THE THEORY OF FINANCIAL INTERMEDIATION

Financial intermediaries are a crucial part of financial markets. In the past, households need
financial intermediaries to reduce transaction costs and asymmetric information. Nowadays,
households need financial intermediaries for risk management and to reduce participation
costs. However, traditional theories are not sufficient to explain this shift in the need. Two
economists Allen & Santomero developed the financial intermediation theory based on
participation costs to explain this situation. This essay will explain this theory by discussing
why traditional theory cannot explain it and in which perspective it should be analyzed,
recent changes in markets and intermediaries, rationales for risk management and why firms
are interested in it, and the role of financial institutions in risk management.
According to traditional theory, financial intermediaries are needed for reducing transaction
costs and asymmetric information. Transaction costs have two components, which are fixed
costs and trading costs. Intermediaries reduce fixed costs by spreading them, and because
they can easily be diversified, they also reduce trading costs. Asymmetric information arises
when one party lacks crucial information necessary for doing the transaction. Intermediaries
reduce it because they have special knowledge about some assets and successfully monitor
borrowers. However, as information technologies advanced, asymmetric information
diminished, and when NYSE allowed competition for brokerage fees, trading costs for
individuals are reduced. As regards traditional theory, these changes should lower the need
for intermediation. However, this is not the case. Households started to use intermediaries
more than they use in the past, but for different reasons like risk management and reduced
participation costs. Traditional theory cannot explain this shift because it uses an
institutional perspective. It focuses on the existing institutions' activities, but it does not
produce healthy outcomes since institutions continuously evolve. On the other hand, the
institutions' functions are more stable, and the functional perspective can explain these
changes. Even though the evolving institutions, functional needs still persist, but they are
packed and delivered differently.
In the past, bond, stock, and exchange markets are dominated by households. These
markets include traditional instruments like bonds, equities, commercial paper, and
commodity futures. As financial markets grow, the usage of traditional instruments has
increased. However, markets are now dominated by intermediaries rather than households.
As developments in information technology followed it, financial innovations started to
occur. For example, various kinds of new derivative instruments are introduced to markets.
Some of these are financial futures, options, swaps, floating-rate debts, and securitized
loans. Since individual participation in the markets is reduced, households have started to
invest more in mutual and pension funds. Also, these new instruments lead to changes in
the bank and insurance companies. Securitized loans help banks to remove the burden in
their balance sheets, and they become able to lend more. Insurance companies and many
other financial institutions started to do risk-shifting. All these changes lead to a new activity,
which is risk management. Risk management involves risk trading; intermediaries trade risk
to and for their clients, and it becomes the primary activity of intermediaries.
Firms behave in a risk-averse manner and try to reduce volatility in the firm’s earnings. The
rationale behind this can be divided into four categories: managerial self-interest, the non-
linearity of taxes, the costs of financial distress, and the existence of capital market
imperfections. Managers of a firm usually own some portion of the firm's stocks; because of
that, they want stability in the firm’s earnings. That is why managers try to reduce volatility
in it. Volatility can also be reduced by using the non-linearity of taxes. When income
smoothing is combined with non-linear tax structures, the effective long-term average tax
rate is reduced. Therefore, volatility in the firm’s earnings is also reduced. Volatility in the
firm’s earning also send negative signals to the market. These negative signals lead to
financial distress in the firm, and in the worst case, can lead to bankruptcy. That is why firms
try to minimize volatility. Additionally, the volatility in the retained earnings sometimes
causes firms to lost profitable investment opportunities. Due to volatility, internal financing
is not enough to finance them, and firms need to seek external financing. However, capital
market imperfections make external financing costly and reduce optimal investment. These
four categories indicate why firms are interested in risk management, but they do not
include costs associated with it, which are transaction costs and agency costs. However,
even though the costs, firms still want to manage the risk, and financial institutions respond
to their need by servicing risk management.
The role of intermediaries in risk management is trading and financing risks. Their franchise
includes bundling and unbundling of risks. These risks can be grouped into three groups:
risks that can be eliminated or avoided by business practices, risks that can be transferred to
other participants, and risks that must be actively managed at the firm level. Business
processes like underwriting standards, due diligence procedures, and portfolio diversification
are used to eliminate the unnecessary risks that are not associated with the financial asset.
When this risk is eliminated, what is left behind is systematic risk and the specific risk
associated with the asset. Also, these remaining risks can be eliminated. However, it should
only be done when the value exceeds the costs of further risk reduction. Potential future
risks associated with the asset can be transferred to a third party by giving a proportion in
the asset's contingent payoffs, which can be done by financial contracts. However, some
risks are cannot be traded or transferred and need to be managed by themselves. These
include financial transactions and contractual relationships that can only be understood by
the institution itself. All these three types of risks require risk management activity where
the institution monitors its business activities' risks and returns. However, if the institution
cannot gain any additional advantage for managing risk, it should be transferred to the
market. The market consists of two groups informed and uninformed. The first group is fully
informed and active participants in the market and manages their portfolios by themselves.
The second group is not an active participant and gives decisions with the most recent
market information. They have limited participation in the market due to costs associated
with being an active participant, which are fixed and marginal costs. Learning information
about a particular financial instrument requires fixed costs. Also, learning the market
mechanism and continuously following the market requires time and money, which builds
up marginal costs. Financial intermediaries offer participation services to this second group
because intermediaries can do it at a much lower cost. These also explain the shift in the
dominance from households to intermediaries in the financial market. Intermediaries offer
low participation costs and stable return investments like mutual funds and new derivative
instruments to households, which in return, increase the need for them and their services.
To conclude, the traditional intermediation theory is insufficient to explain the shift in
intermediaries' role because transaction costs and asymmetric information are not
compromised with the recent changes in the markets and intermediaries. As Allen &
Santomero said, this shift can be explained by participation costs since it is associated with
risk management. Additionally, they state that due to the increase in intermediaries' trading
activities on behalf of their investors, asset pricing theories should be revised and better
integrated into intermediation theories to explain the shift.
REFERANCE
Allen, F. & Santomero, A. M. (1996). The Theory of Financial Intermediation.