Theoretical Foundations of Financial Intermediation

  • Luke Drago Spajić


Despite the apparently significant role played by banks and other intermediaries in financial activity, the theory of financial intermediation has remained in its infancy (van Damme, 1994), at least since Keynes (1936, 1937a,b) raised the issue of centrality of bank credit to GNP change.47 Financial markets are, as Arrow (1953) pointed out, an essential ingredient in allowing the authoritative paradigm of intertemporal competitive general equilibrium to operate parsimoniously, without complete markets for all commodities under all states of nature.48 But money and banks are awkward ingredients in it, as Hahn (1987) in particular has shown in relation to money.


Interest Rate Monetary Policy Mutual Fund Balance Sheet Bank Loan 
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  1. 47.
    In Keynes (1936, 1937a,b), the investment-induced rise in GNP is possible only because bank credit bridges the gap between investment outlays and their eventual financing through GNP induced savings. In focusing on this banking function, Keynes was of course following Wicksell, Thornton, and the ‘Real Bills’ doctrine of Smith. Otherwise banking continued until very recently to be seen as a technical subdivision of the State’s role in cutting the production cost of money and appropriating the resulting seignorage.Google Scholar
  2. 48.
    As suggested by Samuelson (1958), however, the technology of overlapping generations (OLG) can instead be used to introduce money and financial intermediation. Indeed the OLG approach may make it possible to introduce money (as opposed to securities) more substantively than in Arrow-Debreu general equilibrium. See Geanakopoulos (1987) for a broad overview. In the Walrasian paradigm, as in OLG models, frictions in the capital market are absent by assumption.Google Scholar
  3. 49.
    A key point is that financial intermediaries are significant in linking real economic activity to interest rates. See Gertler (1988) and Levine (1997) for surveys of literature.Google Scholar
  4. 53.
    For a discussion of the relationship between market liquidity and noisy prices, see Black (1986). Although not a matter of concern to this study, it should be noted that as specialist institutions, markets can be organised either to be quote-driven or order-driven. It is mainly in quote-driven, smaller, markets that liquidity is directly related to intermediary or market maker capital. A broadly based order-driven market may (at least in principle) achieve liquidity through breadth alone.Google Scholar
  5. 55.
    See Kindleberger (1996) for a colourful exposition of the history of crises in finance.Google Scholar
  6. 56.
    See for example Kim and Santomero (1988). The BIS (1988) standard overlooks possibilities of risk diversification and risk control in setting capital adequacy requirements.Google Scholar
  7. 57.
    Note that there is a close connection between time-horizons that are inappropriately short, risk aversion that is excessive, and rates of time preference which are too high. The debate over’ short-termism’ is well-known in the United Kingdom (Marsh, 1992).Google Scholar
  8. 60.
    For a complete compendium of derivative and option pricing theory, as well as term structure considerations, refer to Hull (1997). An elegant text is also offered by Briys et al. (1998) which covers more exotic derivatives in detail.Google Scholar
  9. 62.
    Two charming analogies by Miller (1991: pp. 269–70) for each of the propositions are: (a) “Think of a firm as a gigantic pizza, divided into quarters. If now, you cut each quarter in half into eighths, the Modigliani-Miller proposition says that you will have more pieces, but not more pizza”; (b) “The Modigliani-Miller dividend proposition amounts to saying that if you take money from your left-pocket and put it in your right-pocket, you are no better off”.Google Scholar
  10. 63.
    This essential step, Markowitz (1952), is needed in order to be able to extract testable results without placing ad hoc restrictions on the expected-utility functions assigned to investors.Google Scholar
  11. 66.
    See Mandelbrot (1964), along with other contributions to Cootner (1964); and Fama (1970, 1991) on the theory and evidence of efficient markets.Google Scholar
  12. 67.
    Bernstein (1996) provides a colourful discussion of history of risk. It is a revealing historical account of the way in which risk has come to be identified, measured and managed.Google Scholar
  13. 69.
    An authoritative account of the microeconomics of banking is Freixas and Rochet (1997).Google Scholar
  14. 70.
    As Tobin (1963) notes, once asset risk is introduced, i.e., under uncert ainty, minimising cash reserves does not necessarily optimise bank risk-return s, i.e., maximise profits.Google Scholar
  15. 71.
    On the ‘Real Bills’ doctrine see Friedman and Schwartz (1965); Boorman and Havrilesky (1975, pp. 91 and 95); Sargent and Wallace (1982); Podolski (1973,1986); Selgin (1989) and, finally, Dowd (1996: pp. 306-10) offers a modern critique.Google Scholar
  16. 72.
    There is also a gain merely through financing, e.g., of working capital needs (Hicks, 1969).Google Scholar
  17. 73.
    Rationing will be observed chiefly in P-loans, though strictly for the opposite reason to that originally suggested by Stiglitz and Weiss (1981): the lender understands the borrower’ s budget constraint, and hence the quality of the loan, too well to pass on rising deposit rates fully into loan rates.Google Scholar
  18. 74.
    Strictly this term refers to the hedging of one interest rate commitment (say, a long bond) by another or more interest rate commitments (say, a combination of short bonds). See Schaefer (1992) for a review of immunisation and duration.Google Scholar
  19. 78.
    Reproduced at the more microeconomic level of banking competition is the parallel between export surpluses and budget deficits found in macroeconomic aggregate demand analysis. Tobin (1963) noted the expansionary effect of public debt on financial intermediation.Google Scholar
  20. 84.
    The holding of these deposits by the general public is justified by the bank’s informational efficiency (over security markets) in monitoring capital formation. Fama (1985)Google Scholar
  21. 92.
    A good treatment of banking and prudential regulation can be found in both Dewatripont and Tirole (1993) and Tirole (l994b).Google Scholar
  22. 94.
    Examples of regulatory restrictions which are in decline or demise are the McFadden and Glass-Steagall Acts of the United States (restrictions on entry); exchange control (restriction on portfolio composition); and Regulation Q of the Federal Reserve (restriction on pricing). The main prudential regulation has become capital adequacy ratios based on the BIS (1988) standard. Reserve requirements, though occasionally treated as prudential, are really tools of monetary policy.Google Scholar
  23. 97.
    Here it is interesting to note a clear deficiency of the BIS (1988) accord on capital adequacy: pooled loans which were securitised could be taken off balance sheet, thus releasing capital; yet exposure to interest rate risk remained.Google Scholar

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© Springer Science+Business Media New York 2002

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  • Luke Drago Spajić

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