Solutions ( Borrowing and Lending ) - Indirect Lending and Bankruptcy

This part has helped me a great deal to understand why Lehman Brothers actually went bankrupt. Let us see why. Indirect Lending is a process wherein I shall lend my money to a company which needs it, but through a financial intermediary. Lehman was one such intermediary. Suppose I lend my 5 lac Rs to Lehman and Lehman loans it to this company. Although I am the ultimate source of the loan, now the promise to me is from Lehman and not from the company. If the company defaults, the bank's promise to me is not affected. Since Lehman is a renowned bank, I am hardly at a risk of Lehman defaulting as opposed tot he company defaulting. (That sounds funny considering what happened, but that's the precise reason why it shook the world .. The chances of a bank defaulting are one in a million). The following are the distinct advantages -

Informational - Lehman can obtain lots and lots of information being a renowned bank, such information as is not made available to the public at large. The company will also not hesitate to give the info as there is less risk that its secrets will be leaked. So the bank is better poised to invest your money in a good way.

Pooling - Compared to individual investors banks make very large loans. This is because making large loans is relatively less expensive than making small ones because the other costs like those of gathering information are the same. So why not make a larger loan to get a larger profit than make a small loan ? This has a big advantage as far as the liquidity problem is concerned. I can get my money back from Lehman much easier than I can get it back from the company. Lehman is expected to have lots of money with it at any given time, considering that so many lenders lend money to it everyday. Although withdrawals and deposits are both pretty high, but their timing is different by nature - only rarely will a day of many withdrawals be a day of very few deposits. So in general, the bank will always have ready cash to give to any depositor who needs it there and then. However, if all depositors want to withdraw their money at once ( exactly what heppened with Lehman ), then the bank will be in trouble. Such a tendency of the depositors is called a bank run.

Gains from specialization - I don't think this part needs any explanation. Banks are obviously better at assessing the creditworthiness of borrowers as also in reading financial statements etc.

Value of a Continuing Relationship - A company will expect to come back to a bank for borrowing more in the future and hence, it would not like to jeopardize its ability to do so by failing to pay up on time.

Diversification - The amount of money that I, as an individual, can lend to the company is small compared to the average amount that borrowers like the above company want to borrow. I will obviously not be able to lend to more than a few companies. If they default, I am gone !! However, Lehman has deposits of thousands of people like me. It can therefore make many small loans to many companies out of the money which I give it. Even if a few default, I am not at much risk. this is called diversification. As such, if I was sure that my company is good, then I would definitely get a higher return if I directly lent the money without Lehman being there. But then I can never be sure of such a thing. There is a chance factor involved there. If my company defaults, I don't get anything. In case Lehman invests, the chance factor is such that even after considering all probability of the companies defaulting, I am sure to get a sure return of 5 % from Lehman on my money. Its just a matter of deciding which one's better? A sure return of 5 % ? Or a possible return of 10 % ?

What is Bankruptcy after all ? Bankruptcy if filed when an organization is unable to pay off its debts. Either the organization files it, or the creditors may be able to force the organization into it. It is thus, a legal process, supervised by a court, that settles all claims against the bankrupt, tot he extent possible. The concept is to ensure that debts are paid off in an orderly manner rather than everyone scrambling to get theirs first. There are two types of bankruptcy - liquidation and re-organization. In a liquidation, the organization ceases to exist and its remaining assets are sold to pay off the creditors to whatever extent possible. In a reorganization, all creditors and the organization agree upon a plan for future payment of all or a part of corporation's debts. However, bankruptcy is costly in terms of legal fees and the firm's reputation. sometimes, it may be in the interest of lenders to let the organization continue and repay later, especially if the problem is temporary.