WhyDoFinancialIntermediariesExist

Why Do Financial Intermediaries Exist?

Evolution of Financial Institutions

• Advances in information economics, agency theory, and corporate finance have redefined the understanding of financial intermediaries.

• The pre-1970s view focused on commercial banks as conduits of monetary policy, particularly due to their role in money supply via checking accounts.

• The question of why financial intermediaries exist was largely overlooked, centering more on liquidity supply.

Frictionless Capital Markets

• In a theoretical competitive, frictionless market:

  • Individual borrowers and lenders can easily contract without financial intermediaries.

  • Financial intermediaries (FIs) are unnecessary if there are no information or transaction costs.

• The existence of financial intermediaries arises from market frictions that make contracting costly (e.g., information asymmetry).

Microeconomic Models

A Theory of the Banking Firm (Klein, 1971)

• Addresses why banks exist through a unique model.

• Banks can attract demand deposits without paying interest, acting as payment system administrators.

• Assumes banks as monopolistic price setters with market power in the loan market (relationship pricing).

• Concludes that interest rate regulations (Reg Q) are unnecessary, as loan decisions align with government securities' average returns.

• Fisher Separation Theorem applies under assumptions of independence between loan and borrowing rates, affecting term structure and interest rate risk.

Bank Funds Management in an Efficient Market (Black, 1975)

• Discusses the influence of information and transaction costs on bank services.

• Highlights that banks lower transaction costs for depositors and borrowers through ongoing relationships providing valuable information.

• Emphasizes the importance of market contracting costs in influencing bank strategies.

A Transactions Cost Approach to Financial Intermediation (Benston & Smith, 1976)

• Argues that financial intermediaries reduce contracting costs by streamlining information access and enforcement of contracts.

• Outlines that consumer demand for intermediation stems from minimizing transaction costs in financial decisions over time.

Banking in the Theory of Finance (Fama, 1980)

• Reconsiders the uniqueness of banks, concluding that regulation is the primary reason banks differ from other intermediaries.

• Examines banking’s role in money creation and the influence of reserve requirements on deposit limits.

Modeling the Banking Firm: A Survey (Santomero, 1984)

• Surveys microeconomic models influencing banking decisions on assets and capital structure.

• Addresses portfolio choice as affected by market nature and contracting costs.

• Highlights models with market power assumptions guiding loan supply.

Existence Literature Overview

• Klein (1973): Banks provide divisibility of securities services.

• Benston & Smith (1976): Banks mitigate transaction costs.

• Kane & Buser (1979): Banks form cheaper portfolios.

• Leland & Pyle (1977): Information asymmetries drive banks’ existence.

• Campbell & Kracaw (1980): Banks emerge as information producers.

More Sophisticated Models

Financial Intermediation & Delegated Monitoring (Diamond, 1984)

• Financial intermediaries mitigate contracting costs linked to information asymmetries.

• Examines moral hazard due to the uncertainty of monitoring borrowers post-loan.

• Demonstrates that diversification in loans resolves moral-hazard issues, underscoring economies of scale in information production.

Bond Covenants & Delegated Monitoring (Berlin & Loeys, 1988)

• Analyzes how firm reputation and monitoring costs affect financial contracting choices.

• Highlights costs associated with agency relationships and inflexible covenants affecting choices in contracts.

Information Production and Market Signaling (Campbell & Kracaw, 1980)

• Reviews theories explaining financial intermediaries’ existence relative to appropriability and moral hazard problems in information production.

• Proposes that successful signals in the market rely on information stakeholders having significant stakes.

Reputation Acquisition in Debt Markets (Diamond, 1991)

• Investigates how reputation influences borrower-lender interactions and subsequent investment risk choices.

• Concludes that financial intermediaries enhance social value through borrower monitoring and moral hazard mitigation.

Asymmetric Information & Risky Debt Maturity Choice (Flannery, 1986)

• Investigates signaling implications of debt maturity choices under asymmetrical information.

• Suggests that good firms may choose to bear costs to signal their quality effectively.

Relationships in Banking

Retail Bank Deposits as Quasi-Fixed Factors of Production (Flannery, 1982)

• Proposes a model explaining behaviors in deposit rate environments focusing on core deposits and their value.

Insiders & Outsiders: The Choice between Informed & Arm's-Length Debt (Rajan, 1992)

• Compares informed banks that monitor firms' projects with arm's-length lenders lacking such oversight.

• Discusses the trade-off between flexibility in lending versus the risk of firm project failure.

Equilibrium Loan Pricing Under the Bank-Client Relationship (Greenbaum et al., 1989)

• Examines how relational banking enhances lenders' informational advantage affecting pricing strategies and borrower terms.

• Suggests ongoing relationships entrench informational advantages, allowing nuanced loan offers.