The Modern Theory of Financial Intermediation

The Traditional Theory of FI Based on asymmetric information and transaction costs. Intermediaries may signal their informed status to investors by taking an equity stake based on the information that they produce. Sufficiently diversified intermediaries may credibly serve as delegated monitors in the presence of reputational penalties. However, recently, intermediation has increased despite declines in asymmetric information and transactions costs.

Recent Changes in FI Traditional intermediaries (e.g., banks, insurance companies) have declined in importance even as the sector itself has been expanding GE Capital provides credit, but raises money entirely by issuing securities rather than taking deposits. Disintermediation: Securitization of bank loans Insuring the insurer

How to Explain These Changes? Think about the traditional view on the existence of mutual funds High trading costs make it expensive for individual investors to diversify, thus efficient diversification is achieved by intermediation. Mutual funds have cheaper access to info about firms that issue securities. Puzzle: Despite declines in individuals’ trading costs and reduced information asymmetry due to technological innovation, mutual funds are today more important than ever.

The New Role of FIs Risk transfer Reducing participation costs Traditional theories have little to say why intermediation is necessary to distribute risk across different market participants. Reducing participation costs The cost of learning about effectively using the markets The cost of participating in markets on a day to day basis

The Role of FI in Risk Trading Risks can be segmented into three groups: Risks that can be eliminated by business practices (e.g., underwriting standards, due diligence, portfolio diversification) Risks that can be transferred to other market participants (e.g., swaps, adjustable rate lending) Risks that must be actively managed at the firm level.

FI and Participation Costs Households hold a few stocks and participate in only a limited number of financial markets. Why? Fixed costs of learning about financial instruments and how the market works. Marginal cost of monitoring the markets day to day to learn how the payoffs are changing and how portfolios should be adjusted.