Financial disintermediation

Suppose a company needs Rs 200 crore. It has two doors it can knock on.

The old door is a bank. The company asks for a term loan or a line of credit. The bank has already taken deposits from savers. It lends that money on. The bank sits in the middle of the deal. That is what makes it an intermediary.

The new door is the securities market. The company issues commercial paper or bonds. Investors buy the paper straight from the company. No bank sits in the middle.

Financial disintermediation is the name for the second route growing at the expense of the first. The middleman is cut out.

The workbook says it plainly. Before securities markets grew, this job was done by banks. They were the main intermediaries in the financial system. The spread of primary markets has contributed to the process of financial disintermediation. A company may find it more cost-efficient to issue commercial paper or bonds than to take a traditional line of credit or term loan.

What the workbook claims, and what it does not.

The passage sits inside the list of roles the securities market plays. The first role on that list is an orderly channel for transfer of funds: primary markets channel savings from millions of investors to borrowers in an organised and regulated manner. The workbook then notes that banks used to do this job, and that the expansion of securities markets has contributed to financial disintermediation.

The reason it gives for the shift is cost. A company may find issuing commercial paper or bonds more cost-efficient than a traditional line of credit or term loan from a bank. The workbook does not break that cost down, and it gives no figure at all for this concept — no share of corporate borrowing, no rate comparison, no rupee amount. So do not expect a number on disintermediation from this paper, and do not supply one.

The two instruments it names, and where each one sits. Chapter 2 classifies debt by tenor. Securities with maturities up to one year are issued and traded in the money market; longer maturities belong to the capital market. Private sector companies issue commercial paper in the money market and bonds in the long-term capital market. So a company that replaces a short working-capital line with commercial paper is disintermediating inside the money market, and a company that replaces a term loan with a bond issue is doing it inside the capital market.

Debt capital, two ways. Chapter 2 opens its debt section by saying that debt capital can be created either by borrowing from banks and other institutions, or by issuing debt securities. Disintermediation is simply the second of those two growing.

What the borrower gains, in the workbook's terms. The securities market lets borrowers raise capital at an efficient price, and lets investors reduce the risk of being defrauded, because it is an organised and regulated platform for the transfer of capital. Note the verb the workbook uses: the market has contributed to a process. It does not say banks stop lending.

Who carries the credit risk afterwards. Chapter 2 adds the point that the rate at which corporates, banks and institutions borrow depends on the credit quality of the borrower, and that the credit or default risk of a borrower is measured by the credit rating of the bond. In the bank route the bank assesses that risk and holds it. In the market route the rating agency assesses it and the investors hold it.

Illustrative. The interest rates below are assumptions used only to make the arithmetic run; this workbook gives no rates for either route.

Shreyas Auto Components Ltd needs Rs 200 crore of working capital for one year.

Route 1 — the bank. It asks its bank for a one-year line of credit. Assume the bank quotes 9.50 per cent.

Interest for the year = Rs 200 crore x 9.50% = Rs 19.00 crore

Route 2 — the market. Shreyas is a well-rated issuer, so it can sell commercial paper instead. Commercial paper is money market paper: this workbook puts maturities of up to one year in the money market. Assume the paper prices at 8.20 per cent, with issue expenses of Rs 0.40 crore.

Cost for the year = (Rs 200 crore x 8.20%) + Rs 0.40 crore = Rs 16.40 crore + Rs 0.40 crore = Rs 16.80 crore

Saving = Rs 19.00 crore − Rs 16.80 crore = Rs 2.20 crore

That saving is the whole of financial disintermediation in one line. The bank has not been beaten on service. It has been beaten on price, because the investors who buy the commercial paper are lending to Shreyas directly and there is nobody in between who has to be paid.

Now look at it from the saver's side. The same households whose fixed deposits the bank would have lent out can instead buy units of a debt scheme that holds Shreyas commercial paper. Their money still reaches Shreyas. It simply no longer travels through the bank's balance sheet.

And notice what travelled with it. In Route 1 the bank had assessed Shreyas and would have absorbed a default. In Route 2 the credit rating does the assessing and the investors absorb it.

Chapter 1 (Understanding Securities Markets and Performance), section 1.4 (Role of Securities Markets). Financial disintermediation appears inside the first of the roles listed there — an orderly channel for transfer of funds — and the rest of that list is generating productive investments, liquidity, price discovery and information signalling through prices.

The question form is recognition, not calculation. A stem describes a company choosing to issue commercial paper or bonds rather than take a bank loan, and asks what the process is called, or which role of the securities market the example illustrates. Chapter 2 supplies the other half of it: which of those two instruments sits in the money market and which in the capital market. Learn the workbook's own example — commercial paper or bonds against a line of credit or term loan — because it is the clearest handle on the term and the words are reused across both chapters.

• Disintermediation does not mean banks stop lending. The workbook says the expansion of securities markets has contributed to the process. Both doors stay open.
• The direction matters. Money shifting from bank lending to market issuance is disintermediation. A company that drops its bond programme and goes back to a term loan is moving the other way.
• A bank can be involved without being the intermediary. Banks act as bankers to an issue, as Self-Certified Syndicate Banks and as buyers of corporate paper. What disintermediation removes is the bank's role as the lender in the middle, not the bank.
• Commercial paper is money market paper. Chapter 2 puts maturities up to one year in the money market, so do not offer commercial paper as the substitute for a long-term term loan. Bonds are the long-term substitute.
• This paper attaches no figure to the concept. If an option quotes a percentage for the size of Indian disintermediation, it does not come from this workbook.
• Do not confuse it with private placement, which is about who is offered the securities. A privately placed bond is still disintermediation; a widely sold one is too.