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Direct vs Indirect

The financial system offers two different ways to lend:  (1) direct lending through financial markets, and (2) indirect lending through financial intermediaries, such as banks, finance companies, and mutual funds.

Direct Lending

Direct lending involves the transfer of funds from the ultimate lender to the ultimate borrower, most often through a third party.  An example is a private party purchasing the securities issued by a firm.  The securities are usually sold to the public through an underwriter, someone 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 of securities makes sense for the borrower only when the amount to be raised is substantial.

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 obligation to return the principal, but is expected to pay dividends.  What if 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. 

Secondary Markets

There are two types of secondary markets, dealers and brokers.  Dealers stand ready to buy or sell from their own inventory at quoted prices, profiting by the markup in those prices.   Brokers simply bring buyers and sellers together but do not buy or sell securities.  Their profit is normally a commission on the resulting sale.  The existence of a good secondary market is of benefit to borrowers as well as lenders.  It makes the loans more liquid and therefore more attractive to lenders.  A more attractive loan lowers the cost to the borrower.

Indirect Lending

Indirect lending is lending by the ultimate lender to a financial intermediary who pools the funds of many lenders in order to re-lend at a markup over the cost of the funds.  The ultimate borrowers are normally unknown to the ultimate lenders.  A lender faces less risk in indirect lending because, as a specialist in the field, the intermediary normally has a well-established credit standing.  Of course, lower risk usually means less gain for the lender. 

Indirect lending generally offers lower cost to the ultimate borrower for small or short-term loans.  Most borrowers lack sufficient credit standing to borrow directly.  Borrowers who do have that option may find it cheaper, especially for large sums.  In fact it may not even be possible to borrow large sums indirectly through intermediaries.  The capacity of the direct financial markets is much larger than that of 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 problematic because the relationship is generally at arms length and legalistic.  The risks are often unknown to the lender.  With indirect lending, the intermediary is usually in a much better position to know whether the problem is permanent or temporary.  As the sole lender, the intermediary can alter the terms without having to obtain the agreement of others. 

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