Nature of Banking and Financial Intermediation

Objectives : Understand the role played by banks in the economic system through the services it provides as a financial intermediary Explain the theory and purpose of financial intermediation. Show that financial intermediation is welfare superior to direct transformation of current consumption to future consumption. Describe the process of financial intermediation and the role that banks enable in its efficient functioning.

Financial Intermediation : Financial Intermediation The mechanism whereby surplus funds from ultimate savers are matched to deficits incurred by ultimate borrowers The process by which ultimate savers are matched to ultimate borrowers. Saving = Income – Consumption Typically decisions to save are made independently of decisions to invest

Chanelling of Funds : Chanelling of Funds In a simple economy we have firms and households Households are the savers and firms are the investors. The mechanism by which households save is by demanding securities from firms The mechanism by which firms invest is by supplying securities to households These securities are claims to the assets of the firm

Simple model of direct finance : Simple model of direct finance HOUSEHOLDS FIRMS FUNDS LENT FINANCIAL CLAIMS

Direct Finance : Direct Finance Lending and borrowing can occur as a result of direct transacting. But there are costs associated with direct finance Search costs – searching for potential transactors Verification costs – costs in evaluating investment proposals Monitoring costs – costs of monitoring the actions of borrowing Enforcement costs – costs of enforcing contracts

Efficient Direct Finance : Efficient Direct Finance Some of these costs can be reduced through the organisation of a market through a Regulated Banking Intermediation system Direct financing requires the existence of an efficient securities market. An additional issue is that the maturity period of finance for the firm is long term. The maturity period of the household is mostly short term. The maturity mismatch of households and firms provide the incentive for the development of intermediated finance.

Indirect (Intermediated) Finance : Indirect (Intermediated) Finance HOUSEHOLDS Financial Intermediary FIRMS Funds Lent Financial Claims

Who are the savers and borrowers? : Who are the savers and borrowers? Savers or lenders are households, firms, governments and foreigners Investors or borrowers are households, firms, governments and foreigners. Savers can hold corporate securities (shares), government securities (bonds), currency, bank deposits, foreign currency assets Borrowers can sell shares, sell bonds, issue currency, take bank loans, issue foreign currency liabilities

General Flow of Funds : General Flow of Funds Lenders – Savers 1. Households 2. Firms 3. Government 4. Foreigners FINANCIAL MARKET Borrowers – Spenders 1. Firms 2. Government 3. Households Foreigners Financial Intermediary Indirect Finance Direct Finance

Banks as Financial Intermediaries : Banks as Financial Intermediaries Loan or credit services are: Retail loans: Are given to individuals for meeting one time requirements. Personal overdrafts: Are given by the bank whereby an individual can draw a certain amount over and above the balance in their account. Credit cards: Using a credit card, a cardholder gets some time to pay for the purchases or cash withdrawals he has made.

Business/Corporate credit: Business entities require financial assistance for the following: Acquisition of fixed assets Financing current assets Loans for acquiring fixed assets can be in the form of: Term loan LeasingTerm loans: Funds required for acquiring fixed assets are given as long-term loans, which are repaid in instalments from the profits of the organisation. Leasing: The assets required by the business are acquired by the bank and leased out to the customer.Banks as Financial Intermediaries (Contd.) The nature of working capital facilities are: Overdraft Cash credit Packing credit Demand loans and lines of credit

Overdraft: Is used for meeting short term requirements. Is used for meeting temporary mismatches in cash flow. Can be secured or unsecured. Cash credit: Is the most common and popular facility in India. Is similar to current account. Is a running account. Is permanent in nature. Maintains that limit established and withdrawals are within limit.

Is secured by a hypothecation charge on current assets. Maintains margin over the value of assets. Packing credit: Is similar to cash credit. Is used for meeting export orders. Is originally done on order to order basis. Maintains that the presently-running account facility is permitted. Maintains the concessional interest rate. Maintains that delay in liquidation attracts penalty. Is secured by a charge on the current assets.

Demand loans and lines of credit: Is used for meeting short term requirements. Attracts cheaper interest. Is preferred by large powerful corporates as a cost effective solution. Is liquidated at the end of the stipulated period. Maintains that line of credit is given as an assurance by the banker to make short term credit available when needed.

Maintains that terms and conditions are pre-agreed. Gives a feeling of security to the corporate. Maintains that assurance is given over a period of time.

The various modes of post-sale finance are: Cheque purchase Bill purchase Bill discount Letter of credit Bill negotiation Guarantees Business cards are a replacement for the cash credit facility, in which no interest free period is allowed for payment.

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