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Why Banks?

Microeconomic Foundations of Financial Intermediaries

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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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Foreword XIV

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XIV Foreword Foreword What makes for a beautiful problem in science? First, it may have logical beauty. Second, a problem takes on extra luster if its solution provides useful knowledge. By these criteria, llonka Ruhle's book is fascinating. Institutions such as firms and especially banks either do not appear in our economic models, or their existence remains unexplained. Nevertheless, as every theoretician knows, banks do exist "in the real world", and normally we understand their role in economic development in terms of the definition provided many decades ago by Joseph Schumpeter, namely to provide capital for investments entailing risk, to transform risks and to minimize monitoring costs in the capital markets. The 1970s saw the emergence of a "new institutional economics", built around the concepts of asymmetric information and bounded rationality. It comes as no surprise that, according to this view of the "economics of banks and capital markets", two phenomena in particular play a major role: moral hazard and adverse selection. The present study on the theory of banking ties together these different ideas and approaches to form a concise, coherent picture. As Akerlof showed in 1970, without additional institutions or information, capital markets will inevitably break down. Yet the intervention of financial intermediaries does not solve the fundamental problem, but merely raises it to a meta-level: that of monitoring the intermediary. In other words- and more generally - Pareto improvements under these circumstances are possible only if "banks" are trustworthy. A foreword, like an aperitif, should merely whet...

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