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Pros and cons of investing through indirect intermediaries

Nov 02 2012, 02:38 IST
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SummaryAll of us have regular interactions with indirect market intermediaries. After all, we maintain accounts with commercial banks, and many of us invest in mutual funds and buy insurance policies.

All of us have regular interactions with indirect market intermediaries. After all, we maintain accounts with commercial banks, and many of us invest in mutual funds and buy insurance policies. So, what exactly is the indirect market and why is it termed as such?

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

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