financil seminar group 10
TRANSCRIPT
UNIVERSITY OF NAIROBI
SCHOOL OF BUSINESS
MASTER OF BUSINESS ADMINSTRATION (MBA) PROGRAMME
DFI 605: FINANCIAL SEMINAR
MAY-AUGUST 2011 SEMESTER
GROUP WORK ASSIGNMENT
GROUP 10
THEORY OF FINANCIAL INTERMEDIATION
Submitted by:
NAME REG NO1. TIMOTHY SHITSHESWA2. RHODAH ONYANGO. D61/63208/2010 3. KENNETH OCHIENG. D61/61672/20104. JULIUS OPALA D61/64457/20105. BEN KAMONYE6. DENIS AGINI D61/63052/20107. WANJUI WINFRED D61/62884/20108. WILLIAM NYIKULI D61/60580/2010
SUPERVISOR: DR. ADUDA/MR. MIRIE
TABLE OF CONTENTS
CHAPTER ONE
1.0: INTRODUCTION
What is Financial Intermediation?
Financial intermediation is the process which involves firms with surplus funds
depositing such funds to financial institutions who then lend to firms with deficits.
According Matthews and Thompson (2008); In the process of financial intermediation,
certain assets/liabilities are transformed to different assets/liabilities. As such, financial
intermediaries channel funds from economic units with surplus (savers) funds to
economic units which have deficits (borrowers) and these intermediaries attract funds
from individuals, businesses, and governments.
There are two types of financial intermediaries.
i) Banks
These are deposit financial institutions that advance loans directly to borrowers and
include commercial banks, savings banks, credit unions, etc.
ii) Non-bank financial intermediaries
These types of intermediaries lend through purchase of securities and include insurance
companies, pension funds and investment trusts that purchase securities, thus providing
capital indirectly rather than advancing loans.
Functions of Financial Intermediaries
Financial intermediaries ensure steady flow of funds from surplus to deficit units through
performing the following functions:
Maturity transformation: This is through converting short term liabilities to long term
assets. Banks deal with large number of lenders and borrowers and reconcile their
conflicting needs.
Risk transformation: This is through converting risky investments into relatively risk-free
ones through lending to multiple borrowers to spread risk.
Convenience denomination: This is through matching small deposits with large loans and
large deposits with small loans.
1.1: THEORITICAL FRAMEWORK
To conduct monetary and fiscal policies successfully, policy makers must have an
accurate assessment of the timing and effects of their policies on the economy. This
includes an understanding of the monetary transmission mechanisms through which
monetary policy affects the decisions of firms, households, financial intermediaries and
investors that alter the level of economic activity and prices.
Under the assumptions that financial markets are complete and information and
transaction costs are non-existent, the Modigliani and Miller (1958) theorem states that
the mix of debt and equity used to finance firms’ expenditures does not affect the
expected profitability of the project – the same investment decisions would be made,
irrespective of the mix of debt and equity finance. Fama’s (1980) extension of the
Modigliani-Miller theorem to the entire financial system allows the abstraction from
considerations of credit market conditions in macroeconomic models.
While the complete market assumption remains important in economics, the assumption
of zero information and transaction costs (or perfect information) has come under
increasing criticism since Akerlof’s (1970) seminal paper, which illustrated how
imperfect information between buyers and sellers can cause market malfunctioning. With
imperfect information, the market price reflects buyers’ perception of the average quality
of the product being sold, and sellers of low quality products will receive a premium at
the expense of those selling high quality goods. As a result, some high quality sellers will
stay out of the market, which will lower the average quality of the product and price of
the product even further, leading more high quality sellers to stay out of the market. The
process will continue and may preclude the market from actually opening. Efficient
markets require some mechanisms for overcoming the imperfect information problem.
In financial markets, an information asymmetry arises between borrowers and lenders
because borrowers generally know more about their investment projects than lenders do.
