The FinanciaI Environment

FinanciaI lntermediaries

The flow of funds from savers to investors in real assets can be direct; if there are financial intermediaries in an economy, the flow can also be indirect. Financial intermediaries consist of financial institutions, such as commercial banks, savings institutions, insurance companies, pension funds, finance companies, and mutual funds. These intermediaries come between ultimate borrowers and lenders by transforming direct claims into indirect claims. Financiai intermediaries purchase direct (or primary) securities and, in turn, issue their own indirect (ot secondary) securities to the public. For example, the direct security that a savings and loan association purchases is a mortgage; the indirect claim issued is a savings u..o.r.rt o, u certificate of deposit. A life insurance company, on the other hand, purchases corporate bonds, among other things, and issues life insurance policies. Financial intermediation is the process of savers depositing funds with financial intermediaries (rather than directly buyrng stocks and bonds) and letting the intermediaries do the lending to the ultimate investors. We usually think of financial intermediation making the markets more efficient by lowering the cost and/or inconvenience to consumers of financial services.

Among the various financial intermediaries, some institutions invest much more heavily in the securities of business firms than others. In what follows, we concentrate on those institutions involved in buying and selling corporate securities.

Deposit lnstitutions. Commercialbanks are the most important source of funds for business firms in the aggregate. Banks acquire demand (checking) and time (savings) deposits from individuals, companies, and governments and, in turn, make loans and investments. Among the loans made to business firms are seasonal and other 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.

Other deposit institutions include savings and loan associations, mutual savings banks, and credit unions. These institutions are primarily involved with individuals, acquiring their savings and making home and consumer loans.

lnsurance Companies. There are two t)?es of insurance companies: property and casualty companies and life insurance companies. These are in the business of collecting periodic payments from those they insure in exchange for providing payouts should events, usually adverse, occur. With the funds received in premium payments, insurance companies build reserves. These reserves and a portion of the insurance companies' capital are invested in financial assets.

Property and casualty companies insure against fires, thefts, car accidents, and similar unpleasantness. Because these companies pay taxes at the full corporate income tax rate, they invest heavily in municipal bonds, which offer tax-exempt interest income. To a lesser extent they also invest in corporate stocks and bonds.

Life insurance companies insure against the loss of life. Because the mortality of a large group of individuals is highly predictable, these companies are able to invest in long-term securities. Also, the income of these institutions is partially exempt from taxes owing to the buildup of reserves over time. They therefore seek taxable investments with yields higher than those of tax-exempt municipal bonds. As a result, life insurance companies invest heavily in corporate bonds. Also important are mortgages, some of which are granted to business firms.

Other FinanciaI lntermediaries. Pension fund.r and other retirement funds are established to provide income to individuals when they retire. During their working lives, empioyees usually contribute to these funds, as do employers. Funds invest these contributions and either pay out the cumulative amounts periodically to retired workers or arrange annuities. In the accumulation phase, monies paid into a fund are not taxed. When the benefi.ts are paid out in retirement, taxes are paid by the recipient. Commercial banks, through their trust departments, and insurance companies offer pension funds, as do the federai government, local governments, and certain other noninsurance organizations. Because of the long-term nature oftheir liabilities, pension funds are able to invest in longer-term securities. As a result, they invest heavily in corporate stocks and bonds. In fact, pension funds are the largest single institutional investors in corporate stocks.

Mutual investment funds also invest heavily in corporate stocks and bonds. These funds accept monies contributed by individuals and invest them in specific types of financial assets. The mutual fund is connected with a management company, to which the fund pays a fee (frequently 0.5 percent of total assets per annum) for professional investment management. Each individual owns a specified percentage of the mutual fund, which depends on that person's original investment. Individuals can sell their shares at any time, as the mutual fund is required to redeem them. Though many mutual funds invest only in common stocks, others specialize in corporate bonds; in money market instruments, including commercial paper issued by corporations; or in municipal securities. Various stock funds have different investment philosophies, ranging from investing for income and safety to a highly aggressive pursuit of growth. In all cases, the individual obtains a diversified portfolio managed by professionals. Unfortunately, there is no evidence that such management results in consistently superior performance.

Finance companies make consumer installment loans, personal loans, and secured loans to business enterprises. These companies raise capital through stock issues as well as through borrowings, some of which are long term but most of which come from commercial banks. In turn, the finance company makes loans.