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
– 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:
1. Risks that can be eliminated by business
practices (e.g., underwriting standards, due
diligence, portfolio diversification)
2. Risks that can be transferred to other market
participants (e.g., swaps, adjustable rate
lending)
3. 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.