The savings rate in a credit-based economy is frequently low. The savings that do exist typically flow into tangible assets and real property (purchase of houses, land, etc.) that are reputed to offer protection against inflation. In this context, savings do not flow towards corporate needs. Lacking sufficient supply, the capital markets therefore remain embryonic. As a result, companies can finance their needs only by borrowing from banks, which in turn refinance themselves at the central bank.
The lender’s risk is that the corporate borrower will not generate enough cash flow to service the debt and repay the principal, or amount of the loan. Even if the borrower’s financial condition is weak, the bank will not be required to book a provision against the loan so long as payments are made without incident. In an economy with no secondary market, the investor’s financial risk lies with the cash flows generated by the assets he holds and their liquidity.
In a market-based economy, companies cover most of their financing needs by issuing financial securities (shares, bonds, commercial paper, etc.) directly to investors. A capital market economy is characterised by direct solicitation of investors’ funds. Economic agents with surplus resources invest a large portion of their funds directly in the capital markets by buying companies’ shares, bonds, commercial paper or other short-term negotiable debt.
They do this either directly or through mutual funds. Intermediation gives way to the brokerage function, and the business model of financial institutions evolves towards the placement of companies’ securities directly with investors.
