Finance Fundamentals Essay

Direct finance is a method of financing in which borrowers (spenders) and lenders (savers) meet directly and exchange funds without a third party involvement. A very good illustration of direct financing is individual lending money to his friends who would repay the individual later with or without an interest rate. There is no other party involved in this fund transfer. Debts markets, securities traded on stock exchanges are examples of direct financing. Indirect finance is a method of financing in which financial intermediaries such as banks, insurance companies are involved in the funds transfer between borrower and lender. In indirect financing, a lender deposits money with a financial intermediary which in turn loans out that money to a borrower. A very good example of indirect financing is Mutual Funds. The main distinction between direct and indirect finance is the involvement of a financial intermediary. Direct financing requires lenders and borrowers to find each other on their own whereas indirect financing establishes the relationship between lender and borrower via a middle man called ‘Financial Intermediary’. The time and money spent in carrying out financial transactions (Transaction costs) is one of the burdens faced by people. Indirect financing helps in eliminating this burden by channeling funds between spenders and savers. Financial intermediaries help the system with the advantage economies of scale due to their large size and developed expertise. This is not possible with direct financing. In indirect financing, a financial intermediary will take the ownership of the activities and help facilitate trade by clearing and settling payments between the parties. Financial intermediaries eliminate risks and uncertainties about returns on investor assets. In direct financing, the borrower and lender share the responsibility of ensuring funds availability, payment and settlements. Direct Financing enables both lender and borrower to share each other’s information transparently. In indirect financing, the financial intermediary maintains information on lenders and borrowers but the transparency of the information is limited. In direct finance, only the lender can choose the person to whom he wants to lend the money but in indirect finance, the financial intermediary decides on how to invest (lending) the money that it has been deposited with. Indirect financing allows diversified investments through financial intermediaries whereas diversified investments are limited in direct financing. Due to their size and low transactional costs, financial intermediaries allow higher liquidity services to both borrowers and lenders.

Following the Great Depression of 1930s, many bank regulations came into effect. Regulation Q (1933), Glass-Steagall (1933 & 1935) and McFadden Act (1927) act are few regulations that came into effect in US as a result of the crisis. However, these bank regulations failed to control the growth of number of banks leading to overcapacity. This overgrowth imposed risk to the financial stability. With no cap on interest rates for savings deposits, banks lured customers with higher interests for deposits. To prevent another financial disaster, few steps were taken in the US banking sector in 1980s. Between 1978 and 1986, Regulation Q was repealed in phases. This act repeal enforced ceiling on interest rate for savings deposits. This imposed cap on savings deposit interest rates also encouraged customers to find other options to banks. Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 abolished all prohibitions on interstate banking. This enabled banking between states and movement of money in diversified way.These relaxed laws allowed the emergence of alternatives to banks such as mutual funds etc.., and merger of banks soon took place. Due to large economies of scale and economies of scope, bigger banks provide increased financial stability. As

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