3 WhyDoFinancialIntermediariesExist

3 WhyDoFinancialIntermediariesExist - Why Do Financial...

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Why Do Financial Intermediaries Exist? Existence for Financial Institutions Advances in information economics, agency theory, and corporate finance have fundamentally changed the way financial economists view the role of commercial banks and other financial intermediaries in the economy. Prior to the 1970s, the prevailing focus was on commercial banks as conduits of monetary policy. This perspective resulted from the fact that commercial banks were the only institutions that were authorized to offer checking accounts and thus played a key role in the money-supply process. As a result of this focus on banks as suppliers of liquidity, little attention was given to the role of commercial banks in the capital acquisition process—In fact, little attention was paid to the more fundamental question of Why Financial Intermediaries Exist! In a competitive, frictionless capital market (i.e., a market in which there are no information or contracting costs and all market participants are price takers) financial intermediaries that consume any real resources (i.e., charge a fee for their services) would not exist! In a frictionless capital market, individual borrowers and lenders can costlessly contract among themselves for the services that financial intermediaries provide. These facts makes clear that the raison d’etre (the reason for being) for financial intermediaries is the existence of frictions that make it costly to create, transfer, and enforce financial contracts. A. Microeconomic Models A Theory of the Banking Firm , Michael A. Klein [1971] This article concerns the existence question: Why do banks exist? The paper’s purpose is to provide a model (theory) for banking. Banks are distinguished from other intermediaries since they can attract demand deposits without paying explicit interest (issuing demand deposits makes banks the administrators of the nation's payment mechanism). The Klein model concerns decision-making behavior of banks with respect to asset and liability decisions based on whether interest payments should be allowed on demand deposits (i.e., Reg Q). Klein makes assumptions that the bank is a monopoly price setter (i.e., has market power in loan market—relationship pricing). Relationship pricing implies bilateral lock-in (i.e., both parties hold each other captive —the bank can set prices, but the bank must invest in information about the borrowing firm). Bank has price setting ability because of downward sloping demand curve. Klein concludes that Reg Q (interest rate ceilings) is not necessary since the proportion of a bank’s funds allocated to loans is chosen such that the marginal return on loans is equal to the average expected rate on government securities. A bank’s loan decision is independent of the rate paid to depositors and therefore Reg Q is unnecessary. Also Fisher Separation Theorem is driven by his one-period model where correlation between loan and borrowing rate is zero (i.e., lending/borrowing rates are independent); with this inter-temporal model, term structure and
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3 WhyDoFinancialIntermediariesExist - Why Do Financial...

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