What Is The Difference Between Direct And Indirect Finance?


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Direct Finance is more risky- it takes place between an ultimate lender and an ultimate borrower, with no intermediary (i.e. No bank). An example would be you borrowing £100 from your friend on agreement to pay it back at a later date (with some interest). I say it is risky because one party may default on the payment..    Indirect Finance involves a middle-man, typically a bank. So if I borrow £100 from the bank, I am effectively borrowing £100 from the person who deposited that money in the bank (so he is technically the one loaning me the money). In this case, he is insured against the risk of default as the bank will cover the loan should I default on the payment.    So direct finances tend to be less efficient, as there are costs incurred in finding a second party willing to proceed with the agreement (transaction costs), and also there is a higher risk premium imposed (since there is greater risk that you may default, the lender will likely charge a higher interest on the loan).    Indirect finance has numerous advantages. Through maturity transformation, loans can be re-packaged into different maturities (banks can operate with liabilities that have shorter maturities than their assets), usually with increasingly high interest rates as the term increases (Interest rate term structure). Furthermore, the intermediaries remove the risk of default and have a 'monitoring' role to ensure no overly risky loans are made (though this certainly hasn't been the case lately). Intermediaries also provide a means for portfolio adjustment, and serve as a basis for the payments mechanism.

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