In varying degrees, all business firms operate within the financial system. When a product or service is sold, the seller receives either cash or a financial asset in the form of an account receivable. In addition, the firm invests idle funds in marketable securities, and here it has direct contact with the financial markets. More importantly, most firms use financial markets to finance their investment in assets. In financial analysis, the market price of a company's securities is the test of whether it is a success or a failure. While business firm competes' either each other in the product markets, they must continually interface with the financial markets. Financial market consists of several institutions and markets serving all businesses, firms, individuals, and governments.
2.1 PURPOSE OF FINANCIAL MARKETS
There are many purposes for financial markets which are commonly in purpose of ensuring the financial assets exits in an economy. This is due to the savings of many individuals, corporations, and governments during a period of time are different compared to their investment in real assets. Real assets include house, building, equipments, inventory, and durable tangible goods. Investment in economic unit in real assets that exceeds its savings and finance by borrowings or issuing equity securities would need the creation of financial assets.
Moreover, purposes of financial markets in an economy are also to allocate saving efficiently to all users. The more the diversity patterns of desired savings and investments among economic unit, the greater the need for efficient financial market to channel savings to users. Efficient financial markets are absolutely essential to assure adequate capital formation and economic growth in an economy. If there were no financial assets other than money, then each economic unit could invest only to be the extent that it saved.
2.2 FINANCIAL INSTITUTIONS
Financial institutions can be described as a medium to transfer money from an individual to another individual. This medium is called as financial situation which means the transfer of capital between the savers and those who need capital. There are three different says where this process takes place. The ways are direct transfer of money, investment banking house and also financial intermediaries. Among the number of institutions involved in the financial system, only a handful invests heavily in the securities of business firms. In what follows, we concentrate on those institutions involved in buying and selling corporate securities.
2.2.1 DIRECT TRANSFERS OF MONEY AND SECURITIES
Direct transfer of money can be described as a process where businesses sells their stocks and bonds directly to investors without accompany of any type of financial institutions. This business delivers its securities to investors who in return gives the firm the money it needs according to the level of purchase of its stocks and bonds. This process occurs as illustrated as the diagram below:
Securities (Stocks and Bonds)
Money
2.2.2 INVESTMENTS BANKING HOUSE
Investment banking house can be described as an organization that provides and distribute new securities for investment to benefit organizations in need of help to obtain good financial status. An underwriter can be also called as a controller or provider who serves as middle person and facilitate the issuances of the securities. These underwriters being company sells their issued stocks and bonds to investment banks who in return sells their stocks and bonds securities to savers or investors. Moreover, it is best to describe investment banking house as an indirect transferor of transactions in relevance to stocks and bonds. The process of indirect transfer of stocks and bond securities in investment banking house is as illustrated in diagram below:
Securities
Securities
Dollars
Dollars
2.2.3 FINANCIAL INTERMEDIARIES
From now, we have considered only the direct flow of savings from savers to users of funds. The flow in an economy will be indirect when there are financial intermediaries. Financial intermediaries transform funds in a way that makes them more attractive. A variety of services and economies are provided. Economies of scale are possible and may be passed on to borrower and lender in the form of lower cost of operations. A financial intermediary also is able to pool savings to purchase primary securities of varying sizes. The financial intermediary provides often needed expertise in investing in primary securities.
Thus, financial intermediaries tailor the denomination and type of indirect securities they issue to the desires of savers. Their purpose, of course, is to make a profit by purchasing primary securities yielding more than their expenses and the return they must pay on the indirect securities issued. In so doing, they channel funds from the ultimate lender to the ultimate borrower at a lower cost and with less inconvenience than would be possible if the ultimate lender directly purchased primary securities. Financial intermediaries include institutions such as commercials banks, savings banks, and loan associations, life insurance companies, and funds. The transactions using financial intermediaries' process are as illustrated as diagram below:
Intermediaries
Securities
Business's
Securities
Dollars
Dollars
2.3 TYPES OF FINANCIAL INTERMEDIARIES
There are few classes of intermediaries which are categorized into 3 different institutions which are Depository Institution, Contractual Saving Institution and Investment Company. Below explains all the financial intermediaries according to its respective category of institution.
2.3.1 DEPOSITORY INSTITUTIONS
Commercial bank is a type of depository institution which is most aggregate as source of fund for business firms. Commercial banks acquire demand and time for deposited principals from individual, companies, and government are used to provide loan or investment for users. Among the loans made to business firms are seasonal and others short-term loans, intermediate-term loans of up to five years, and mortgage loans. Besides performing a banking function, commercial banks affect business firms through their trust departments, which invest in corporate bonds and stocks. They also make mortgage loans available to companies and manage pension funds.
