The Theory of Financial Intermediation:

THE THEORY OF FINANCIAL INTERMEDIATION AN experiment ON WHAT IT DOES (NOT) EXPLAIN by Bert Scholtens and Dick van Wensveen SUERF The European Money and Finance Forum Vienna 2003 CIP The possibleness of pecuniary intermediation An Essay On What It Does (Not) Explain by Bert Scholtens, and Dick van Wensveen Vienna SUERF (SUERF Studies 2003/1) ISBN 3-902109-15-7 Keywords Financial Intermediation, Corpo appreciate Finance, Assymetric In solveation, Economic Development, Risk Management, Value Creation, Risk Transformation. JELclassificationnumbers E50,G10,G20,L20,O16 2003 SUERF, ViennaCopyright reserved. Subject to the exception domiciliated for by law, no fortune of this publication may be reproduced and/or published in print, by photocopy, on microfilm or in any some separate way without the written consent of the copyright holder(s) the resembling applies to whole or partial adaptations. The publisher retains the sole right to collect from third parties fees payable in resp ect of copying and/or take legal or other action for this purpose. THE THEORY OF FINANCIAL INTERMEDIATION AN ESSAY ON WHAT IT DOES (NOT) EXPLAIN+ by Bert Scholtens* Dick van WensveenAlso read Theories Seen in OjtAbstract This essay radiates upon the family family in the midst of the current scheme of fiscal mediation and hearty- solid intellect practice. Our critical analysis of this conjecture go outs to several make blocks of a brand-new supposition of monetary mediation. Current pecuniary mediation speculation builds on the picture that intermediaries serve to reduce transaction be and instructional asymmetries. As victimizations in discip striving technology, deregulating, deepening of pecuniary merchandises, and so on end to reduce transaction costs and festeringal asymmetries, pecuniary intermediation theory sh tout ensemble keep down to the conclusion that intermediation becomes useless. This agate lines with the practitioners view of fiscal in termediation as a value-creating scotchal process. It likewise conflicts with the keep and change magnitude economic brilliance of pecuniary intermediaries. From this paradox, we conclude that current fiscal intermediation theory fails to be sick up a satisfactory under(a)standing of the introduction of pecuniary intermediaries. We wish to thank Arnoud Boot, David T. Llewellyn, Martin M. G. Fase and Robert Merton for their help and their stimulating comments. However, achievely opinions take a hop those of the authors and precisely we argon responsible for mistakes and omissions. * Associate Professor of Financial Economics at the University of Groningen PO Box 800 9700AVGroningenTheNetherlands(correspondingauthor). Professor of Financial Institutions at the Erasmus University of Rotterdam PO Box 1738 3000 DR Rotterdam The Netherlands, (former Chairman of the Managing Board of MeesPierson).We dumbfound structure blocks for a theory of pecuniary intermediation t hat aims at understanding and explaining the existence and the behavior of reliable-life monetary intermediaries. When info asymmetries be not the driving force asshole intermediation activity and their elimination is not the commercial motive for monetary intermediaries, the brain arises which paradigm, as an election, could better express the essence of the intermediation process. In our opinion, the concept of value creation in the context of the value chain great power serve that purpose.And, in our opinion, it is jeopardize and hazard caution that drives this value creation. The absorption of risk is the central service of both banking attach toing and insurance. The risk pop off bridges a mismatch between the tot of nest egg and the subscribe to for investitures as savers argon on average more(prenominal) than risk averse than real investors. Risk, that government agency maturity risk, counterparty risk, grocery store risk (interest rate and stock p rices), life expectancy, income expectancy risk etc. , is the core product line of the fiscal fabrication.Financial intermediaries good enshroud d sore risk on the shield required by the grocery store place because their scale permits a sufficiently diversify portfolio of investments needed to offer the security required by savers and policyholders. Financial intermediaries be not just agents who check and monitor on behalf of savers. They atomic number 18 active counterparts themselves offering a specific product that brush offnot be offered by individual investors to savers, viz. cover for risk. They use their disposition and their balance sheet and off-balance sheet items, rather than their really limited own currency, to act as such counterparts.As such, they piss a pivotal perish deep down the modern economy. TABLE OF CONTENTS 1. Introduction7 2. The Perfect Model9 3. Financial Intermediaries in the Economy11 4. Modern Theories of Financial Intermediation 15 5. Critical judicial decision21 6. An selection Approach of Financial Intermediation31 7. Building Blocks for an amend Theory37 8. A New Research Agenda41 References45 Appendix A53 display boards 1. Share of habit in Financial go in Total Employment (percentages)12 2. Share of Value-Added in Financial Services in GDP (percentages)12 3.Financial Intermediary Development over Time for About 150 Countries (percentages)12 4. (Stylized) Contemporary and Amended Theory of Financial Intermediation38 SUERF56 SUERF Studies57 1. Introduction When a banker starts to take apart the theory of pecuniary intermediation in request to better understand what he has done during his professional life, he enters a military man unfathomable to him. That gentleman is full of concepts which he did not, or hardly, knew before and full of expressions he never accept himself unsymmetric information, perverse selection, observe, pricey state verification, moral hazard and a couple more of t he same kind.He gets the uneasy signature that a growing divergence has emerged between the micro- economic theory of banking, as it took shape in the put out three decades, and the e reallyday behavior of bankers consort to their business motives, expressed in the language they use. This essay tries to reflect on the merits of the present theory of pecuniary intermediation, on what it does and does not explain from both a practical and a theoretical point of view. The theory is impressive by the multitude of applications in the financial military man of the agency theory and the theory of asymmetric information, of adverse selection and moral hazard.As well as by their relevance for authorized aspects of the financial intermediation process, as is shown in an ever-growing stream of economic studies. But the study of all these theories leaves the practitioner with the impression that they do not deliver a satisfactory answer to the radical question which forces really driv e the financial intermediation process? The current theory shows and explains a capacious variety in the behavior of financial intermediaries in the commercialize in their relation to savers and to investors/entrepreneurs.But as removed as the authors of this essay are aware, it does not, or not yet, provide a satisfactory answer to the question of why real-life financial institutions exist, what keeps them alive and what is their essential contri preciselyion to (inter)national economic public assistance. We believe that this question cannot be intercommunicate by a further extension of the present theory, by the modelling of the agency theory and the theory of asymmetric information. The question goes into the heart of the present theory, into the paradigm on which it is ground.This paradigm is the famous classical thought process of the spotless market, introduced by Marshall and Walras. Since then, it has been the leading principle, the central point of reference in t he theory of competition, the neoclassical growth theory, the portfolio theory and to a fault the leading principle of the present theory of financial intermediation. Financial intermediaries, concord to that theory, have a function only because financial markets are not perfect. They exist by the coldcock of market 7 8Introduction imperfections.As long as thither are market imperfections, in that location are intermediaries. As soon as markets are perfect, intermediaries are redundant they have lost their function because savers and investors dispose of the perfect information needed to dress distributively other directly, immediately and without any impediments, so without costs, and to deal at optimal prices. This is the common equilibrium model a la Arrow-Debreu in which banks cannot exist. Obviously, this contrasts with the huge economic and companionable importance of financial intermediaries in highly developed modern economies.Empirical observations point at an increa sing office for financial intermediaries in economies that experience vastly decreasing information and transaction costs. Our essay goes into this paradox and comes up with an amendment of the existing theory of financial intermediation. The structure of this paper is as follows. First, we introduce the foundations of the modern literature of financial intermediation theory. From this, we infer the fall upon predictions with respect to the use of the financial go-between within the economy.In Section 3, we give investigate the de facto function of financial intermediaries in modern economies. We discuss views on the theoretical relevance of financial intermediaries for economic growth. We also present some stylized facts and verifiable observations about their current position in the economy. The mainstream theory of financial intermediation is briefly presented in Section 4. Of course, we cannot pay sufficient attention to all nurtures in this area but will focus on the in troductory rationales for financial intermediaries according to this theory, i. . information problems, transaction costs, and standard. Section 5 is a critical measure outment of this theory of financial intermediation. An ersatz entree of financial intermediation is unfolded in Section 6. In Section 7, we present the main building blocks for an alternative theory of financial intermediation that aims at understanding and explaining the behavior of real-life financial intermediaries. Here, we argue that risk heed is the core issue in understanding this behavior.Transforming risk for ultimate savers and lenders and risk humpment by the financial go-between itself creates economic value, both for the mediator and for its client. Accordingly, it is the transformation and practisement of risk that is the intermediaries contribution to the economic welfare of the society it operates in. This is in our opinion the hidden or neglected economic rationale behind the thusly fart and the existence and the future of real-life financial intermediaries.In Section 8, we conclude our essay with a proposal for a look for agenda for an amended theory of financial intermediation. 2. The Perfect Model Three pillars are at the priming coat of the modern theory of pay 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. balance wheel means that markets are cleared by price adjustment through arbitrage at each moment in judgment of conviction.In the neoclassical model of a perfect market, e. g. the perfect market for roof, or the Arrow-Debreu world, the quest criteria usually must be met no individual party on the market can determine prices conditions for borrowing/lending are satisfactory for all parties under equal circumstances in that location are no discriminatory taxes abse nce of scale and scope economies all financial titles are homogeneous, divisible and tradable there are no information costs, no transaction costs and no insolvency costs all market parties have ex ante nd ex send immediate and full information on all factors and events relevant for the (future) value of the traded financial instruments. The Arrow-Debreu world is based on the paradigm of complete markets. In the study of complete markets, present value prices of investment projects are well defined. Savers and investors find each other because they have perfect information on each others preferences at no cost in nightspot to exchange savings against readily available financial instruments.These instruments are constructed and traded costlessly and they fully and simultaneously meet the inescapably of both savers and investors. Thus, each possible future state of the world is fully covered by a so-called Arrow-Debreu security (state contingent claim). Also important is that the supply of capital instruments is sufficiently diversified as to provide the possibility of full risk diversification and, thanks to complete information, market parties have homogeneous expectations and act rationally.In so far as this does not occur infixedly, intermediaries are useful to bring savers and investors together and to create instruments that meet their needs. They do so with reimbursement of costs, but costs are by definition an chemical element or, rather, characteristic of market imperfection. on that pointfore, intermediaries are at top hat tolerated and would be buy the farmd in a move towards market perfection, with all intermediaries becoming 9 10The Perfect Model redundant the perfect state of disintermediation. This model is the scratch 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 vary financial intermediaries, are betn as market imperfectio ns. This wording suggests that intermediation is something which processs a situation which is not perfect, therefore is undesirable and should or will be temporary. The perfect market is like nirvana, it is a teleological perspective, an ideal standard according to which reality is judged. As soon as we are in heaven, intermediaries are superfluous. There is no room for them in that magnificent place.Are we going to heaven? Are intermediaries increasingly becoming superfluous? One would be inclined to answer both questions in the affirmative when looking to what is actually happening Increasingly, we have to make do with liberalized, deregulated financial markets. 