The central component of any model of a modern financial system is the nature of the conduits through which the financial assets of the ultimate savers flow to the liabilities of the ultimate users of finance, both within and between national economies. This involves alternative and competing modes of financial intermediation, or “contracting” between the parties in financial transactions. In this section, we shall discuss the intermediation framework in terms of a model that can be useful in making defensible prognoses of structural shifts in national and global banking and financial markets through time.

A convenient model that can be used to guide thinking on financial contracting and the role of financial institutions and markets is summarized in Figure 2.1. The diagram depicts the financial process (flow-of-funds) among the different sectors of the economy in terms of underlying environmental and regulatory determinants or drivers as well as the generic advantages needed to profit from the three primary intersectoral linkages:

1. • Savings/commercial banking and other traditional forms of intermediated finance.

2. • Investment banking and securitized intermediation.

3. • Various financial direct-connect mechanisms between borrowers and lenders.

Ultimate sources of surplus funds arise in the household sector (deferred consumption or savings), the corporate sector (retained earnings or business savings) and the government sector (budgetary surpluses).

1. • Under the first or “classic” model of financial intermediation, savings (or funds-sources) are held in the form of deposits or alternative types of claims issued by commercial banks, savings organizations, insurance companies or other forms of financial institutions entitled to finance themselves by placing their liabilities directly with the general public. Financial institutions then use these fund flows (liabilities) to purchase domestic and international assets issued by non-financial institution agents such as firms and governments.

2. • Under the second model of fund flows, savings may be allocated directly to the purchase of securities publicly issued and sold by various governmental and private sector organizations in the domestic and international financial markets.

3. • Under the third alternative, savings surpluses may be allocated directly to borrowers through various forms of private placement and other direct-sale mechanisms.