Intermediaries, which specialize in collecting information, evaluating projects and
borrowers, and monitoring borrowers’ performance, can help overcome the information
problem. Financial intermediaries thus exist because there are information and
transactions costs that arise from imperfect information between borrowers and lenders.
This implies that the assumptions upon which the Modigliani-Miller theorem is based,
and thus the macroeconomic models used by policy makers, do not hold. Conditions in
financial and credit markets can affect the real economy; and interest and exchange rates
are an incomplete description of the monetary transmission mechanism.
1.2: Traditional Theories of financial Intermediation (The perfect model
assumption)
Traditional theories of intermediation are based on transaction costs and information
asymmetry. They are designed to account for deposit taking institutions and insurance
firms which issue policies and channel funds to firms. They are built on the models of
resource allocation based on perfect and complete markets suggesting that it is frictions
such as transaction costs and asymmetric information that are important in understanding
intermediation (Allen and Santomero, 1997).
One such theory is the Arrow Debreu theory by Arrow and Debreu (1954) which
examined the dynamics of the whole economic system and was able to prove the
existence of a multimarket equilibrium in which there is no excess demand or supply.
The theory is based on assumptions that a competitive equilibrium exists if each person in
the economy possesses some quantity of every good available for sale in the market and
that exploitable labor resources exist which are capable of being used in the production of
desired goods / services.
The General equilibrium theory, by Leon (1934-1910) studied a theoretical economic
system in which all consumers were utility maximizers and firms were perfectly
competitive, showing that a unique stable equilibrium can exist under such conditions.
Modigliani-Miller theorem applied in this context asserts that the financial structure does
not matter. Households can construct portfolios which offset any position taken by an
intermediary and hence intermediation cannot create value (Fama, 1980).
The views above seem to be supported by the fact that increasingly, financial markets
have been and continue to be highly liberalized and deregulated. All information on
important macroeconomic and monetary data and on the quality and activities of market
participants is available in ‘real time’, on a global scale, owing to the developments in
information and communication technology. Firms can now issue shares over the Internet
and investors can put their order directly in financial markets. The communication
revolution has also reduced information costs tremendously. The liberalization and
deregulation give a strong stimulus towards the securitization of financial instruments,
making them transparent, homogeneous, and tradable in the international financial
centers in the world. Only taxes are discriminating, within countries. Transaction costs
still exist, but are declining due to the cost efficiency of ICT and efficiencies of scale.
The Arrow-Debreu Theory is based on the paradigm of complete markets. In the case of
complete markets, present value prices of investment projects are well defined. Savers
and investors interact easily because there is perfect information in the market at no cost.
Financial instruments are constructed and traded cost free and they fully and
simultaneously meet the needs of both savers and investors. With complete information,
it is expected that market parties have homogenous expectations and act rationally. In so
far as this does not occur naturally, intermediaries are useful to bring savers and investors
together and to create instruments that meet their needs.
Therefore, intermediaries are at best tolerated and would be eliminated in a move towards
market perfection, with all intermediaries becoming redundant; the perfect state of
disintermediation. This model is the starting point in the present theory of financial
intermediation. All deviations from this model which exist in the real world and which
cause intermediation by the specialized financial intermediaries are seen as market
imperfections. This suggests that intermediation is something which exploits a situation
which is not perfect, therefore is undesirable and should or will be temporary (Scholtens
and Wensveen, 2003).
It would be expected that financial intermediation should be fading away. One might
think so from the forces shaping the current financial environment: deregulation and
liberalization, communication, internationalization and so on. On the contrary, economic
importance of financial intermediaries is higher than ever and appears to be increasing.
Modern theories therefore try to explain this paradox:-
1.3: Modern Theories of Financial Intermediation
The modern theories of financial intermediation revolve around optimality, arbitrage
and equilibrium. Optimality refers to the notion that rational investors aim at optimal
returns. Arbitrage implies that the same asset has the same price in each single period in
the absence of restrictions. Equilibrium means that markets are cleared by price
adjustment – through arbitrage – at each moment in time (Scholtens and Wensveen,
2003).
