How the Financial System Moves Funds
The financial system channels funds from savers to borrowers in two ways. In direct finance, borrowers sell securities straight to lenders in financial markets. In indirect finance, financial intermediaries such as banks stand in between. Markets in turn split into money markets (short-term) and capital markets (long-term).
Why it matters
Savers have funds but no projects, and borrowers have projects but no funds. The system bridges them either directly through markets or indirectly through intermediaries that pool, transform, and monitor on the savers’ behalf.
Worked examples
A firm raises cash by (a) issuing a bond that investors buy or (b) taking a bank loan. Which is direct finance and which is indirect?
Issuing a bond that investors buy is direct finance, because funds flow straight through the market. The bank loan is indirect finance, because the bank intermediates between its depositors and the firm.
Common mistakes
- ✗Banks just store your money. They are intermediaries that channel savers’ funds to borrowers, transforming maturity, size, and risk along the way.
- ✗Markets and banks do the same job the same way. Markets enable direct finance, while intermediaries provide indirect finance, which dominates in most economies.
Revision bullets
- •Direct finance: borrowers sell securities to lenders in markets
- •Indirect finance: intermediaries stand in between
- •Money markets (short-term) vs capital markets (long-term)
Quick check
A company issues bonds that pension funds buy directly. This is an example of
Connected topics
Sources
- Mishkin (2018), Ch. 2Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.An overview of the financial system: direct and indirect finance, financial markets, and intermediaries.