RDP 9315: The Provision of Financial Services – Trends, Prospects and Implications 2. Information, Intermediation and Capital Structure

To understand the structure of the financial system, it is necessary to relate the functions provided by the system to the characteristics and financial demands of households and firms. The financial system performs two broad functions, the transfer of funds from savers (typically households) to borrowers (firms and the government) and the provision of payments services. These functions are performed by a range of institutions and markets. The extent to which they are performed by banks, other intermediaries or through securities markets depends, in part, on how the various institutions and markets:

• help overcome the problems faced by lenders in gathering and assessing information about borrowers;
• allow savers to diversify risk; and
• provide liquidity management and payment services.

The cost of gathering and assessing information on borrowers and the extent to which their performance needs to be monitored is at the core of explaining why financial intermediaries exist. These costs make it difficult for households to assess the prospects of many individual borrowers and to monitor them to ensure loans are repaid. They inhibit the direct transfer of funds from savers to borrowers. Financial intermediaries can take advantage of economies of scale to dissipate the high fixed costs involved in assessing and monitoring borrowers. By pooling the funds of a large number of individuals, they can influence management investment decisions, overcome problems of moral hazard, and better align the interests of management and creditors. In addition, through their deposit-taking functions, some financial intermediaries gather information about the performance of firms. Thus, economies of scope also provide intermediaries with a comparative advantage in the provision of finance.

Some firms also have an incentive to provide particular intermediaries – usually banks – with privileged access to information about their prospects, conferring upon them an advantage over both other intermediaries and direct credit markets in providing finance. This is because, in highly competitive environments, firms may prefer to provide intermediaries with information on their prospects rather than have this information more widely disseminated to lenders and potential competitors. Also, firms may wish to provide information to intermediaries if their ability to raise debt finance provides a positive signal to the direct credit markets about their creditworthiness.^[2] Establishing a good track record with a reputable intermediary may thus increase the opportunities for, and reduce the costs of, direct finance.

Funds will be channelled directly to borrowers when good quality information is easily accessible. Large firms with publicly disclosed information and a good track record will be able to tap securities markets – both debt and equity – directly. Stringent disclosure requirements and the existence of credit-rating agencies encourage the provision of direct finance. For small firms, however, meeting the disclosure requirements of securities markets is too difficult or costly, and claims on their assets are likely to be too illiquid to trade in these markets. These firms will always rely upon a combination of internal and intermediated funds to finance their investment. Information is, therefore, also an important determinant of the extent and nature of the external funding of firms.^[3]

Financial intermediaries are thus necessary to overcome deficiencies in the market for information. Intermediaries, however, also play a significant role in improving the risk-return trade-off available to savers. By pooling the savings of households and investing in a diversified portfolio of assets, intermediaries can diversify away idiosyncratic risks, and offer households – and particularly small-scale savers – higher returns at lower risk than they could achieve on their own. In doing so, they allow households to minimise their holdings of liquid balances.

Differences between financial intermediaries – banks, NBFIs, finance companies, managed funds, and superannuation funds – can be partly traced to their comparative advantages in performing the above services. Managed funds, for example, provide both risk sharing and liquidity management services and pension funds provide only risk sharing services – neither provide information-intensive loans.

While these functions explain the existence of different types of intermediaries, they do not explain the existence of banks in particular. Banks are unique in that they provide all three services, and they are the predominant providers of information-intensive loans. No single theory provides a good explanation of the benefits of this structure.

The discussion above suggests that the franchise value of banking may be derived in part from economies of scope – that is, banks have a comparative advantage in monitoring and assessing borrowers because they independently gather information about their assets and cash flow through their deposits.^[4] Some argue that the banks' liability structure helps overcome the agency problem which arises between depositors and banks, as the potential for the swift withdrawal of deposits at par provides banks with a stronger incentive than other intermediaries to monitor the progress of their loans.^[5] It may also be that existing bank branch networks provide them with continued advantages over other intermediaries which will only be eroded slowly over time.

Many argue that the franchise value of banking is derived from the regulatory benefits conferred on them.^[6] Governments have recognised the central role banks play in the financial system and have provided depositors with either explicit or implicit deposit guarantees to help maintain bank stability. This may have enabled banks to raise funds more cheaply and hence provide them with a comparative advantage over other intermediaries. Some argue that the safety net accorded banks is justified given their unique value as credit evaluators and monitors,^[7] and it is widely recognised that the structure of bank balance sheets allows society to conserve on liquid assets, freeing capital for longer term, more productive use.^[8]

The factors that determine the structure of the financial sector are not immutable and will evolve with financial innovation and deregulation. These, in turn, will be shaped by changes in how households prefer to hold their financial wealth, the liquidity requirements of the private sector, the resolution of information problems, and by the performance of the macro economy and economic policy generally. Through this paper we examine developments with reference to the functions being performed by intermediaries, and focus in particular on their impact upon banking.

Footnotes

Leland and Pyle (1977) and James and Wier (1990). [2]

Gertler (1988) and Gertler and Hubbard (1988) examine the determinants of capital structure and in particular the relationship between capital structure and firm size. [3]

This argument was probably more significant previously than it is today. [4]

Chant (1987) and Diamond (1984). [5]

Boyd and Gertler (1993) argue that in the USA, the banks' comparative advantage stems at least partly from the regulatory system and the nature of the public safety net. [6]

Goodhart (1988). [7]

O'Brien and Browne (1992), Bencivenga and Smith (1991) and Diamond and Dybvig (1983). [8]