The term ‘indirect’ connotes that money does not directly flow from the party saving money to the party who is seeking to borrow.

By- Sunil K. Parameswaran

Commercial banks are institutions that mobilise deposits and make loans and advances. They constitute a key component of what is termed as the indirect financial market. The term ‘indirect’ connotes that money does not directly flow from the party saving money to the party who is seeking to borrow. On the contrary there is an intermediary. In this case, the banks mobilise deposits from account holders and make loans to corporate and non-corporate borrowers.

Claim on the bank

A depositor has a claim on the bank and not on the party who borrows from it. If you were to make a deposit with ABC Bank which in turn makes a loan to Alpha Ltd, you cannot stake a claim on Alpha if ABC is unable to pay you back. How does a bank make a profit? Like all dealers it too has a bid-ask spread termed as Net Interest Margin (NIM), which is the difference between its lending rate and its borrowing rate.

Denomination transformation

A bank can raise deposits ranging from small to large amounts from various depositors, and make large loans to borrowers. This is termed as ‘Denomination Transformation’. Also, borrowers seek to borrow for long periods to avoid the hassle of repeatedly rolling over short-term borrowings, whereas most lenders seek to lend for short periods. Banks raise funds from short-term, medium-term, and long term depositors. And when a short-term deposit matures, it will be either rolled over, or else another short-term depositor will take the place of the depositor who is leaving. Thus banks can convert short-term borrowings into long-term loans.

Risk diversification

One of the basic tenets of finance is risk diversification. That is, most of us will not make a large investment in a single asset, and would rather spread the investment over a portfolio of assets. For instance, if you were to receive `2 crore cash, would you put the entire amount into a single stock?

Most of us would possibly buy an apartment, buy some gold, deposit some money in a fixed deposit, and invest the balance in stocks. And while investing in stocks, we would not invest in a single sector of the economy, but would look to invest in a variety of sectors such as IT, pharma, metals. etc. And if we decide to invest `10 lakh in the IT sector it will not be in a single company.

Most retail investors do not have large amounts to invest which can be deployed across multiple fund raisers. This is where banks come in. Every rupee that is deposited in a bank is lent to a cross-section of borrowers. That is, if two depositors A, and B, were to open accounts with a bank, it is not the case that A’s money goes to an IT company while B’s goes to a pharma company. Every rupee goes everywhere. Thus banks facilitate risk diversification for the depositors.

The author is visiting faculty at various business schools including IIMs