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, twenty-four hours a day, thanks to the breathtaking phylogenesiss in information and communication technology.Firms issue shares over the Internet and inves tors can put their order directly in financial markets thanks to the virtual reality. The communication transmutation also reduces information costs tremendously. The liberalization and deregulating give, moreover, a soused stimulus towards the securitization of financial instruments, making them transparent, homogeneous, and tradable in the international financial centers in the world. and taxes are discriminating, inside and between countries. Transaction costs are lock there, but they are declining in relative importance thanks to the cost efficiency of ICT and efficiencies of scale.Insolvency and liquidity risks, however, still are an important rise of heterogeneity of financial titles. Furthermore, every new crash or crisis invokes calls for admissional and more timely information. For example, the Asia crisis resulted in more advanced and verifiable and controllable international financial statistics, whereas the Enron debacle has put the existing business accounting an d reporting standards into question. There appears to be an al well-nigh unstoppable demand for additional information. 3. Financial Intermediaries in the EconomySo, we are making important progress in our march towards heaven and what happens? Is financial intermediation attenuation away? One might think so from the forces shaping the current financial environment deregulation and liberalization, communication, internationalization. But what is actually happening in the real world? Do we really witness the end of the financial institutions? Are the intermediaries about to vanish from planet Earth? On the contrary, their economic importance is high than ever and appears to be increasing.This is the case even during the nineties when markets became al about fully liberalized and when communication on a global scale made a real and almost complete breakthrough. The tendency towards an increasing role of financial intermediation is illustrated in accedes 1 and 2 that give the relat ive contribution of the financial domain to the two key items of economic wealthiness and welfare in most nations, i. e. GDP and labor. These tables show that, even in highly developed markets, financial intermediaries tend to play a substantial and increasing role in the current economy.Furthermore, Demirguc-Kunt and Levine (1999) among others, conclude that claims of deposit money banks and of other financial institutions on the private sphere have steadily increased as a percentage of GDP in a giving number of countries (circa 150), rich and poor, between the 1960s and 1990s. The pace of increase is not declining in the 1990s. This is reflected in Table 3. In the 1960s, Raymond Goldsmith (1969) gave stylized facts on financial structure and economic development (see appendix A). He found that in the course of economic development, a countrys financial formation grows more rapidly than national wealth.It appears that the main determinant of the relative size of a countrys fina ncial system is the separation of the functions of saving and investing among contrastive (groups of) economic units. This observation sounds remarkably modern. Since the early 1990s, there has been growing recognition for the positive daze of financial intermediation on the economy. Both theoretical and empirical studies find that a well-developed financial system is beneficial to the economy as a whole. Basically the affirmation behind this idea is that the efficient apportioning of capital within an economy fosters economic growth (see Levine, 1997).Financial intermediation can dissemble economic growth by acting on the saving rate, on the split of saving channeled to investment or on the social marginal productivity of investment. In general, financial development will be positive for economic growth. But some improvements in risk-sharing and in the 11 12Financial Intermediaries in the Economy address market for households may decrease the saving rate and, hence, the grow th rate (Pagano, 1993). Table 1 Share of Employment in Financial Services in Total Employment (percentages) root word OECD, bailiwick Accounts (various issues)Table 2 Share of Value-Added in Financial Services in GDP (percentages) arising OECD, National Accounts (various issues) Table 3 Financial Intermediary Development over Time for About 150 Countries (percentages) Source Demirguc-Kunt and Levine (1999, Figure 2A) 1970 1980 1985 1990 1995 2000 Canada 2. 4 2. 7 2. 9 3. 0 3. 2 3. 1 France 1. 8 2. 6 2. 9 2. 8 2. 7 2. 8 Germany 2. 2 2. 8 3. 0 3. 1 3. 3 3. 3 japan 2. 4 3. 0 3. 2 3. 3 3. 4 3. 5 Switzerland 4. 6 4. 8 4. 8 4. 9 get together Kingdom 3. 0 3. 5 4. 6 4. 4 4. 4 United States 3. 8 4. 4 4. 7 4. 8 4. 8 4. 8 1970 980 1985 1990 1995 2000 Canada 2. 2 1. 8 2. 0 2. 8 2. 9 3. 1 France 3. 5 4. 4 4. 8 4. 4 4. 6 4. 8 Germany 3. 2 4. 5 5. 5 4. 8 5. 8 5. 7 Japan 4. 3 4. 5 5. 5 4. 8 5. 6 5. 3 Netherlands 3. 1 4. 0 5. 3 5. 6 5. 5 5. 8 Switzerland 10. 4 10. 3 13. 1 12. 8 United State s 4. 0 4. 8 5. 5 6. 1 7. 2 7. 1 1960s 1970s 1980s 1990s Liquid liabilities/GDP 32 39 47 51 Claims by deposit money banks on private sector/GDP 20 24 32 39 Financial Intermediaries in the Economy13 There are polar views on how the financial structure affects economic growth exactly (Levine, 2000). The bank-based view holds that bank-based systems in bad-tempered at early stages of economic development foster economic growth to a greater phase than market-based systems. ? The market-based view emphasizes that markets provide key financial service that stimulate innovation and long-run growth. ? The financial work view stresses the role of banks and markets in researching firms, exerting corporate control, creating risk management devices, and mobilizing societys savings for the most productive endeavors in tandem.As such, it does regard banks and markets as complements rather than substitutes as it focuses on the quality of the financial services produced by the entire financia l system. ? The legal-based view rejects the analytical validity of the financial structure debate. It argues that the legal system shapes the quality of financial services (for example La Porta et al. , 1998). The legal-based view stresses that the component of financial development explained by the legal system critically influences long-run growth.Political factors have been introduced too, in order to explain the relationship between financial and economic development (see Fohlin, 2000 Kroszner and Strahan, 2000 Rajan and Zingales, 2000). From empirical research of the relationship between economic and financial development, it appears that history and path-dependency weigh very heavy in determining the growth and design of financial institutions and markets. Furthermore, idiosyncratic shocks that surprise institutions and markets over time appear to be quite important.Despite obvious connections among political, legal, economic, and financial institutions and markets, long-term causative relationships often prove to be elusive and appear to depend upon the methodology chosen to study the relationship. 1 But it is important to realize that efficient financial intermediation confers two important benefits it raises 1 For example, see Berthelemy and Varoudakis, 1996 Demetriades and Hussein, 1996 Kaplan and Zingales, 1997 Sala-i-Martin, 1997 Fazzari et al. , 1988 Levine and Zervos, 1998 Demirguc-Kunt and Levine, 1999 Filer et al, 1999 Beck and Levine, 2000 Beck et al. 2000 Benhabib and Spiegel, 2000 Demirguc-Kunt and Maksimovic, 2000 Rousseau and Wachtel, 2000 Arestis et al. , 2001 Wachtel, 2001. 