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Financial Intermediaries: A Case Study

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The third approach to explain the raison d’être of financial intermediaries is based on the regulation of money production and of saving in and financing of the economy (see Guttentag and Lindsay, 1968; Fama, 1980; Mankiw, 1986; Merton, 1995b). Regulation affects solvency and liquidity with the financial institution. Diamond and Rajan (2000) show that bank capital affects bank safety, the bank’s ability to refinance, and the bank’s ability to extract repayment from borrowers or its willingness to liquidate them. The legal-based view especially (see Section 3), sees regulation as a crucial factor that shapes the financial economy (La Porta et al., 1998). Many view financial regulations as something that is completely exogenous to the financial …show more content…

Furthermore, money and its value, the key raw material of the financial services industry, to a large extent is both defined and determined by the nation state, i.e. by regulating authorities par excellence. Safety and soundness of the financial system as a whole and the enactment of industrial, financial, and fiscal policies are regarded as the main reasons to regulate the financial industry (see Kareken, 1986; Goodhart, 1987; Boot and Thakor, 1993). Also, the financial history shows a clear interplay between financial institutions and markets and the regulators, be it the present-day specialized financial supervisors or the old-fashioned sovereigns (Kindleberger, 1993). Regulation of financial intermediaries, especially of banks, is costly. There are the direct costs of administration and of employing the supervisors, and there are the indirect costs of the distortions generated by monetary and prudential supervision. Regulation however, may also generate rents for the regulated financial intermediaries, since it may hamper market entry as well as …show more content…

It appears that the latter issue is regarded to be dealt with when satisfactory answers on the former are being provided. Market optimization is the main point of reference in case of the functioning of the intermediaries. The studies that appear in most academic journals analyze situations and conditions under which banks or other intermediaries are making markets less imperfect as well as the impediments to their optimal functioning. Perfect markets are the benchmarks and the intermediating parties are analyzed and judged from the viewpoint of their contribution to an optimal allocation of savings, that means to market perfection. Ideally, financial intermediaries should not be there and, being there, they at best alleviate market imperfections as long as the real market parties have no perfect information. On the other hand, they maintain market imperfections as long as they do not completely eliminate informational asymmetries, and even increase market imperfections when their risk aversion creates credit crunches. So, there appears not to be a heroic role for intermediaries at all! But if this is really true, why are these weird creatures still in business, even despite the fierce competition amongst themselves? Are they truly dinosaurs, completely unaware of the

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