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Gary Gorton

Andrew Winton

Working Paper 8928



1050 Massachusetts Avenue

Cambridge, MA 02138

May 2002

Forthcoming in Handbook of the Economics of Finance, edited by George Constantinides, Milt Harris and Rene Stulz (Amsterdam: North Holland). The views expressed herein are those of the author and not necessarily those of the National Bureau of Economic Research.

© 2002 by Gary Gorton and Andrew Winton. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

Financial Intermediation Gary Gorton and Andrew Winton NBER Working Paper No. 8928 May 2002 JEL No. G0, G2


The savings/investment process in capitalist economies is organized around financial intermediation, making them a central institution of economic growth. Financial intermediaries are firms that 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 do financial intermediaries exist? What are their roles? Are they inherently unstable? Must the government regulate them? Why is financial intermediation so pervasive? How is it changing? In this paper we survey the last fifteen years’ of theoretical and empirical research on financial intermediation. We focus on the role of bank-like intermediaries in the savings-investment process. We also investigate the literature on bank instability and the role of the government.

Gary Gorton Andrew Winton The Wharton School Carlson School of Management University of Pennsylvania University of Minnesota Philadelphia, PA 19104-6367 and NBER gorton@wharton.upenn.edu I. Introduction Financial intermediation is a pervasive feature of all of the world’s economies. But, as Franklin Allen (2001) observed in his AFA Presidential Address, there is a widespread view that financial intermediaries can be ignored because they have no real effects. They are a veil. They do not affect asset prices or the allocation of resources. As evidence of this view, Allen pointed out that the millennium issue of the Journal of Finance contained surveys of asset pricing, continuous time finance, and corporate finance, but did not survey financial intermediation. Here we take the view that the savings-investment process, the workings of capital markets, corporate finance decisions, and consumer portfolio choices cannot be understood without studying financial intermediaries.

Why are financial intermediaries important? One reason is that the overwhelming proportion of every dollar financed externally comes from banks. Table 1, from Mayer (1990), is based on national flow-of-funds data. The numbers are percentages, so in the United States for example, 24.4% of firm investment was financed with bank loans during the 1970 - 1985 period. Bank loans are the predominant source of external funding in all the countries. In none of the countries are capital markets a significant source of financing. Equity markets are insignificant. In other words, if finance department staffing reflected how firms actually finance themselves, roughly 25 percent of the faculty would be researchers in financial intermediation and the rest would study internal capital markets.

As the main source of external funding, banks play important roles in corporate governance, especially during periods of firm distress and bankruptcy. The idea that banks “monitor” firms is one of the central explanations for the role of bank loans in corporate finance. Bank loan covenants can act as trip wires signaling to the bank that it can and should intervene into the affairs of the firm. Unlike bonds, bank loans tend not to be dispersed across many investors. This facilitates intervention and renegotiation of capital structures. Bankers are often on company boards of directors. Banks are also important in producing liquidity by, for example, backing commercial paper with loan commitments or standby letters of credit.

Consumers use bank demand deposits as a medium of exchange, that is, writing checks, using credit cards, holding savings accounts, visiting automatic teller machines, and so on. Demand deposits are securities with special features. They can be denominated in any amount; they can be put to the bank at par (i.e., redeemed at face value) in exchange for currency. These features allow demand deposits to act as a medium of exchange. But, the banking system must then “clear” these obligations. Clearing links the activities of banks in clearinghouses. In addition, the fact that consumers can withdraw their funds at any time has, led to banking panics in some countries, historically, and in many countries more recently.

Banking systems seem fragile. Between 1980 and 1995, thirty-five countries experienced banking crises, periods in which their banking systems essentially stopped functioning and these economies entered recessions. (See Demirgüç-Kunt, Detragiache, and Gupta (2000), and Caprio and Klingebiel (1996).) Because bank loans are the main source of external financing for firms, if the banking system is weakened, there appear to be significant real effects (e.g., see Bernanke (1983), Gibson (1995), Peek and Rosengren (1997, 2000)). The relationship between bank health and business cycles is at the root of widespread government policies concerning bank regulation and supervision, deposit insurance, capital requirements, the lender-of-last-resort role of the central bank, and so on. Clearly, the design of public policies depends on our understanding of the problems with intermediaries. Even without a collapse of the banking system, a credit crunch has sometimes been alleged to occur when banks tighten lending, possible due to their own inability to obtain financing. Also, the transmission mechanism of monetary policy may be through the banking system.