14Financial Intermediaries in the Economy the level of investment and savings, and it increases the efficiency in the allocation of financial funds in the economic system. There is a structural tendency in the small-arm of national wealth represented in financial titles in many countries, especially the Anglo Saxon, towards the electrical switch of bank held asse ts (bank loans etc. ) by securitized assets held by the public (equity, bonds) (Ross, 1989).This substitution is often interpreted as a proof of the disintermediation process (e. g. Allen and Santomero, 1997). However, this substitution does not imply that bank loans are not growing any more. To the contrary, they continue to grow, even in the U. S. where the substitution is most visible (see Boyd and Gertler, 1994 Berger et al. , 1995). Therefore, this substitution may not be interpreted as a sign of a diminishing role of banking in general. This is because it is the banks that play an essential role in the securitized instruments.They initiate, couch and underwrite the floating of these instruments. They often maintain a secondary market. They invent a multitude of off-balance instruments derived from securities. They provide for the clearing of the deals. They are the custodians of these constructions. They provide stock lending and they finance market makers in options and futu res. Thus, banks are of the essence(p) drivers of financial innovation. Furthermore, it is still an unsolved question of how the off-balance instruments should be counted in the statistics of national wealth.Their huge notional amounts do not reflect the constantly varying values for the incuring parties. Banks are moving in an off-balance vigilance and their purpose is increasingly to develop and provide tradable and non-tradable risk management instruments. And other kinds of financial intermediaries play an increasingly important role in the same direction, both in securitized and non-tradable instruments, both on- and off-balance insurance companies, pension funds, investments funds, market makers at stock exchanges and derivative markets.These incompatible kinds of financial intermediaries transform risk (concerning future income or accidents or interest rate fluctuations or stock price fluctuations, etc. ). Risk transformation and risk management is their job. Thus, despit e 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. This seems paradoxical. It points to something important which the modern financial intermediation theory, and the neo-classical market theory on which it is based, do not explain.Might it be the case that it overlooks something crucial? Something that is to be linkd to information production but that is, so far, not uncovered by the theory of financial intermediation? 4. Modern Theories of Financial Intermediation In order to give firm ground to our argument and to illustrate the paradox, we will first review the doctrines of the theory of financial intermediation. 2 These are specifications, relevant to the financial services industry, of the agency theory, and the theory of imperfect or asymmetric information.Basically, we may distinguish between three lines of reasoni ng that aim at explaining the raison detre of financial intermediaries information problems, transaction costs and regulative factors. First, and that used in most studies on financial intermediation, is the informational asymmetries argument. These asymmetries can be of an ex ante nature, generating adverse selection, they can be interim, generating moral hazard, and they can be of an ex post nature, resulting in auditing or costly state verification and enforcement. The informational asymmetries generate market imperfections, i. . deviations from the neoclassical framework in Section 2. Many of these imperfections lead to specific forms of transaction costs. Financial intermediaries appear to overcome these costs, at least partially. For example, ball field and Dybvig (1983) consider banks as coalitions of depositors that provide households with insurance against idiosyncratic shocks that adversely affect their liquidity position. Another approach is based on Leland and Pyle (197 7). They interpret financial intermediaries as information sharing coalitions.Diamond (1984) shows that these intermediary coalitions can achieve economies of scale. Diamond (1984) is also of the view that financial intermediaries act as delegated monitors on behalf of ultimate savers. Monitoring will involve increasing returns to scale, which implies that specializing may be entrancing. Individual households will delegate the observe activity to such a specialist, i. e. to the financial intermediary. The households will put their deposits with the intermediary. They may withdraw the deposits in order to discipline the intermediary in his monitoring function.Furthermore, they will positively value the intermediarys involvement in the ultimate investment (Hart, 1995). Also, there can be assigned a positive incentive proceeding of short-term debt, and in particular deposits, on bankers (Hart and Moore, 1995). For example, Qi (1998) and Diamond and Rajan (2001) show that deposit fin ance can create 2 We have used the widely cited reviews by Allen, 1991 Bhattacharya and Thakor, 1993 Van Damme, 1994 Freixas and Rochet 1997 Allen and Gale, 2000b Gorton and Winton, 2002, as our main sources in this section. 15 6Modern Theories of Financial Intermediation the right incentives for a banks management. Illiquid assets of the bank result in a fragile financial structure that is essential for disciplining the bank manager. Note that in the case households that do not turn to intermediated finance but prefer direct finance, there is still a brokerage role for financial intermediaries, such as investment banks (see Baron, 1979 and 1982). Here, the reputation effect is also at stake. In financing, both the reputation of the borrower and that of the operate are relevant (Hart and Moore, 1998).Dinc (2001) studies the effects of financial market competition on a bank reputation mechanism, and argues that the incentive for the bank to keep its commitment is derived from its re putation, the number of competing banks and their reputation, and the competition from bond markets. These four aspects clearly move (see also Boot, Greenbaum and Thakor, 1993). The informational asymmetry studies focus on the bank/borrower and the bank/lender relation in particular. In bank lending one can basically distinguish proceeding-based lending (financial statement lending, asset- based lending, credit scoring, etc. ) and relationship lending.In the former class information that is relatively easily available at the time of loan origination is used. In the latter class, data gathered over the course of the relationship with the borrower is used (see Lehman and Neuberger, 2001 Kroszner and Strahan, 2001 Berger and Udell, 2002). Central themes in the bank/borrower relation are the harbouring and monitoring function of banks (ex ante information asymmetries), the adverse selection problem (Akerlof, 1970), credit rationing (Stiglitz and Weiss, 1981), the moral hazard problem (Stiglitz and Weiss, 1983) and the ex post verification problem (Gale and Hellwig, 1985).Central themes in the bank/lender relation are bank runs, why they occur, how they can be prevented, and their economic consequences (Kindleberger, 1989 Bernanke, 