While the complete market assumption remains important in economics, the assumption
of zero information and transaction costs (or perfect information) has come under
increasing criticism. Akerlof’s (1970) seminal paper, illustrated how imperfect
information between buyers and sellers can cause market malfunctioning. With imperfect
information, the market price reflects buyers’ perception of the average quality of the
product being sold, and sellers of low quality products will receive a premium at the
expense of those selling high quality goods. As a result, some high quality sellers will
stay out of the market; which will lower the average quality of the product and price of
the product even further, leading to more high quality sellers to stay out of the market.
The process will continue and may preclude the market from actually opening. Efficient
markets require some mechanisms of overcoming the imperfect information problem
(Akerlof, 1970).
Leland and Pyle, (1977) noted that traditional models of financial markets have difficulty
explaining the existence of financial intermediaries. They argued that if transactions costs
are not present, ultimate lenders might just as well purchase the primary securities
directly and avoid the costs which intermediation must involve. They concluded that
transactions costs could explain intermediation, but their magnitude does not in many
cases appear sufficient to be the sole cause and suggested that informational asymmetries
may be a primary reason that intermediaries exist.
Below are some of the theories or lines of reasoning that try to explain the existence of
financial intermediation thus:
Transaction Costs theory
Liquidity Insurance theory
Information sharing/asymmetry theory
Delegated monitoring theory
i. Transaction Costs Theory (Benston and Smith 1976)
The transaction costs approach holds that financial intermediaries exist because they have
a transaction costs advantage over individuals.
This is based on non convexities in transaction technologies, whereby the financial
intermediaries act as coalition of individual lenders or borrowers who exploit economies
of scale or scope in the transaction technology. The notion of transaction costs
encompasses not only exchange or monetary transaction cost (Tobin, 1963; Towey, 1974;
Fischer, 1983) but also search costs and monitoring and auditing costs (Benston and
Smith, 1976).
Financial intermediaries have a cost advantage in acquiring or processing information.
One reason for this advantage is that financial intermediation avoids duplication of
information collection (having a financial intermediary collect and process information
means that investors do not have to duplicate one another’s efforts). Also, financial
intermediaries are better able to assess the likelihood that a prospective borrower will
default, because of their past experience with borrowers. This cost advantage means that
the intermediaries have to specialize in the provision of financial services and, as a result,
resources can be allocated more efficiently.
ii. Liquidity Insurance Approach / Theory
Attributed largely to the works of Pyle (1971), Diamond and Dybvig (1983), and Hellwig
(1991). They consider banks as coalition of depositors that provide households with
insurance against shocks that adversely affects their liquidity position. They argued that
in the absence of perfect information, consumers are unsure of their future liquidity
requirements in the face of unanticipated events and hence they maintain a pool of
liquidity. Provided that shocks are not perfectly correlated across individuals, portfolio
theory suggests that total liquid reserves needed by financial institutions will be less than
the aggregation of reserves required by individual consumers acting independently.
The role of the financial intermediaries here is to transform particular financial claims
into other types of claims (qualitative asset transformation). As such, they offer liquidity
(Pyle, 1971) and diversification opportunities (Hellwig, 1991). The provision of liquidity
is a key function for savers and investors and increasingly for corporate customers,
whereas the provision of diversification increasingly is being appreciated in personal and
institutional financing. Holmström and Tirole (2001) suggest that this liquidity should
play a key role in asset pricing theory.
Diamond and Dybvig (1983) analyse the provision of liquidity (the transformation of
illiquid assets into liquid liabilities) by banks. In Diamond and Dybvig’s model, ex ante
identical investors (depositors) are risk averse and uncertain about the timing of their
future consumption needs. Without an intermediary, all investors are locked into illiquid
long-term investments that yield high payoffs only to those who consume late. Those
who must consume early receive low payoffs because early consumption requires
premature liquidation of long-term investments. Banks can improve on a competitive
market by providing better risk sharing among agents who need to consume at different
(random) times. An intermediary promising investors a higher payoff for early
consumption and a lower payoff for late consumption relative to the non-intermediated
case enhances risk sharing and welfare.
