The Principles of Intermediation

Summary

Intermediaries perform several functions. The traditional view of such functions is addressed in Section 1. First, they alleviate market imperfections caused by economies of scale in transactions in financial markets and in information gathering and portfolio management. Among intermediaries, whose main rationale is to be found in this role, are the various investment trusts, unit trusts, pension funds, etc. If it was not for such imperfections, everyone could in theory manage his own financial assets as well as a trust manager. Secondly, intermediaries provide insurance services: people dislike the prospect of accidents such as fire, injury, burglary, and are quite prepared to accept lower mean expected incomes (after payment of insurance premia) in order to insure against the risk of a severe reduction in living standards. These forms of financial intermediation need not involve much risk-taking by the intermediary: the unit trust, whose existence depends on economies of scale, can perform its functions at a profit while matching its assets with its liabilities, while the insurance company can match its assets to the actuarial expectation of its contingent liabilities.

The third, and archetypal type of financial intermediation, involves issuing liabilities of a kind preferred by lenders (at relatively low yields) and investing a proportion of the funds in higher-yielding earning assets of a form which borrowers prefer to issue. The intermediary attracts funds from the public by offering varying combinations of redemption terms — e.g., the date of its maturity, concomitant services and interest payments. If the intermediary offers very liquid liabilities, it will in general have to maintain a larger proportion of low-yielding reserves in its portfolio in order to honour its redemption obligations; so there will normally be an inverse relationship between the liquidity of the intermediary’s liability and the rate of interest offered in it, an extreme example being the low yields offered on sight deposits.

In some part, the preference of savers for liquid assets and of borrowers for loans of longer-term maturities can be regarded as a form of insurance against the timing and magnitude of future uncertain cash flows. The desire of depositors for such insurance cannot, however, be provided by a standard insurance contract, since the desire to spend early is privately, not publicly, observable. The role of information asymmetries in determining the need for, and form of, financial intermediaries provides the main theme of Section 2, which sets out the newly emerging theory of financial intermediation.

One of the crucial information asymmetries is that the executives of most businesses know considerably more about their current and future prospects than anyone else. This hinders the development of public markets in the assets of such private-sector firms. There are means of overcoming this asymmetry, via signalling methods and the use of information gathering and disseminating agencies, e.g., auditors, credit rating agencies, etc., but there are limits to their usefulness. Given the absence of well-functioning markets in primary securities issuable by smaller companies and persons, the bank acts as a substitute for such incomplete markets by specialising in assessing credit risk and monitoring loan projects. Such asymmetries of information imply that the optimal loan contract will be of a fixed interest form, supported by collateral and/or bankruptcy penalties and, analogously, the optimal bank liability will also be a fixed interest deposit supported by a buffer of bank capital.

Having discussed the various functions undertaken by financial intermediaries, we then turn in Section 3 to the question of whether there is anything special about banks, as compared with other financial intermediaries (OFIs), in the determination of their respective equilibria, or in the adjustment process to that equilibrium. In both cases the equilibrium conditions have to be assessed within a portfolio adjustment framework in which there is no fundamental, or significant, difference between the economic context facing banks as compared with OFIs. On the other hand, the impact and dynamic adjustment path resulting from a supply-side shock within the banking system may differ from that arising from a supply-side shock elsewhere, in so far as the counterpart to bank asset expansion is more commonly absorbed in buffer-stock monetary adjustment.