1983 Diamond and Dybvig, 1983). Another avenue in the bank/lender relationship are models for competition between banks for deposits in relation to their lending policy and the prob top executive that they fulfill their obligations (Boot, 2000 Diamond and Rajan, 2001). wink is the transaction costs approach (examples are Benston and Smith, 1976 Campbell and Kracaw, 1980 Fama, 1980).In contrast to the first, this approach does not contradict the assumption of complete markets. It is based on nonconvexities in transaction technologies. Here, the financial intermediaries act as coalitions of individual lenders or borrowers who exploit economies of scale or scope in the transaction technology. The notion of transaction costs encompasses n ot only exchange or monetary transaction costs (see Tobin, 1963 Towey, 1974 Fischer, 1983), but also search costs and monitoring and auditing costs (Benston and Smith, 1976). Here, the role of Modern Theories of Financial Intermediation17 he financial intermediaries is to transform particular financial claims into other types of claims (so-called soft 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 private and institutional financing. Holmstrom and Tirole (2001) suggest that this liquidity should play a key role in asset determine theory.The result is that unique characteristics of bank loans emerge to enhance efficiency between borrower and lender. In loan contract design, it is the urge to be able to efficiently bargain in later (re)negotiations, rather than to fully assess current or expected default risk that structures the ultimate contract (Gorton and Kahn, 2000). With transaction costs, and in contrast to the information asymmetry approach, the reason for the existence of financial intermediaries, namely transaction costs, is exogenous. This is not fully the case in the third approach.The third approach to explain the raison detre of financial intermediaries is based on the regulation of money production and of saving in and financing of the economy (see Guttentag and Lindsay, 1968 Fama, 1980 Mankiw, 1986 Merton, 1995b). Regulation affects solvency and liquidity with the financial institution. Diamond and Rajan (2000) show that bank capital affects bank safety, the banks ability to refinance, and the banks ability to extract repayment from borrowers or its uncoercedness to liquidate them.The legal-based view especially (see Section 3), sees regulation as a crucial factor that shapes the financia l economy (La Porta et al. , 1998). Many view financial regulations as something that is congeriesly exogenous to the financial industry. However, the activities of the intermediaries inherently ask for regulation. This is because they, the banks in particular, by the way and the art of their activities (i. e. qualitative asset transformation), are inherently insolvent and illiquid (for the example of deposit insurance, see Merton and Bodie, 1993).Furthermore, money and its value, the key raw material of the financial services industry, to a heavy(a) extent is both defined and determined by the nation state, i. e. by regulating authorities par excellence. Safety and soundness of the financial system as a whole and the enactment of industrial, financial, and fiscal policies are regarded as the main reasons to regulate the financial industry (see Kareken, 1986 Goodhart, 1987 Boot and Thakor, 1993).Also, the financial history shows a clear interplay between financial institutions an d markets and the regulators, be it the present-day specialized financial supervisors or the old-fashioned sovereigns (Kindleberger, 1993). Regulation of financial intermediaries, especially of banks, is costly. There are the direct costs of administration and of employing the supervisors, and 18Modern Theories of Financial Intermediation there are the indirect costs of the distortions generated by monetary and prudent 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 operation 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 when they go into the dynamics of financial regulation. Thus, to summarize, 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 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 trans formation 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 3 The importance of regulation for the existence of the financial intermediary can best be understood if one is prepared to account for the diachronic and institutional setting of financial intermediation (see Kindleberger, 1993 Merton, 1995b).Interestingly, and illustrating the crucial importance of regulation for financial intermediation, is that there are some a uthors who suggest that unregulated finance or free banking would be highly desirable, as it would be stable and inflation-free. Proponents of this view are, among others, White, 1984 Selgin, 1987 Dowd, 1989. Modern Theories of Financial Intermediation19 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, that means to market perfection. Ideally, financial intermediaries should not be there and, being there, they at best gentle 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 alone eliminate inf ormational 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 these weird creatures still in business, even despite the fierce competition amongst themselves? Are they truly dinosaurs, on the whole unaware of the experimental extinction they will face in the very near future? This seems highly unlikely. Section 3 showed and argued that the financial intermediaries are alive and kicking. They 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.Therefore, the next section is a critical assessment of the modern theory of financial intermediation in the face of the real-world behavior and impact of financial institutions and markets. 5. Critical Assessment Two issues are of key importance. The first is about why we demand banks and other kinds of financial intermediaries. The answer to this question, in our opinion, is risk management rather than informational asymmetries or transaction costs. Economies of scale and scope as well as the delegation of the screening and monitoring function especially apply to dealing with risk itself, rather than only with information.The second issue that matters is why banks and other financial institutions are willing and able to take on the risks that are inevitably involved in their activity. In this respect, it is important to note that financial intermediaries are able to create comparative advantages with respect to information acquisition and impact in relation to their sheer size in relation to the customer whereby they are able to manage risk more efficiently. We suggest Schumpeters view of entrepreneurs as innovators and Mertons functional perspective of financial intermediaries in tandem are very helpful in this respect.One should question whether the existence of financial intermediaries and the structural development of financial intermediation can be fully explained by a theoretical framework based on the neo-classical concept of perfect competition. The mainstream theory of financial intermediation, as it has been developed in the chivalric tense few decades, has without any doubt provided numerous valuable insights into the behavior of banks and other intermediaries and their managers in the financial markets under