FINANCIAL INTERMEDIATION

Financial Intermediation



Financial Intermediation

Introduction

In this paper we review the state of intermediation theory and attempt to reconcile it with the observed behavior of institutions in modern capital markets. We argue that many current theories of intermediation are too heavily focused on functions of institutions that are no longer crucial in many developed financial systems. They focus on products and services that are of decreasing importance to the intermediaries, while they are unable to account for those activities which have become the central focus of many institutions. In short, we suggest that the literature's emphasis on the role of intermediaries as reducing the frictions of transaction costs and asymmetric information is too strong. The evidence we offer suggests that while these factors may once have been central to the role of intermediaries, they are increasingly less relevant.

We offer in its place a view of intermediaries that centers on two different roles that these firms currently play. These are facilitators of risk transfer and in dealing with the increasingly complex maze of financial instruments and markets. Risk management has become a key area of intermediary activity, though intermediation theory has offered little to explain why institutions should perform this function. In addition, we argue that the facilitation of participation in the sector is an important service provided by these firms. We suggest that reducing participation costs, which are the costs of learning about effectively using markets as well as participating in them on a day to day basis, play an important role in understanding the changes that have taken place.

Review and Critique of Current Intermediation Theory

In the traditional Arrow-Debreu model of resource allocation, firms and households interact through markets and financial intermediaries play no role. When markets are perfect and complete, the allocation of resources is Pareto efficient and there is no scope for intermediaries to improve welfare. Moreover, the Modigliani-Miller theorem applied in this context asserts that financial structure does not matter: households can construct portfolios which offset any position taken by an intermediary and intermediation cannot create value. See Fama (1980).

A traditional criticism of this standard market-based theory is that a large number of securities are needed for it to hold except in special cases. However, the development of continuous time techniques for option pricing models and the extension of these ideas to general equilibrium theory have negated this criticism. Dynamic trading strategies allow markets to be effectively complete even though a limited number of securities exist.

Such an extreme view - that financial markets allow an efficient allocation and intermediaries have no role to play- is clearly at odds with what is observed in practice. Historically, banks and insurance companies have played a central role. This appears to be true in virtually all economies except emerging economies which are at a very early stage. Even here, however, the development of intermediaries tends to lead the development of financial markets themselves. See McKinnon (1973).

In short, banks have existed since ancient times, taking deposits from households and making loans to economic agents ...