In Diamond and Dybvig (1983) the illiquidity of assets provides both the rationale for the
existence of banks and for their vulnerability to runs. A bank run is caused by a shift in
expectations. When normal volumes of withdrawals are known and not stochastic,
suspension of convertibility of deposits will allow banks both to prevent bank runs and to
provide optimal risk sharing by converting illiquid assets into liquid liabilities. In the
more general case (with stochastic withdrawals), deposit insurance can rule out runs
without reducing the ability of banks to transform assets.
iii. Information Asymmetry Theory
This theory contends that financial intermediaries exist because there are information and
transactions costs that arise from imperfect information between borrowers and lenders.
The information asymmetry theory is attributed to the works of Leland and Pyle (1977),
Diamond and Dybvig (1983) and Diamond (1984) among others.
Numerous markets are characterized by informational differences between buyers and
sellers. In financial markets, an information asymmetry arises between borrowers and
lenders because borrowers generally know more about their investment projects than
lenders do. Borrowers typically know their collateral, industriousness, and moral
rectitude better than do lenders; entrepreneurs possess "inside" information about their
own projects for which they seek financing.
Lenders would benefit from knowing the true characteristics of borrowers. But moral
hazard hampers the direct transfer of information between market participants. Borrowers
cannot be expected to be entirely straightforward about their characteristics, nor
entrepreneurs about their projects, since there may be substantial rewards for
exaggerating positive qualities and verification of true characteristics by outside parties
may be costly or impossible. Without information transfer, markets may perform poorly
(Leland and Pyle, 1977). Intermediaries, which specialise in collecting information,
evaluating projects and borrowers, and monitoring borrowers’ performance, can help
overcome the information problem.
These asymmetries can be of ex ante nature, generating adverse selection, they can be
interim, generating moral hazard, and they can be of ex post nature resulting in auditing
or costly state verification and enforcement.
Information asymmetry can cause a problem of adverse selection which can generate a
moral hazard resulting to auditing or costly verification and enforcement. Information
asymmetries generate market imperfections that lead to transaction costs. Financial
intermediaries seem to overcome these costs at least partly. Diamond and Dybvig, (1983)
consider banks as coalitions of depositors that provide households with insurance against
idiosyncratic shocks that adversely affect their liquidity position. Diamond (1984) shows
that these intermediary coalitions can achieve economies of scale and also act as
delegated monitors on behalf of ultimate savers. Monitoring involves increasing returns
to scale, which implies that specialization may be attractive. Individual households will
delegate monitoring activities to those specialists; the depositors will save their deposits
with the intermediaries and at times withdraw their deposits to discipline the intermediary
in his monitoring function.
iv. Theory of delegated monitoring of borrowers
This is one of the most influential theories in the literature on the existence of banks.
Diamond (1984) is of the view that financial intermediaries act as delegated monitors on
behalf of ultimate savers. Monitoring of a borrower by a bank refers to information
before and after a loan is granted including screening of on going creditworthiness and
ensuring that the borrower conforms to the contract.
A bank often has privileged information in the process because when it operates the
client’s current account then it can observe the flows of income and expenditures. This is
most relevant in the case of small and medium enterprises (Mathew and Thompsons2008)
The basic idea behind the theory of delegated monitoring is that not all savers (depositors
and the other creditors) have the time, inclination of or expertise to monitor institution
borrowers for defaults risk. They engage in indirect finance through using an
intermediary rather than direct financing.
Monitoring of borrowers involves increasing returns to scale which reinforces the view
that it is efficiently performed by specialist intermediacy. The monitor must have an
incentive to perform properly. One possibility is through reputational effects and banks
have developed substantial amounts of repopulation capital as monitors of debt (loan)
contracts issued to them by the borrowers that they fund and issue unmonitored debt
(deposit) contract.