a broad variety of perceived and observed circumstances.For example, the agency revolution, unleashed by Jensen and Meckling (1976), focussed on principal-agent relation asymmetries. Contracts and conflicts of interest on all levels inside and outside the firm in a world full of information asymmetries became the central theme in the analysis of financial decisions. Important aspects of financial decisions, which antecedently went unnoticed in the neo- classical theory, could be studied in this approach, and a subdued bo x of financial decision making was opened. But the power of the agency heory is also her weakness it mainly explains ad hoc situations new models based on different combinations of assumptions continuously extend it. 4 In nearly all 4 To this extent, one can draw a striking parallel with the conventional Newtonian view of the natural world. The planetary orbits round the Sun can be explained very well with the Newtonian laws of gravitation and force. evident anomalies in the orbital movement of Neptune turned out to be caused by the influence of an hitherto unknown planet (Pluto).Its (predicted) astronomical 21 22Critical Assessment financial decisions, information differences and, as a consequence, conflicts of interest, play a role. Focussed on these aspects, the agency theory is capable of investigating nearly every contingency in the interaction of economic agents deviating from what they would have done in a market with perfect foresight and equal incentives for all agents. H owever, the applications from agency theory have mainly anecdotal value they are tested in a multitude of specific cases.But the theory fails to evolve into a general and coherent explanation of what is the basic function of financial intermediaries in the markets and the economy as a whole. Various researchers interested in real world financial phenomena have pointed out that banks in particular do make a difference. They come up with empirical recite that banks are special. For example, Fama (1985) and James (1987) analyze the incidence of the implicit tax due(p) to reserve requirements. Both conclude that bank loans are special, as bank CDs have not been eliminated by non-bank alternatives that bear no reserve requirements.Mikkelson and Partch (1986) and James (1987) look at the abnormal returns associated with announcements of different types of security offerings and find a positive response to bank loans. Lummer and McConnel (1989) and Best and Zhang (1993) have confirmed th ese results. Slovin et al. (1993) look into the adverse effect on the borrower in case a borrowers bank fails. They find Continental Illinois borrowers incur strong negative abnormal returns during the banks impending failure. Gibson (1995) finds similar results when studying the effects of the health of Nipponese banks on borrowers.Gilson et al. (1990) find that the likelihood of a successful debt restructuring by a firm in grief is positively related to the extent of that firms reliance on bank borrowing. James (1996) finds that the higher(prenominal)(prenominal)(prenominal) the proportion of total debt held by the bank, the higher the likelihood the bank debt will be impaired, and so the higher the likelihood that it participates in the restructuring. Hoshi et al. (1991) for Japan and Fohlin (1998) and Gorton and Schmid (1999) for Germany also find that in these countries, banks provide valuable services that cannot be replicated in capital markets.Current intermediation theor y treats such observations often as an anomaly. But, in our perspective, it relates rather to the insufficient explanatory power of the current theory of financial intermediation. observation was regarded as an even greater success for Newtonian theory. However, it took Einstein and Bohr to reveal that this theory is only a limit case as it is completely unable to deal with the behavior of microparticles (see Couper and Henbest, 1985 Ferris, 1988 Hawking, 1988). Critical Assessment23The basic reason for the insufficient explanatory power of the present intermediation theory has, in our opinion, to be sought in the paradigm of asymmetrical information. Markets are imperfect, according to this paradigm, because the ultimate parties who operate in the markets have insufficient information to conclude a transaction by themselves. Financial intermediaries position themselves as agents (middlemen) between savers and investors, alleviating information asymmetries against transaction costs to a level where total savings are absorbed by real investments at equilibrium real interest rates.But in the real world, financial intermediaries do not consider themselves agents who intermediate between savers and investors by procuring information on investors to savers and by selecting and monitoring investors on behalf of savers. That is not their job. They deal in money and in risk, not in information per se. Information production predominantly is a means to the end of risk management. In the real world, borrowers, lenders, savers, investors and financial supervisors look at them in the same way, i. . risk managers instead of information producers. Financial intermediaries deal in financial services, created by themselves, mostly for their own account, via their balance sheet, so for their own risk. They attract savings from the saver and lend it to the investor, adding value by meeting the specific needs of savers and investors at prices that equilibrate the supply and dem and of money. This is a creative process, which cannot be characterized by the reduction of information asymmetries.In the intermediation process the financial intermediary transforms savings, given the preferences of the saver with respect to liquidity and risk, into investments according to the needs and the risk profile of the investor. It might be clear that for these reasons the views of Bryant (1980) and of Diamond and Dybvig (1983) on the bank as a coalition of depositors, of Akerlof (1970) and Leland and Pyle (1977) on the bank as an information sharing coalition, and of Diamond (1984) on the bank as delegated ( monitor, do not reflect at all the view of bankers on their own role. Nor does it reflect the way in which society experiences their existence. crimson with perfect information, the time and risk preferences of savers and investors fail to be matched completely by the price (interest rate) mechanism there are (too many) missing markets. It is the financial intermedi ary that somehow has to make do with these missing links. The financial intermediary manages risks in order to allow for the activities of other types of households within the economy.One would expect that the theory of the firm would pay ample attention to the driving forces behind entrepreneurial activity and could thus explain in more general terms the existence of financial intermediation as an entrepreneurial 24Critical Assessment activity. However, this is not the focus of that theory. The theory of the firm is preoccupied with the functioning of the corporate enterprise in the context of market structures and competition processes.In the instigate of Coase (1937), the corporate enterprise is part of the market structure and can even be considered as an alternative for the market. This view laid the foundation for the transaction