Basically, financial intermediation is the root institution in the savings-investment process.

Ignoring it would seem to be done at the risk of irrelevance. So, the viewpoint of this paper is that financial intermediaries are not a veil, but rather the contrary. In this paper, we survey the results of recent academic research on financial intermediation.

In the last fifteen years, researchers have made significant progress in understanding the roles of financial intermediaries. These advances are not only theoretical. Despite a lack of data as rich as stock market prices, significant empirical work on intermediaries has been done. All of this work has contributed to a deeper appreciation of the role of banks in the savings-investment process and corporate finance, of the issues in crises associated with financial intermediation, and of the functioning of government regulation of intermediation. We concentrate on research addressing why bank-like financial intermediaries exist, and the implications for their stability. By bank-like financial intermediaries, we

mean firms with the following characteristics:

1. They borrow from one group of agents and lend to another group of agents.

2. The borrowing and lending groups are large, suggesting diversification on each side of the balance sheet.

3. The claims issued to borrowers and to lenders have different state contingent payoffs.

The terms “borrow” and “lend” mean that the contracts involved are debt contracts. So, to be more specific, financial intermediaries lend to large numbers of consumers and firms using debt contracts and they borrow from large numbers of agents using debt contracts as well. A significant portion of the borrowing on the liability side is in the form of demand deposits, securities that have the important property of being a medium of exchange. The goal of intermediation theory is to explain why these financial intermediaries exist, that is, why there are firms with the above characteristics.

Others have cited additional important characteristics of bank-like financial intermediaries, but in our view these seem less important. For example, the maturity of the loan contracts is typically longer than the maturity of the debt on the liability side of the balance sheet, but that is essentially the third point above. Also, Boyd and Prescott (1986) assert that financial intermediaries lend to agents whose information set may be different from their own, in particular, would-be borrowers have private information concerning their own credit risk. Although this suggests a clear role for intermediaries, it is not clear that this is a necessary condition.

Empirical observation is the basis for the statement that intermediaries involve large number of agents on each side of the balance sheet and also for the view that the nature of the securities issued to borrowers and lenders are different. On the liability side of the balance sheet, intermediaries often issue a particular security to households, demand deposits, securities that serve as a medium of exchange. On the asset side of the balance sheet, bank loans are not the same as corporate bonds. Moreover, the structure of the bank loans does not mirror the bank’s obligations in the form of deposits. Financial intermediaries with the above characteristics correspond most closely to commercial banks, savings and loans, and similar institutions. But, securitization vehicles and conduits also satisfy the above definition, blurring the distinction between intermediated finance and direct finance, a topic we return to below.

There are a number of issues in studying intermediation that are perhaps unique, compared to other areas of finance. First, there are issues of data. While governments often collect an enormous amount of data about banks, for example, in the U.S. there are the Call Reports that provide a massive amount of accounting information about commercial banks, there is a lack of price data. Thus, unlike other areas of finance, there is an almost embarrassing lack of essential information, prices of loans, of secondary loan sales, and so on. Researchers have been creative in finding data, however, as we discuss below. Other periods of history have also been intensively studied. Apparently, more so than other areas of finance, research in financial intermediation is intimately linked with economic history. In addition, other countries offer rich laboratories as banking systems vary across countries to a significant degree.

Second, in the study of financial intermediation, institutions, regulations, and laws are important.

Banking systems have been influenced by laws and regulations for hundreds of years and it is difficult to make progress on many issues without understanding the enormous variation in banking system structures across countries and time, which is due to these laws and regulations. This is most apparent in the variety of industrial organization of banking systems around the world and through history. This variation is just beginning to be exploited by researchers and seems a likely area for further work.

Finally, intermediation is in such a constant state of flux that it is not much of an exaggeration to say that many researchers in financial intermediation do not realize that they are engaged in economic history. It is a challenge to determine whether there are important features of intermediation that remain constant across time, or whether intermediation is being fundamentally altered by securitization, loan sales, credit derivatives, and other recent innovations.

The paper proceeds as follows. We begin in Section II by discussing evidence on the uniqueness of banks and theories that seek to motivate the existence and structure of these financial intermediaries.

Key issues include monitoring or evaluating borrowers, providing consumption smoothing and other types of liquidity, combining lending and liquidity provision as a commitment mechanism, and the coexistence of banks and markets.

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