Banks are able to perform as delegated monitors and to transfer loan that require costly
monitoring into deposits that do not depends critically on their use of portfolio
diversification. If the bank is sufficiently diversified across independent loans with
expected repayments in excess of the face value of deposit then the probability of the
bank defaulting on its deposit approaches zero. The theory shows that diversifying the
loan portfolio enables low-cost delegated monitoring. A key element in this theory is the
analysis and benefits of monitoring.
The collection of private information by intermediaries results in some benefits from
using this additional information in lending. The net demand for monitoring depends on
the cost of monitoring which in turn depends on the number of lenders who contract with
a given number of borrowers.
Regulation of financial intermediaries, especially of banks, is costly. There are the direct
costs of administration and of employing the supervisors, and there are the indirect costs
of the distortions generated by monetary and prudential supervision. Regulation however,
may also generate rents for the regulated financial intermediaries, since it may hamper
market entry as well as exit. So, there is a true dynamic relationship between regulation
and financial production. It must be noted that, once again, most of the literature in this
category focuses on explaining the functioning of the financial intermediary with
regulation as an exogenous force. Kane (1977) and Fohlin (2000) attempt to develop
theories that explain the existence of the very extensive regulation of financial
intermediaries in the dynamics of financial regulations.
CHAPTER TWO
2.0: EMPERICAL EVIDENCE
Evidence on the Determinants and Economic Consequences of Delegated
Monitoring: Anne Beatty, Scott Liao and Joseph Weber (December 2008)
The study objective was to investigate the factors that determine the cost and benefit
trade-offs of delegated monitoring and to examine the factors that determine delegated
monitoring, the consequences of delegated monitoring and whether the borrower
compensate the delegated monitor for their efforts through increased interest rate on the
loan. They used a sample of firms that entered into both public and private debt contracts
during the period January 1994 to February They studied 426 firms that had bank loans
outstanding before public debt issuances and 480 firms that issue bank debt while the
public debt is outstanding by analyzing several variables such as the size of the firm, level
of leverage, return on assets, firms credit rating and the standard deviation of returns.
The result showed that firms with cross-acceleration provisions are smaller, have a larger
returns variance, and have worse credit ratings implying that the firms are riskier while
firms using cross-acceleration provisions have larger absolute value of discretionary
accruals, suggesting that the performance of these firms is more difficult to measure.
They concluded that firms with cross-acceleration provisions also appear to have a more
concentrated group of lenders, with the lead lender holding a relatively larger share of the
loan. This suggests that firms with cross-acceleration provisions, on average, borrow
from banks with higher monitoring incentives. In terms of the control variables, they
found that riskier borrowers have larger spreads on their private debt agreements.
More specifically as leverage and return volatility increase and credit ratings get
worse, firms are charged larger interest rates. Firms that are required to provide
collateral are also charged a relatively larger rate but the rate decreases as return on
assets increases.
Are Banks liquidity transformers?: Akash Deep and Guido Schaefer (May 2004)
The study objective was to gauge the extent of liquidity transformation performed by
individual banks .They used data from the Reports of Condition and Income filed by all
federally regulated US commercial banks. The sample consists of the 200 largest banks
based on asset size in June 2001, which together controlled over 75% of total assets in the
US commercial banking sector.
The quarterly data used ranged from the second quarter of 1997 to the second quarter of
2001. Only banks that had data available for all these quarters were included in the
sample. The explanatory variables that they considered were deposit insurance coverage,
credit risk, bank size, and loan commitments.
They found out that a view of banks as primary liquidity transformers does not appear to
have a solid empirical foundation. The paper showed that the most important regulatory
initiative for facilitating liquidity transformation through deposit insurance has only
modest impact. The found out those additional insured deposits largely replaces
uninsured liabilities rather than expanding the deposit base of the bank or encouraging it
to make more loans while credit risk has a substantial impact on crowding out liquidity
risk from bank portfolios.
