Financial intermediation is a pervasive feature of all of the world’s economies. However, there is a widespread view that financial intermediaries can be ignored because they have no real effects. They are a ‘veil’ covering real economic activities. They do not affect asset prices or the allocation of resources. However, in this article, I 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.

So, I ask the question: Why are financial intermediaries important? One reason is that the overwhelming proportion of every cent financed externally to Sierra Leone comes from banks. Bank loans are the predominant source of external funding in many countries. But capital markets and equity markets are not a significant source of financing, even in developed countries with well-established and functioning capital and equity 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.

The Relationship Between Bank Health and Business Cycles

Banking systems seem fragile. Between 1980 and 1995, at least thirty-five countries in the world experienced banking crises, periods in which their banking systems essentially stopped functioning and these economies entered recessions. The case of IBTI in Sierra Leone is still fresh in the minds of many bankers in this country. 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.

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.

Understanding the Roles of Financial Intermediaries

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. I concentrate on research addressing why bank-like financial intermediaries exist, and the implications for their stability.

By bank-like financial intermediaries, it is meant 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 my 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, it can be said 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.

Issues involved

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 Sierra Leone, the Banking Supervision Department of the Bank of Sierra Leone collects a massive amount of accounting information about commercial banks, yet there are data gaps such as the 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. 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 Existence of Financial Intermediaries

The most basic question with regard to financial intermediaries is: why do they exist? This question is related to the theory of the firm because a financial intermediary is a firm, perhaps a special kind of firm, but nevertheless a firm. Organization of economic activity within a firm occurs when that organizational form dominates trade in a market. In the case of the savings-investment process, households with resources to invest could go to capital markets and buy securities issued directly by firms, in which case there is no intermediation.

To say the same thing a different way, non-financial firms need not borrow from banks; they can approach investors directly in capital markets. Nevertheless, as mentioned in the above, most new external finance to firms does not occur this way. Instead, it occurs through bank-like intermediation; in which households buy securities issued by intermediaries who in turn invest the money by lending it to borrowers.

Again, the obligations of firms and the claims ultimately owned by investors are not the same securities; intermediaries transform claims. The existence of such intermediaries implies that direct contact in capital markets between households and firms is dominated. “Why is this?” is the central question for the theory of intermediation. Bank-like intermediaries are pervasive, but this may not require much explanation. On the liability side, demand deposits appear to be a unique kind of security, but originally this may have been due to regulation.

Today, money market mutual funds may be good substitutes for demand deposits. On the asset side, intermediaries may simply be passive portfolio managers, that is, there may be nothing special about bank loans relative to corporate bonds. This is the view articulated by many writers.

Conclusion

It is clear from the above analysis that banks play a leading role in the economy providing much needed loans for investments. In Sierra Leone where capital and equity markets are far less developed, banks are the only hope for businesses to raise capital. Without such crucial loans from banks, many businesses in Sierra Leone would have collapsed, which would resulted to a warped economy.

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