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Why Banks?

Microeconomic Foundations of Financial Intermediaries


Ilonka Rühle

In the banking literature the existence of financial intermediaries is generally explained in terms of the transformation of risks, terms and lot-sizes. Yet these functions could also be performed by system of perfect and complete markets. Therefore, the approach taken in Why Banks? is to start by investigating the conditions that, in the real world, render markets imperfect and incomplete, namely asymmetric information distribution and uncertainty. Incentive compatible financing instruments (standard debt contracts as well as equity participation) provide a means of solving these problems. Financial intermediaries ultimately owe their existence to their ability to save transaction costs using these instruments and to solve problems relating to the enforcement of contracts.


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The „Development and Finance“ Series X


X The "Development and Finance" Series The "Development and Finance" Series We define "development" as a change for the better in the living conditions of as large a number of people as possible: more opportunities in life, more freedom and more social justice. A precondition for this kind of change, and at the same time a part of it, is the improvement or modernization of economic mechanisms and institutions. Thus, although development always means more than merely quantitative economic growth, it is nonetheless true that growth helps to foster - and indeed, in some respects, is a necessary precondition for - development in the broader sense of the term. As with "development", we also use the concept of "finance" in a very broad sense. Finance takes in the entire financial system and thus the complete range of possibilities for obtaining external funds, accumulating financial assets, providing financial security against risks, and conducting payment transactions, which are available to the people of a region, a country or indeed a group of countries. Of course, at the hub of the financial system are the financial markets and the financial institutions, in particular the banks and the services they provide. Yet the foundations on which the financial system is built consist of people and their economic activities and problems - in other words, the real economy. Even if there were no such thing as money, no financial institutions or financial markets, people would still have to invest and save, to handle risks and...

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