An empirical analysis of interest rate spread in Kenya: Rose W.Ngugi (May,
2001)
The study aimed to explain the factors determining interest rate spread for Kenya’s
banking sector the data consisted of monthly observations of treasury bill rates, commercial
bank loans and deposits, lending rates, deposit rates, inter-bank rates, provision for bad loans,
and liquidity and cash ratios. These data was obtained from the Central Bank of Kenya and
the sample ran from July 1991 to December 1999 for all data set except the inter-bank rate,
which was only available from April 1993.Cointergaration tests were carried out to ensure
long run relationship.
The result showed that the interest rate spread increased because of yet-to-be gained
efficiency and high intermediation costs. She showed that fiscal policy actions saw an
increase in treasury bill rates and high inflationary pressure that called for tightening of
monetary policy which resulted in banks increasing their lending rates but were reluctant to
reduce the lending rate when the treasury bill rate came down because of the declining
income from loans. The banks responded by reducing the deposit
rate, thus maintaining a wider margin as they left the lending rate at a higher level. High
implicit costs were realized with the tight monetary policy, which was pursued with
increased liquidity and cash ratio requirements.
CHAPTER THREE
3.0: UNRESOLVED ACADEMIC ISSUES IN FINANCIAL INTERMEDIATION
The main focus on financial intermediation theory what can be said to be the traditional
view of financial intermediation theory has been a focus on financial institutions i.e. the
so called financial institutes as channels or media of exchange where funds from units
who have surpluses are given to the financial intermediaries who then channel these
funds to areas of deficit units who need these funds. In the process financial
intermediaries have been known to perform four main critical functions namely:
Optimization of transaction costs
Provision of liquidity insurance
Bridging the information asymmetry gap, and;
Delegated monitory.
A lot of research has gone into these four key theories of financial intermediation which
seek to show and explain the behavior of financial intermediaries and their relation to
savers and to investors/entrepreneurs; however the key question of why financial
institutions exist still lingers on. Modern day financial theory is faced with questions and
challenges on what forces really drive the financial intermediation theory, what keeps
them alive and what is their contribution to the national and/or international economic
welfare.
It has been observed that despite the globalization of financial services, driven by
deregulation and information technology, and despite strong price competition, the
financial services industry is not declining in importance but it is growing (Bert Scholtens
& Wensveen, 2003). This seems paradoxical as it points to something important which
the financial intermediation theory, and the neo-classical market theory on which the
financial intermediation theory is based, do not explain, meaning that the existing
theories are actually leaving something out, something related to information production
but not covered by the theory of financial intermediation.
Bert Scholtens & Dick van Wensveen noted that all studies on the reasons behind
financial intermediation focused on the functioning of intermediaries in the
intermediation process but did not in themselves examine the existence of the real-world
intermediaries.
Two issues are of key importance arose, the first is about why there is demand for
financial intermediaries and the second is why financial intermediaries are willing and
able to take on the risks involved in their activity.
It has been proposed that risk management rather than informational asymmetries or
transaction costs is the reason why there is demand for financial institutions. Economies
of scale and scope as well as the delegation of the screening and monitoring function by
these intermediaries apply to dealing with risk itself, rather than only with information.
Risk, and not asymmetric information fuels its activity and risk taking basically
determines the value addition of financial intermediation to national income.
The growing importance of risk and the growing need of risk absorbing institutions and
instruments can explain the growing importance of the financial industry to the national
income. The demand for risk covering instruments grows and will continue to grow,
under the increasing volatility of interest rates, stock prices and foreign exchange rates.
In light of all these, the approach to financial intermediation that seek to answer why
there is demand for financial intermediaries and why financial intermediaries are willing
and able to take on the risks involved in their activity has brought about a new way of
looking at financial intermediation theory, namely;
Role of financial intermediaries in product and market innovation Role of financial intermediaries as an entrepreneurial provider of financial services Role of financial intermediaries in asset transformation, risk transformation and value
creation Financial intermediaries and their orientation to their customers both real investors
and savers
These four distinct roles form the backbone of the unresolved academic issues in
financial intermediation. Battacharya & Thakor in 1993 listed some of the issues which
they regarded as key questions and puzzles for financial intermediation research which
Scholtens and Wensveen branded as “unresolved issues” in 2003 and to the best of our
knowledge these issues have still not been conclusively resolved and could cover grounds
for future research. These are;
1. What is the role of financial institutions in financial innovation? Is this to the welfare of the society and the economy or themselves?