cost theory (see Williamson, 1988), for the agency theory (Jensen and Meckling, 1976), and for the theory of asymmetric information (see Stiglitz an d Weiss, 1981 and 1983). Essential in the approaches of these theories is that the corporate enterprise is not treated as a black box, a uniform entity, as was the case in the traditional micro-economic theory of the firm.It is regarded as a coalition of interests operating as a market by itself and optimizing the opposing and often conflicting interests of different stakeholders (clients, personnel, financiers, management, public authorities, non-governmental organizations). The rationale of the corporate enterprise is that it creates goods and services, which cannot be produced, or only at a higher price, by consumers themselves. This exclusive function justifies transaction costs, which are seen as a form of market imperfection.The mainstream theory of the firm evolved under the paradigm of the agency theory and the transaction costs theory as a theory of economic organization rather than as a theory of entrepreneurship. A separate line of thinking in the theory of the firm is th e dynamic market approach of Schumpeter (1912), who stressed the essential function of entrepreneurs as innovators, creating new products and new distribution methods in order to gain competitory advantage in constantly developing and changing markets.In this approach, markets and enterprises are in a continuous process of creative desolation and the entrepreneurial function is pre-eminently dynamic. Basic inventions are more or less exogenous to the economic system their supply is perhaps influenced by market demand in some way, but their generation lies outside the existing market structure. Entrepreneurs seize upon these basic inventions and transform them into economic innovations. The successful innovators reap large short-term profits, which are soon bid away by imitators.The effect of the innovations is to disequilibrate and to alter the existing market structure, until the process eventually settles down in wait for the next (wave of) innovation. The result is a punctuated pattern of economic development that is perceived as a series of business cycles. Financial intermediaries, the ones that mobilize savings, allocate capital, manage risk, ease transactions, and monitor firms, are essential for economic growth and development. That is what Joseph Schumpeter argued early in this century.Now there is evidence to support Schumpeters view financial services promote development (see King and Critical Assessment25 Levine, 1993 Benhabib and Spiegel, 2000 Arestis et al. , 2001 Wachtel, 2001). The abstract link runs as follows Intermediaries can promote growth by increasing the fraction of resources society saves and/or by improving the ways in which society allocates savings. Consider investments in firms. There are large research, legal, and organizational costs associated with such investment.These costs can include evaluating the firm, coordinating financing for the firm if more than one investor is involved, and monitoring managers. The costs might be prohibitive for any single investor, but an intermediary could perform these tasks for a group of investors and lower the costs per investor. So, by researching many firms and by allocating credit to the best ones, intermediaries can improve the allocation of societys resources. Intermediaries can also diversify risks and exploit economies of scale.For example, a firm may want to fund a large project with high expected returns, but the investment may require a large lump-sum capital outlay. An individual investor may have incomplete the resources to finance the entire project nor the desire to devote a disproportionate part of savings to a single investment. Thus profitable opportunities can go unexploited without intermediaries to mobilize and allocate savings. Intermediaries do ofttimes more than passively decide whether to fund projects. They can initiate the creation and transformation of firms activities.Intermediaries also provide payment, settlement, clearing and netting se rvices. Modern economies, replete with complex interactions, require secure mechanisms to settle transactions. Without these services, many activities would be impossible, and there would be less scope for specialization, with a corresponding loss in efficiency. In addition to improving resource allocation, financial intermediaries stimulate individuals to save more efficiently by offering attractive instruments that combine attributes of depositing, investing and insuring.The securities most useful to entrepreneurs equities, bonds, bills of exchange may not have the exact liquidity, security, and risk characteristics savers desire. By offering attractive financial instruments to savers deposits, insurance policies, mutual funds, and, especially, combinations thereof intermediaries determine the fraction of resources that individuals save. Intermediaries affect both the quantity and the quality of societys output devoted to productive activities. Intermediaries also curve finan cial instruments to the needs of firms.Thus firms can issue, and savers can hold, financial instruments more attractive to their needs than if intermediaries did not exist. Innovations can also spur the development of financial services. Improvements in computers and communications have triggered financial innovations over the past 20 years. Perhaps, more important for developing countries, growth can increase the demand for financial services, sparking their adoption. 26Critical Assessment In translating these concepts to the world of financial intermediation, one ends up at the so-called functional perspective (see Merton, 1995a).The functions performed by the financial intermediaries are providing a transactions and payments system, a mechanism for the pooling of funds to undertake projects, ways and means to manage un surety and to control risk and provide price information. The key functions remain the same, the way they are conducted varies over time. This looks quite similar to what Bhattacharya and Thakor (1993) regard as the qualitative asset transformation operations of financial intermediaries, resulting from informational asymmetries.However, in our perspective, it is not a set of operations per se but the function of the intermediaries that gives way to their carriage in the real world. Of course, we are well aware of the fact that in the real-world the everyday performance of these different functions can be experienced by clients as to quote Boot (2000) an annoying set of transactions. The key functions of financial intermediaries are fairly stable over time. But the agents that are able and willing to perform them are not necessarily so. And neither are the focus and the instruments of the financial supervisors.An insurance company in 2000 is quite dissimilar in its products and distribution channels from one in 1990 or 1960. And a bank in Germany is quite different from one in the UK. Very different financial institutions and also very diff erent financial services can be developed to provide the de facto function. Furthermore, we have witnessed waves of financial innovations, consider swaps, options, futures, warrants, asset backed securities, MTNs, NOW accounts, LBOs, MBOs