Chapter 8. Financial Intermediation

The savings/investment process in capitalist economies is organized around bank-like financial intermediaries (“banks”), making them a central institution of economic growth. These intermediaries borrow from consumer/savers and lend to companies that need resources for investment. In contrast, in capital markets investors contract directly with firms, creating marketable securities. The prices of these securities are observable, while financial intermediaries are opaque. Why are banks so pervasive? What are their roles? Are banks inherently unstable? Must the government regulate them? In this chapter we survey the last 15 years’ of theoretical and empirical research on these issues We begin with theories and evidence on the uniqueness of banks. Key issues include monitoring or evaluating borrowers, providing liquidity, combining lending and liquidity provision as a commitment mechanism, and the coexistence of banks and markets. We then examine interaction between banks and borrowers in more detail, focusing on the pros and cons of dynamic bank–borrower relationships, the relationship between loan structure and monitoring, and between banking sector structure and monitoring, “credit cycles” and capital constraints, and the role of “non-traditional” bank activities such as equity investment. We then turn to research on banking panics and the stability of the banking system, focusing on the incidence of banking panics internationally and historically, the causes of panics, the role of bank coalitions in forestalling panics, and whether banks are inherently flawed. This leads to questions concerning government regulation of banks. Here, we focus on possible moral hazard problems emanating from deposit insurance and on the roles of bank corporate governance and capital requirements. We conclude with a summary of our current understanding and directions for future research.