2. What are the economic bases for differences among financial systems across countries and through time due to technological differences and globalization?
3. What are the issues in banking system design - organizational structures, common trend of mergers and acquisitions amongst others?
4. How securities markets and non-bank financial intermediaries should be structured and regulated. Studies that move away from banks.
5. Regulation interferes in the intermediation process and it makes the financial sector an even more imperfectly competing – in more than one respect industry, as regulation by its nature is based on imperfect information for all other market participants.
6. The risks that are faced by the financial institutions such as credit risks, foreign exchange risk, technology risk, operational risk, political risk amongst others
CONCLUSION
In summary according to the modern theory of financial intermediation, financial
intermediaries are active because market imperfections prevent savers and investors from
trading directly with each other in an optimal way. The most important market
imperfections are the informational asymmetries between savers and investors. Financial
intermediaries, banks specifically, fill as agents and as delegated monitors of information
gaps between ultimate savers and investors. This is because they have a comparative
informational advantage over ultimate savers and investors. They screen and monitor
investors on behalf of savers. This is their basic function, which justifies the transaction
costs they charge to parties.
They also bridge the maturity mismatch between savers and investors and facilitate
payments between economic parties by providing a payment, settlement and clearing
system. Consequently, they engage in qualitative asset transformation activities. To
ensure the sustainability of financial intermediation, safety and soundness regulation has
to be put in place. Regulation also provides the basis for the intermediaries to enact in the
production of their monetary services.
All studies on the reasons behind financial intermediation focus on the functioning of
intermediaries in the intermediation process; they do not examine the existence of the
real-world intermediaries as such. It appears that the latter issue is regarded to be dealt
with when satisfactory answers on the former are being provided. Market optimization is
the main point of reference in case of the functioning of the intermediaries. The studies
that appear in most academic journals analyze situations and conditions under which
banks or other intermediaries are making markets less imperfect as well as the
impediments to their optimal functioning. Perfect markets are the benchmarks and the
intermediating parties are analyzed and judged from the viewpoint of their contribution to
an optimal allocation of savings, which means to market perfection. Ideally, financial
intermediaries should not be there and, being there, they at best alleviate market
imperfections as long as the real market parties have no perfect information. On the other
hand, they maintain market imperfections as long as they do not completely eliminate
informational asymmetries, and even increase market imperfections when their risk
aversion creates credit crunches. So, there appears not to be a heroic role for
intermediaries at all! But if this is really true, why are still in business, even despite the
fierce competition amongst themselves? Financial intermediaries have a crucial and even
increasing role within the real-world economy. They increasingly are linked up in all
kinds of economic transactions and processes.
It is predicted in Cecchetti (1999) that financial intermediaries of the future will provide a
host of services that are essential to the functioning of a modern economy. One such
service is access to the payments system. This service may be thought of as trade
execution. A second service financial intermediary will continue to provide is access to
liquidity.
There will always have to be some mechanism for channeling the savings of households
into the investments of firms which is the fundamental role of a financial intermediary. A
third service financial intermediary will have to offer a service related to a traditional
banking function is to package and sell risk, or to repackage and resell risk. This service
could be provided through a number of different institutional arrangements. A fourth
service financial intermediary will be called upon to offer is information. The provision
of information will include the certification of the quality of assets together with credit
review and possible follow-up. Finally, financial intermediaries will remain a means
through which government guarantees will be provided. This service will be provided
both explicitly and implicitly. Some financial intermediaries will continue to have access
to the central bank, which will operate as a lender of last resort.
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