and MBIs, ATMs, EFTPOS, and the distribution revolution leading to e-finance (e. . see Finnerty, 1992 Claessens et al. , 2000 Allen et al. , 2002). From this, financial institutions and markets increasingly are in part complementary and in part substitutes in providing the financial functions (see also Gorton and Pennacchi, 1992 Levine, 1997). Merton (1995a) suggests a path of the development of financial functions. Instead of a secular trend, away from intermediaries towards markets, he acknowledges a some(prenominal) more cyclical trend, moving back and forth between the two (see also Rajan and Zingales, 2000).Merton argues that although many financial products tend to move secularly from intermediaries to markets, the providers of a given funct ion (i. e. the financial intermediaries themselves) tend to oscillate according to the product-migration and development cycle. Some products also move in the opposite direction, for example the mutual fund industry changed the newspaper publisher of the portfolios of US households substantially, that is, from direct held stock to indirect investments via mutual funds (Barth et al. , 1997). In our view, this mutual Critical Assessment27 und revolution in the US and elsewhere is a typical example of the increasing role for intermediated finance in the modern economy. Thus, in our opinion, one should view the financial intermediaries from an evolutionary perspective. They perform a crucial economic function in all times and in all places. However, the form they have changes with time and place. perchance once they were giants, dinosaurs so to say, in the US. Nowadays, they are no longer that powerful but they did not withdraw their key function, their economic niche.Instead, they evolved into much little and less visible types of business, just like the dinosaurs evolved into the much smaller omnipresent birds. Note that most of the theoretical and empirical literature actually refers to banks (as a particular form of financial intermediary) rather than to all financial institutions conducting financial intermediation services. However, the bank of the 21st century completely differs from the bank that operated in most of the 20th century. Both its on- and off-balance sheet activities show a qualitatively different composition.That is, away from purely interest related lending and borrowing business towards fee and provision based insurance-investment-advice-management business. At the same time, the traditional insurance, investment and pension funds enter the world of lending and financing. As such, financial institutions tend to become both more similar and more complex organisations. Thus, it appears that the traditional banking theories relate to the creation of loans and deposits by banks, whereas this increasingly becomes a smaller part of their business.This is not only because of the changing composition of their income structure (not only interest-related income but also fee-based income). Also it is the case because of the blurring borders between the operations of the different kinds of financial intermediaries. Therefore, we argue first that the loan and the deposit only are a means to an end which is admit both by the bank and the customer and that the bank and the non-bank financial intermediary increasingly develop qualitatively different (financial) instruments to manage risks.Questioning whether informational asymmetry is the principal explanatory variable of the financial intermediation process what we do does not imply denial of the pivotal role information plays in the financial intermediation process. On the contrary, under the strong influence of modern communication technologies and of the worldwide libera lization of financial services, the character of the financial intermediation process is rapidly changing. This causes a until now only relative decrease in traditional 28Critical Assessment forms of financial intermediation, namely in on-balance sheet banking.But the counterpart of this process the increasing role of the capital markets where savers and investors deal in marketable securities thanks to world wide real time information would be completely unthinkable without the growing and innovating role of financial intermediaries (like investment banks, securities brokers, institutional investors, finance companies, investment funds, mergers and acquisition consultants, rating agencies, etc. ). They facilitate the entrepreneurial process, provide bridge finance and invent new financial instruments in order to bridge different risk preferences of market parties by means of derivatives.It would be a misconception to interpret the relatively declining role of traditional banks, from the perspective of the financial sector as a whole, as a general process of disintermediation. To the contrary, the increasing number of different types of intermediaries in the financial markets and their increasing importance as financial innovators point to a swelling process of intermediation. Banks reconfirm their positions as engineers and facilitators of capital market transactions.The result is a secular upward trend in the ratio of financial assets to real assets in all economies from the 1960s onwards (see Table 3). It appears that informational asymmetries are not well-integrated into a dynamic approach of the development of financial intermedation and innovation. Well-considered, information, and the ICT revolution, plays a paradoxical role in this process. The ICT revolution certainly has an excluding effect on intermediary functions in that it bridges informational gaps between savers and investors and facilitates them to deal directly in open markets.This functi on of ICT promotes the exchange of loosely tradable, thus uniform products, and leads to the commoditizing of financial assets. But the ICT revolution provokes still another, and essentially just as revolutionary, effect, namely the customizing of financial products and services. Modern network systems and product software foster the development of ever more sophisticated, specific, finance and investment products, often embodying option-like structures on both contracting parties which are developed in specific deals, thus tailor made, and which are not tradable in open markets.Examples are specific financing and investment schemes (tax driven private equity deals), energy finance and transport finance projects, etc. They give competitive advantages to both contracting parties, who often are opposed to public knowledge of the specifics of the deal (especially when tax aspects are involved). So, general trading of these contracts is normally impossible and, above all, not aimed at. (But imitation after a certain time lag can seldom be prevented Informational data (on stock prices, interest and exchange rates, good and energy prices, Critical Assessment29 macroeconomic data, etc. ) are always a key ingredient of these investment products and project finance constructions. In this respect, information is attracting a pivotal role in the intermediation function because it is mostly the intermediation industry, not the ultimate contract parties that develop these new products and services. The function of information in this process, however, differs widely from that in the present intermediation