What Is Finance?
The word “finance” can be confusing to many and is often thought of as a vague term used by evil bankers. But what is finance actually, what do people in finance actually do, why do we need it? This article attempts to explain the simple and complicated sides of the world of finance.
There are a lot of players, terms, and interwoven relationships in the world of finance. On the outside, it can look complicated. It looks a little something like this…
But what does that all mean? How does this apply to and benefit the everyday consumer like you and me?
According to the Cambridge dictionary, the definition of finance is “to provide the money needed for something to happen”. Well, that’s awfully vague. Let’s see a real life application.
Let’s say a brand new company wants to build a factory to make shirts. They have done their research and know that if they put up the money now to build the factory, they will make many times that amount from selling shirts in the future. The company is brand new so it doesn’t have the cash to pay for a whole factory in its pocket. The question is, how will they pay for the factory if they haven’t gotten the money from buying the shirts yet?
What do banks do?
This is where a bank steps in. The company can finance the factory by taking a loan from the bank where they promise to pay them back in the future once they sell their shirts. As a thank-you, they will pay back a little extra money to the bank which we call interest. This is one form of what we call debt financing.
So where does the bank get its money from? They collect deposits from everyday consumers and lend them to the company. As a thank you, they pay back consumers a small portion of the amount the company gives them back in the form of savings account interest, CDs, credit card perks, etc… In turn, the bank will take home the interest rate spread, or the difference between the interest they get from the company and the interest they pay to the consumer. This is the main function of banks, but they have many other things that they do, otherwise known as other businesses.
What do financial services do?
With some of the basics covered, we can move into diving deeper into the chart above. Most of it has to do with equity financing, the other way that our shirt company can get the money they need. Equity financing can be thought of as paying money to own part of a company or more simply, buying and selling stock.
For example, a wealthy individual could give $1,000,000 to our shirt company to build their factory in exchange for 10% ownership of the company. That means that out of all the money that our company makes from selling shirts, 10% of it will go back to our wealthy investor. In an ideal world, the equity financing world might look like this…
But there are many issues with this simple structure:
1-First, it would be hard for the average, non-wealthy consumer to invest in companies and participate in equity financing. Although equity financing typically gives you a higher return than debt financing, many people wouldn’t have the means or connections to participate.
2-Second, most people do not have the time or skillset to research all the different companies with all the different projects they are pursuing and figure out which one is a good investment, or which one is a bad investment.
3-Third, companies may find it much harder to find large amounts of capital in a practical and efficient manner. For example, it’s not every day that you come across a person, group, or organization that is willing to invest $500,000,000 in your company for a large project.
This is where the financial markets step in, they are the intermediary between savers (households) and companies (businesses). We will explore some of the groups which we saw in the first diagram above.
The Buy-side
The buy-side are organizations that help collect money from savers and invest it for them. They are the representatives for savers. This includes pension funds (retirement accounts), mutual funds, endowment funds (ex: from universities), sovereign wealth funds, etc… These groups collect all the money from the public and invest it in companies so, for example, you and I can get the best possible returns on our retirement accounts. They rely on the two groups below to research and execute investments on the companies that would be best.
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The Sell-side
The sell-side are essentially the institutions that get all the companies together and helps offer their equity to the buy-side. They are the representatives for the companies. This includes groups such as bankers and traders. When companies want to offer equity (ownership) of their company in exchange for money for the first time, they turn to investment bankers to help them do this in a process called an IPO.
This is different from the stock that you might trade on your Fidelity account which is just between two investors also known as secondary trading. However, the sell-side also helps in this area too; this is where stock brokers and market makers play. If a buy-side player wants to do something such as buy 100,000 shares of Apple stock, it cannot be done as simply as logging into your Robinhood account. In order to facilitate these trades, buy-side institutions utilize banks and their connections/expertise on the stock exchange to get it done.
In exchange for their services, the sell-side receives commissions from the buy-side and insightful information on what investors are currently looking for. There is also one more player to discuss but we must talk about an important fourth issue before going into it known as the principal-agent problem.
The principal-agent problem
The principal-agent problem essentially asks, how do we know what companies tell investors is the truth? How can our financial environment honestly find out which company out of all the companies is the best investment? The shirt company could easily say they expect $3,000,000 in profit next year when $1,000,000 is more plausible and chalk it up to bad luck. This changes our decisions as investors as we would obviously rather put our money in a $3mm dollar project than a $1mm dollar project. This is where analysts step in.
Analysts
Analysts help research companies and find out which are more likely to perform better or worse in the future. They talk to companies to find out the truth and give them industry information to help them improve their businesses in exchange. They help navigate the dark cloud of the principal-agent problem and make sure companies actually do what they say they will do for investors. As seen in the diagram below, analysts help decipher the asymmetric information we receive from companies and communicate it to the buy-side and sell-side so they can make good decisions.
(They also communicate with the media which then communicates the information to the everyday consumer through the business news (WSJ, NYT, CNBC, etc…))
Analysts often work for a specific bank and receive compensation for helping encourage the buy-side to make trades through the sell-side. They also receive reputation/rankings from all parties which determines how in demand they may be for their services.
And with that, this is just a small snapshot of the financial landscape.
The Bad-side
Does it have to be this complicated? Are there not conflicts of interest? Is it the most efficient system? Unfortunately, these are the problems that we face with our current financial landscape. There are many areas that leave room for dishonesty...
Analysts all too often give buy recommendations instead of sell recommendations as they don’t want to cut connections with companies by telling investors to sell their stock. Certain individuals or groups in high finance will try and game the system in order to make money off of risky ventures.
Of course, there are many upsides that most average consumers don’t see but there are still many cracks in the system. We must seek how we can thin the barriers between savers and companies in a beneficial manner to make the system more efficient and transparent.
Conclusion
Finance is how we connect everyday investors with companies that need money. It helps the money in the economy be where it needs to be, when it needs to be and drive the growth machine forward. I hope this article helped you understand the economic environment we all play in a little bit better.
All credit to Harvard professor Mihir A. Desai for this thought model for understanding finance. His book How Finance Works: The HBR Guide to Thinking Smart About the Numbers is an incredibly enlightening read.
6/24/24 News Update
Finance is essential for managing money effectively.