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The Principles of
Intermediation

Summary

Intermediaries perform several functions. The traditional view of such functions is

addressed in Section 1. First, they alleviate market imperfections caused by econo-
mies of scale in transactions in financial markets and in information gathering and
portfolio management. Among intermediaries, whose main rationale is to be found in
this role, are the various investment trusts, unit trusts, pension funds, etc. If it was not
for such imperfections, everyone could in theory manage his own financial assets as
well as a trust manager. Secondly, intermediaries provide insurance services: people
dislike the prospect of accidents such as fire, injury, burglary, and are quite prepared
to accept lower mean expected incomes (after payment of insurance premia) in order
to insure against the risk of a severe reduction in living standards. These forms of
financial intermediation need not involve much risk-taking by the intermediary: the
unit trust, whose existence depends on economies of scale, can perform its functions
at a profit while matching its assets with its liabilities, while the insurance company
can match its assets to the actuarial expectation of its contingent liabilities.
The third, and archetypal type of financial intermediation, involves issuing
liabilities of a kind preferred by lenders (at relatively low yields) and investing a
proportion of the funds in higher-yielding earning assets of a form which borrowers
prefer to issue. The intermediary attracts funds from the public by offering varying
combinations of redemption terms - e.g., the date of its maturity, concomitant
services and interest payments. If the intermediary offers very liquid liabilities, it will
in general have to maintain a larger proportion of low-yielding reserves in its
portfolio in order to honour its redemption obligations; so there will normally be an
inverse relationship between the liquidity of the intermediary's liability and the rate
of interest offered in it, an extreme example being the low yields offered on sight
deposits.
In some part, the preference of savers for liquid assets and of borrowers for loans
of longer-term maturities can be regarded as a form of insurance against the timing
and magnitude of future uncertain cash flows. The desire of depositors for such
insurance cannot, however, be provided by a standard insurance contract, since the
desire to spend early is privately, not publicly, observable. The role of information
asymmetries in determining the need for, and form of, financial intermediaries
provides the main theme of Section 2, which sets out the newly emerging theory of
financial intermediation.
One of the crucial information asymmetries is that the executives of most
businesses know considerably more about their current and future prospects than
anyone else. This hinders the development of public markets in the assets of such
private-sector firms. There are means of overcoming this asymmetry, via signalling

104
C. A. E. Goodhart, Money, Information and Uncertainty
© C. A. E. Goodhart 1989
 THE PRINCIPLES OF INTERMEDIATION 105

methods and the use of information gathering and disseminating agencies, e.g.,
auditors, credit rating agencies, etc., but there are limits to their usefulness. Given the
absence of well-functioning markets in primary securities issuable by smaller com-
panies and persons, the bank acts as a substitute for such incomplete markets by
specialising in assessing credit risk and monitoring loan projects. Such asymmetries
of information imply that the optimal loan contract will be of a fixed interest form,
supported by collateral and/or bankruptcy penalties and, analogously, the optimal
bank liability will also be a fixed interest deposit supported by a buffer of bank
capital.
Having discussed the various functions undertaken by financial intermediaries, we
then turn in Section 3 to the question of whether there is anything special about
banks, as compared with other financial intermediaries (OFis), in the determination
of their respective equilibria, or in the adjustment process to that equilibrium. In both
cases the equilibrium conditions have to be assessed within a portfolio adjustment
framework in which there is no fundamental, or significant, difference between the
economic context facing banks as compared with OFis. On the other hand, the
impact and dynamic adjustment path resulting from a supply-side shock within the
banking system may differ from that arising from a supply-side shock elsewhere, in so
far as the counterpart to bank asset expansion is more commonly absorbed in buffer-
stock monetary adjustment.

1. The Role of the Intermediary - 1

Because of risk aversion, reinforced by the wish to avoid bankruptcy, there will be a
tendency for private-sector borrowers to issue financial liabilities with a life till
maturity related to the expected life of the investment to be financed, and in a form
(e.g., equity or debt) which reflects to some extent the degree of uncertainty of the
proposed investment project. The preferences of such borrowers may not match
closely the 'preferred habitats' of personal-sector lenders. Because of their need to
keep a sizeable proportion of their assets in liquid form for transaction and
precautionary purposes, personal-sector lenders may exhibit a greater preference for
shorter-dated assets in capital-certain form than private-sector borrowers would wish
to provide, ceteris paribus. An excess supply of long-dated, relatively risky, private
securities and an excess demand for short-dated, capital-certain, private-sector
securities could, therefore, develop. This would lead, naturally, to a rise in yields on
long-dated securities and a fall in yields on short-dated securities in order to tempt
both lenders and borrowers out of their preferred habitats, 1 in order to restore

1 It is for some reason more common to think of variations in yield tempting lenders to depart

from their preferred habitat, to take up a riskier portfolio, than it is to consider the possibility
of borrowers also shifting from their preferred habitat. For example, Leijonhufvud, On
Keynesian Economics and The Economics of Keynes, passim, (1986) e.g., pp. 202-3, 282-314,
354--85, 401-16) argues that Keynes believes that speculators with regressive expectations
might prevent falls in short-term interest rates being translated to the long end of the bond
market. But this (if true at all) would be a serious barrier to the successful contra-cyclical use of
monetary policy only if borrowers for investment projects were also deterred by risk aversion,
or by the same speculative (expectational) considerations, from financing their projects with
shorter-dated liabilities.