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Unformatted text preview: akes on different forms along a continuum that goes from direct market contracting to intermediated contracting (Table 1). At the one extreme, markets bridge the principal‐agent gap through hard public information (arms‐length lending), the liquidity gap through the ability to trade financial contracts easily in deep markets, and the volatility gap through derivative contracts. Asset managers (mutual funds, pension funds, brokers, etc.) cover the middle ground. They help fund suppliers fill the agency gap through expert screening and continuous monitoring (including through direct board room participation), the liquidity gap through pooling, and the volatility gap through diversification. At the other extreme are financial intermediaries that engage in leverage. Commercial banks—the prototypical financial intermediaries—bridge the agency gap through soft private information (relationship lending), debt contracts (a disciplining device), and capital (skin‐in‐the‐game). They absorb the volatility gap and liquidity gap by funding themselves through debt redeemable at par and on demand, respectively, and by absorbing the ensuing risks through capital and liquidity buffers.20 Remarkably, debt and capital (hence leverage) play a key role in intermediaries’ ability to deal with each of the three gaps. 19 Needless to say, to avoid exacerbating cross‐border arbitrage, any such reform would require broad international agreement on the essence of the reforms and their modalities of implementation across borders. 20 In addition, intermediaries, unlike markets, can offer “incomplete” contracts that provide more ex‐post flexibility in adjusting to unforeseen circumstances that can lead to failures in honoring the contracts. See Boot et al. (1993) and Rajan (1998). 26 Chart 1. The gaps finance seeks to bridge and the pitfalls it encounters
encounters Risk Gap Response Market Failure Information
Control Pick and monitor
Contract agent Agency
Maturity Stay liquid
Grab opportunities Externalities Volatility
Uncertainty Adjust portfolio
to risk appetite
Contract insurance Mood swings Idiosyncratic Aggregate 7 Table 1. Filling the finance gaps Gap Channel of finance Information/Control Liquidity/Maturity Volatility/Uncertainty Markets Hard information and governance standards Deep, liquid secondary markets Derivative markets Asset Managers Expert screening, direct board participation and monitoring the monitors Pooling Diversification Intermediaries Pooling, demandable Relationship lending, debt debt and capital/liquidity and capital (skin in game) (buffers) Diversification, debt and capital (buffer) By interposing their balance sheet between borrowers (through assets whose underlying value fluctuates with economic conditions) and investors (through liabilities whose value is fixed by contract), financial intermediaries become exposed to systemic risk. They may fail to address this risk in a socially optimal way, reflecting market failures that...
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