recently.

32. Relative Shares of Financial Intermediary Assets
Commercial
banks are
foremost the
largest financial
intermediaries,
but mutual funds,
pension funds,
and life insurance
companies grew
significantly
recently.
From Chapter 13, page 303

33. • Indirect finance is more
important to borrowers
than direct finance.
• More than half of sources
of external funds (for
non-financial business)
are in indirect finance.
─ bank loans (18%)
─ non-bank loans (38%)
Direct Finance vs. Indirect Finance
Borrowers’ Point of View

34. Basic Facts about Borrowings
It is more convenient and only feasible for households and small
businesses to obtain funds from financial intermediaries (e.g.
banks and finance companies).
• Issuing marketable debt and equity securities (direct finance)
is not the primary way in which many small and medium-size
businesses finance their operations, but the indirect finance is.
• Only large, well-established corporations have easy access to
financial markets to finance their activities (e.g. issuing
stocks, bonds, and commercial papers).
• Collateral, often associated with mortgage, commercial, and
consumer loans, is a prevalent feature of debt contracts for
both households and businesses, as means to prevent moral
hazard problems faced by financial institutions.

35. Figure 1
Sources of External Funds for Nonfinancial Businesses: A
Comparison of the United States with Germany, Japan, and Canada
• In all economies, the
primary source of
external funds for
businesses comprises
loans made by banks and
other financial
intermediaries.
• In other countries, bank
loans are even more
important than direct
finance (stock & bond) as
compared with the U.S. From Chapter 8, Page 163

36. Direct Finance vs. Indirect Finance
Savers’ Point of View
• Did you put your funds in the direct finance (purchasing
stocks and bonds) or in the indirect finance (bank account,
insurance, pension, and mutual funds)?
• Most households do not own either stocks or bonds.
– 2004 survey of consumer finance: only 21% of households in the U.S.
owned stocks and 2% owned bonds, while 91% owned checkable
deposits at financial institutions (mostly commercial bank accounts),
50% owned retirement funds, 24% owned insurance cash value, and
15% owned mutual funds.
– In terms of values of financial assets, 32% of financial assets held by
the U.S. households were stocks and bonds, while 50% were mutual
funds, pension funds, insurance cash value, and annuity.

37. Transaction & Information Costs
in Direct Finance
Why people use indirect finance more than direct finance?
There are significantly high transaction costs and
information problems for small investors in direct finance.
– It is still costly to gather financial information of corporations
and financial instruments (e.g. stocks).
– Many households lack an expertise (knowledge, skill, and
experience) in investment.
– Too much at stake, so people are more cautious on saving rather
than taking risk or acting in guts.
– Not many households can keep up the information of financial
instruments (e.g. stock prices) at any moment and can manage
their savings in timely manner (e.g. buy and sell).

38. Transaction & Information Costs
in Indirect Finance
• Financial intermediaries can reduce transaction costs
and information problems furthermore by economies
of scale and expertise.
– Financial intermediaries gather information at low cost,
analyze information with expertise, and manage savings in
timely manner on behalf of savers.
Ex. When you purchase mutual funds, you do not need to
check each stock and do not need to follow their prices
every day to make transactions. The mutual fund manager
will do all for you.
• Households tend to use financial intermediaries more
often than direct finance.

39. Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University