Let us first consider a direct market transaction. Assume that Mahindra & Mahindra is issuing non-convertible debentures and that we buy such instruments. In such a transaction, funds are directly flowing from the ultimate investor to the ultimate borrower, which is the company.
On the other hand, let us take a situation where we open a savings account with ICICI Bank. The bank will pool the funds deposited by many investors like us and give loans to corporate houses like Mahindra and Mahindra. In this case as well, it is our money that is flowing to the ultimate borrower.
However, it is taking an indirect route in the sense that it is first flowing from us to the commercial bank and from the bank to the ultimate borrowers. Quite obviously, insurance companies and mutual funds are also intermediaries in the indirect market, like commercial banks.
Commercial banks and other indirect market intermediaries perform many vital roles. First, they facilitate denomination transformation and maturity transformation. Let us assume that Mahindra and Mahindra wants to raise R500 million. A typical retail investor may not be in a position to even invest R5 million.
However, a lender like ICICI Bank can. It will raise deposits from hundreds of borrowers who will deposit sums ranging from a few hundred rupees to a few million rupees. Consequently, it will be no problem for the bank to issue a loan of R500 million.
We say that intermediaries like banks perform denomination transformation. That is they raise small-to-medium-size deposits and make much larger investments.
Second, such entities perform what we term as maturity transformation. Let us assume that Mahindra and Mahindra is setting up a factory and wants to raise a loan for 20 years. Most of us would be unwilling to extend such a long maturity loan. However, a bank can. Some of us will make short-term deposits, while others will make medium-to-long-term deposits.
A bank can confidently issue long-term loans because when a deposit matures, either the depositor will renew it or else another depositor will take his place, for, typically, bank accounts are being opened and closed on a daily basis.
The third major role performed by indirect market intermediaries is that they facilitate risk diversification.
Diversification simply means that we should not put all our eggs in one basket. But if we have a corpus of R50,000, can we build a portfolio of 50 stocks Obviously, we cannot, and if we were to try, we would find that transactions costs eat up a substantial part of our capital. This is where a bank can help.
Let us assume that three parties open savings accounts with ICICI Bank by depositing R1 lakh each. Will it be the case that the first partys funds are used to make a loan to the Tatas; the second partys funds to make a loan to the Birlas; and the third partys assets to make a loan to the Ambanis
Quite obviously, every rupee that is deposited with a bank goes everywhere. Thus, whatever we deposit with a bank is deployed across a wide cross-section of borrowers.
Banks and mutual funds can also afford to employ professionals to evaluate the risk and return characteristics of alternative investments, and take calls on what is appropriate and what is not. Individual investors will not usually be in a position to avail of such advice.
Finally, indirect market intermediaries can take advantage of economies of scale. The phrase refers to the ability of entities to spread the fixed cost of operations across a larger magnitude of output and, thereby, bring down the per unit cost. Take, for instance, an operation that costs R1,000 to set up. Assume that the cost of production of a unit of output is R1. If 1,000 units are produced the per unit cost is obviously R1. However, if 5,000 units are produced then it will be only Rs 1.20.
This is what is termed as the ability to generate economies of scale. In practice, this can be exploited only up to a point, for after a certain level of output, the fixed cost will have to be incurred again. From the standpoint of an indirect market intermediary like a mutual fund, the typical size of an investment will be large. Consequently, the magnitude of transactions costs like brokerage commissions will be much lower on a per unit scale.
Quite obviously, there are advantages of investing through indirect market intermediaries. However, there is one disadvantage. Such intermediaries will make a spread, which can be avoided in a direct market transaction.
Take the case of a bank that raises deposits at an average rate of 7.5% per annum and makes loans at an average rate of 9% per annum. We say that the net interest margin for the bank is 1.5%. Now, assume that the potential borrower decides to directly issue debentures to potential depositors carrying an interest of 8.25% per annum. Obviously, the investors are earning 0.75% extra compared to what they would if they were to route the transaction through the bank, while the borrower, too, is saving 0.75%. What we have done is that we have distributed the banks net interest margin across the two parties.
The writer is the author of Fundamentals of Financial Instruments, published by Wiley, India