2.3  The comparative roles of financial intermediaries and markets[5]

The main comparative advantage of financial intermediaries over financial markets is in overcoming the information asymmetry between borrowers and lenders. Financial intermediaries are better suited to reducing the public good problem of free-riding. This is because financial intermediaries can make investments without revealing their actions instantaneously in public markets. With well functioning financial markets information is revealed instantaneously through financial prices, providing individual investors with less incentive to acquire information.

Financial intermediaries are also better at ex post monitoring and exerting corporate control than financial markets. This is because with liquid financial markets, individual investors are able to readily sell their shares and have fewer incentives to monitor managers thoroughly. They also generally have less inside information about firms than financial intermediaries. Financial intermediaries may also be better able to exert ex post corporate control if firms are reliant on them for external finance.[6]

Intermediaries are particularly well suited to providing external finance to newer firms that require staged finance. This is because financial intermediaries can more credibly commit to providing additional funds as projects develop, whereas pre-committed stage finance is more difficult to arrange with publicly traded securities (debt or equity). Information asymmetries tend to be larger for small firms. This is because of reduced economies of scale with respect to acquiring information about small firms. Gertler and Gilchrist (1994a and 1994b), for example, find that bank-dependent firms with poor access to (non-bank) capital markets are typically smaller in size for the manufacturing sector in the United States. Because of the comparative advantage of financial intermediaries over financial markets in terms of collecting and processing information, countries with a large number of small firms might be expected to be more reliant on financial intermediaries than markets for external finance.

Moreover, financial intermediaries are better able to diversify aggregate risk. For example, banks have a unique ability to hedge against market wide liquidity shocks (Gatev and Strahan 2003). This is because banks are viewed as safe havens by investors. Deposits tend to flow in during periods of financial distress (low liquidity), at a time when borrowers want to draw on backup lines of credit as external finance from public securities markets has become too expensive because of low liquidity. By eliminating liquidity risk, banks can increase investment in high-return, illiquid assets and accelerate growth. Financial markets can reduce liquidity risk, but do not eliminate it.

In addition, financial intermediaries can provide intertemporal risk sharing. Financial markets are generally less well suited to provide this insurance. This is because intertemporal risk sharing requires the accumulation of reserves in safe assets whereas investors in financial markets would theoretically (though perhaps not practically) continuously adjust their portfolios to earn the highest rate of return (Dolar and Meh 2003).

Intermediaries directly undertake ex post monitoring of firm managers and exert corporate control when it is costly for outside investors to verify project returns. In Diamond’s (1984) model, financial intermediaries are delegated the costly task of monitoring loan contracts. A financial intermediary must choose an incentive contract such that it has incentives to monitor the information, make proper use of it and make sufficient payments to savers to attract deposits.[7] Providing loan contracts and monitoring is costly and diversification can reduce these costs. In Diamond’s model, the financial intermediary need not be monitored because it bears all penalties for any shortfall of payments and because the diversification of its portfolio makes the probability of incurring these penalties very small. Moreover, the optimal size for a financial intermediary is infinite. This is because costs are lowered indefinitely by diversification, as long as the returns to borrowers are not perfectly correlated with each other.^[8]

Financial markets can also promote corporate control, for example, by structuring compensation such that managerial earnings are conditioned on firms’ performance or by easing takeovers of poorly managed firms (Jensen and Murphy 1990). With takeovers, outsiders buy poorly managed firms, fire managers and transform firms into a more productive enterprise. While takeovers may not always improve performance, in practice the threat of takeover acts to discipline management and so it is difficult to measure the full value of this function. Financial markets possibly facilitate takeovers better than financial intermediaries and thus enhance the flow of capital to its highest value use.

Financial markets provide an alternative to intermediaries and an outlet to limit the potential problems created by powerful banks. Financial intermediaries focus on obtaining information that is not available to other lenders. This focus is crucial to overcome information asymmetry and provide finance, but they may use this inside information to extract rents from firms or to protect firms with close bank ties from competition (Rajan 1992). Financial intermediaries may also collude with firm managers against other lenders and hence obstruct efficient corporate governance (Wenger and Kaserer 1998).

For firms able to access them, financial markets may be better suited for dealing with uncertainty, innovation and new ideas than financial intermediaries because they allow for diversity of opinion. Financial intermediaries such as banks may have a bias towards low risk projects that have a high probability of success. Intermediated financing delegates decisions about investment projects to a relatively small number of decision makers. Disagreement and discrete decision making increases the likelihood of a loan application being rejected and as a result, without specialised intermediaries, intermediated finance may result in the underinvestment in new technologies, for example. For firms with such projects, and which can not access financial markets, the role of specialised intermediaries may be pronounced.

In summary, financial intermediaries and financial markets can in many cases act as substitute sources of financial services. Lenders/savers in particular have a choice between the risk, return and liquidity offered by both segments of the financial system. Each segment is able to offer a different range of investments and offers services to firms that are not complete substitutes. Broadly speaking, financial markets provide lower cost arms length debt or equity finance to a smaller group of firms able to obtain such finance, while financial intermediaries offer finance with a higher cost reflecting the expense of uncovering information and ongoing monitoring. Financial intermediaries and markets may also provide complementary financial services to many firms.