Direct & Indirect System of Finance

Question 1

What is the direct system of finance?

Answer 1

Capital Markets: links borrowers directly with Lenders (selective & specific)

Question 2

How do transactions occur though the direct system of finance?

Answer 2

Issuance of Securities (debt/ equity securities)

Question 3

What is the indirect system of finance?

Answer 3

Funds are pooled from both lenders and investors without a direct connection (core activity of commercial and retail banks, i.e., depositors and lenders).

Question 4

Examples of types of financing through indirect finance?

Answer 4

Bank Deposits, financial instruments, business loans, mortgage loans, and consumer loans.

Question 5

Examples of types of financing through the direct system of finance?

Answer 5

common/preferred stocks; corporate bonds (debt/asset-backed); government debt securities (T-bill/bonds); municipal debt securities).

Question 6

Differences between the two systems of finance?

Answer 6

(Indirect)- contributes more significantly to the creation of credit in the US financial markets (direct) restricted to largest institutions.

Question 7

Banks perform two roles in flow of funds:

Answer 7

(1) Financial intermediation (transforming the risk and/or timing of cash flows from savers to borrowers); (2) maturity transformation (short to long term – i.e., short term deposits are recycled into longer term loans. Because of this, asset yields and funding costs and do change at different rates.

Question 8

Differences Between Bank Finance v. Bond Finance

Question 9

Bank Finance

Answer 9

Banks have monitoring expenses: borrower performance & quality. This makes banks more expensive.

But Banks can offer their loan customers greater flexibility in renegotiating debt terms and covenants.

Question 10

Bond Finance

Answer 10

Borrower quality assessment is often “outsourced” to third parties (i.e., credit rating agencies). This reduces the cost of bond financing compared to bank loans.

Drawbacks: Purchasers of investment securities generally do not (or cannot) influence the business activities of bond issuers.

Bond issuers have less flexibility in renegotiating debt rates, terms and conditions in adverse economic environments.

Question 11

Why do FI buy securities?

Answer 11

• Increase overall net interest income
• Provide a source of liquid assets for borrowing collateralization or balance sheet management Invest funds from excess liquidity if deposit growth exceeds loan growth
• Make use of capital to increase returns earned for shareholders