|Direct vs Indirect
The financial system offers two different ways to lend: (1)
lending through financial markets, and (2) indirect lending through
intermediaries, such as banks, finance companies, and mutual funds.
Direct lending involves the transfer of funds from the
to the ultimate borrower, most often through a third party. An
is a private party purchasing the securities issued by a firm.
securities are usually sold to the public through an underwriter,
who purchases them from the issuer with the intention of reselling them
at a profit. The underwriter negotiates the terms of the contract
with the borrower and appoints a trustee, typically a commercial bank,
to monitor compliance. Because of the costs involved, the issue
securities makes sense for the borrower only when the amount to be
If the security is a bond issue, the borrower is
obligated to return
the principal at maturity and to pay interest during the period of the
loan. If the securities are equities, the borrower has no
to return the principal, but is expected to pay dividends. What
the lender needs his money back immediately? The only solution is
to sell the security in the secondary market. However a secondary
market will exist only if someone has created it.
There are two types of secondary markets, dealers and
Dealers stand ready to buy or sell from their own inventory at quoted
profiting by the markup in those prices. Brokers simply
buyers and sellers together but do not buy or sell securities.
profit is normally a commission on the resulting sale. The
of a good secondary market is of benefit to borrowers as well as
It makes the loans more liquid and therefore more attractive to
A more attractive loan lowers the cost to the borrower.
Indirect lending is lending by the ultimate lender to a
who pools the funds of many lenders in order to re-lend at a markup
the cost of the funds. The ultimate borrowers are normally
to the ultimate lenders. A lender faces less risk in indirect
because, as a specialist in the field, the intermediary normally has a
well-established credit standing. Of course, lower risk usually
less gain for the lender.
Indirect lending generally offers lower cost to the
for small or short-term loans. Most borrowers lack sufficient
standing to borrow directly. Borrowers who do have that option
find it cheaper, especially for large sums. In fact it may not
be possible to borrow large sums indirectly through
The capacity of the direct financial markets is much larger than that
even the largest intermediaries.
Comparison of Risks
The two types of lenders face different problems with
borrowers in financial
difficulty. With direct lending, rescheduling a loan is
because the relationship is generally at arms length and
The risks are often unknown to the lender. With indirect lending,
the intermediary is usually in a much better position to know whether
problem is permanent or temporary. As the sole lender, the
can alter the terms without having to obtain the agreement of