THE FINANCIAL SYSTEM AND ITS END USERS

Abstract

Economy describes the way the financial system channels capital between the end users of the financial system, that is, between the end borrowers and lenders, rather than the financial intermediaries, which also lends and borrows, but only to channel funds between end users. In developed economies, there are people willing to borrow; and an investment can only be realized by borrowing funds in order to finance its installation and to support the firms through the long period before they earn income. The idea of borrowing is the reason why modern economies have quite highly developed financial systems.
End users of financial systems have a choice between three broad approaches. First, they can engage in what is commonly called direct lending. This means that they directly make a settlement with each other. But this is expensive, inefficient, extremely risky and, in practice, not very likely. Second, they may choose to use organized markets. In these markets, lenders buy the obligations issued by borrowers. If the obligation is newly issued, then the issuer receives funds directly from the lender. To this extent, the process bears some resemblance to direct lending, but dealing with liabilities traded on organized markets has advantages for both parties. Organized markets reduce the search costs that would be associated with direct lending because organized markets are crowded with people willing to trade. Organized markets can be used by end lenders and borrowers. But they are also used by financial intermediaries who themselves provide a third channel for the transfer of funds between lenders and borrowers. The advantages of working through intermediaries are similar to those of working in organized markets: lenders and borrowers come together faster, more efficiently and cheaper than if they had to search for each other; and the intermediary is able, through superior knowledge, to reduce the risk of the transaction for both parties.