2.3.1.1 COMMERCIAL BANKS
Commercial banks are largest depository institutional group when its measured by size of its asset as they have similar functions likewise other saving institutions and credit unions that accepts deposits and give loan services. Thus, there are differences between these institution in relations of their assets and liabilities compositions which are very much varied. Liabilities of commercial banks includes several types of non deposit source of fund, while there are broader in range in their loan for consumer, commercial, and real-estate loans. One of the commercial banks activities includes regulated separation of two different institutions which are savings institutions and credits unions.
2.3.1.2 SAVING AND LOAN ASSOCIATION
Saving and loan associations are depository institutional intermediaries that function to provide service for individuals or saver and residents as well as commercial mortgage borrowers. This type of an institution uses funds of many small depositors and uses this money to borrow for loan applications like home buyers. They have more expertise in analyzing credit, setting up loans and making collection from individual savers, so they reduce the costs and increase the availability of real-estate loans. This institution holds large, diversified portfolios for loans and other assets, thus spread risks in a manner that would be impossible if small savers were making mortgage loans directly.
2.3.1.3 MUTUAL SAVING BANKS
Mutual Saving Banks operates primarily to accept primary savings from individuals, and lend only for long-term basis to home buyers and consumers. Unlike commercial bank, mutual saving banks do not offer credit loan borrowing for small amount as they only provide long-term loan basis as well as long term savings accounts. Their fund rising is from investment in long term stocks as well as interest gain in repayments.
2.3.1.4 CREDIT UNIONS
Credit union is mutually organized and owned by depositor members as such it is basically a non-profitable depository institution. Satisfying the depository and lending needs of their members are known to be the primary objective of credit unions. To provide loan and other needs of funds for members, credit unions use the member's deposits to be able to satisfy the member themselves. All earnings from the loans are used to pay higher rates on member's deposits and charge lower rates on member's loans or attract new members from other credit unions. Credit unions do not issue common stock; the members are legally the owners of a credit union.
Credit union also known as cooperative association involves members who possess common bonds for example being employees of the same firm. Every member's savings are only loaned to other members of same group for purposes like auto purchase, home improvement loans or home mortgages. Despite, credit union is known to be the cheapest source of fund for individuals available for borrowing purposes.
2.3.2 CONTRACTUAL SAVING INSTITUTION
Contractual saving institutions are historically referred as savings and loan association. Mutual organizations were established as savings banks which legalize the depositors as the owner of the bank. There are several types of contractual saving institutions for instant pension fund and life insurance companies. These sources of institutions are contractual basis, where it is long term savings.
2.3.2.1 PENSION FUNDS
Pension fund can be described as a corporation and government funded retirement plan where the agencies uses trust departments of commercial banks or life companies to put fund for their employees which are administered by the trust department.
2.3.2.2 LIFE INSURANCE COMPANIES
Life insurance companies are policy and premium selling corporations who takes savings as the form of annual premiums from individual policy takers which are invested in stocks, real-estate, bonds, mortgage and other securities with final beneficiary payment for the insured party.
2.3.3 INVESTMENT COMPANIES
Investment companies, such as mutual funds and real estate investments trusts (REIT'S), pool the fund of many savers and invest these funds in various types of assets. Mutual funds invest in specific financial assets- such as debt and equity securities of corporations or money market instrument- according to the objectives of the fund. Mutual funds attempt to achieve superior performance through diversification and professional investment management. REITs, as the name suggests, invest their pool of funds in real estate. The mutual funds are pool funds which reduce the risk of diversification. Mutual funds are designed differently to meet the objective of different types depending on the favor of savers.
2.4 CONCLUSION
Overall, from the research that I have done, it can be concluded that there are three ways for transferring capital or fund from savers to borrowers in the financial markets. The three ways are direct transfer of money and securities, investment banking house, and also financial intermediaries. Direct transfer is occurring directly with the borrowers without any financial institutions. While investment banking house, is underwrite and distributes new investment securities to obtain financing. And financial intermediaries simply transfer money and securities between firms and savers, they will literally create new financial products.
There are few types of intermediaries which plays roles in transferring of capital. Firstly, depository institutions which divided into commercial banks, savings and loan associations, mutual savings banks, and credit unions. Secondly, contractual saving institutions includes of life insurance companies, and pension funds. And lastly, investment companies, which is mutual funds.
