securities for a period of time, so it is taking a risk—it may not be able to resell
them to savers for as much as it paid. Because new securities are involved and the
corporation receives the proceeds of the sale, this is a primary market transaction.
- Transfers can also be made through afinancial intermediarysuch as a bank or mu-
tualfund.Heretheintermediaryobtainsfundsfromsaversinexchangeforitsown
securities.Theintermediarythenusesthismoneytopurchaseandthenholdbusi-
nesses’securities.Forexample,asavermightgivedollarstoabank,receivingfrom
itacertificateofdeposit,andthenthebankmightlendthemoneytoasmallbusi-
ness in the form of a mortgage loan. Thus, intermediaries literally create new
formsofcapital—inthiscase,certificatesofdeposit,whicharebothsaferandmore
liquid than mortgages and thus are better securities for most savers to hold. The
existence of intermediaries greatly increases the efficiency of money and capital
markets.
In our example, we assume that the entity needing capital is a business, and specifically
a corporation, but it is easy to visualize the demander of capital as a home purchaser, a
government unit, and so on.
Direct transfers of funds from savers to businesses are possible and do occur on oc-
casion, but it is generally more efficient for a business to enlist the services of an invest-
ment banking housesuch as Merrill Lynch, Salomon Smith Barney, Morgan Stanley,
or Goldman Sachs. Such organizations (1) help corporations design securities with fea-
tures that are currently attractive to investors, (2) then buy these securities from the
corporation, and (3) resell them to savers. Although the securities are sold twice, this
process is really one primary market transaction, with the investment banker acting as a
facilitator to help transfer capital from savers to businesses.
The financial intermediariesshown in the third section of Figure 1-2 do more
than simply transfer money and securities between firms and savers—they literally
create new financial products. Since the intermediaries are generally large, they
gain economies of scale in analyzing the creditworthiness of potential borrowers, in
Financial Institutions 17
FIGURE 1-2 Diagram of the Capital Formation Process
Business
Business
Business
- Direct Transfers
- Indirect Transfers through Investment Bankers
- Indirect Transfers through a Financial Intermediary
Savers
Savers
IntermediaryFinancial Savers
Investment Banking
Houses
Securities (Stocks or Bonds)
Dollars
Securities
Dollars
Securities
Dollars
Intermediary’s
Securities
Dollars
Business’s
Securities
Dollars
An Overview of Corporate Finance and the Financial Environment 15
