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Why Banks?

Microeconomic Foundations of Financial Intermediaries

Series:

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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INTRODUCTION 1

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Introduction Introduction In terms of business volume and number of employees, the banking industry is one of the largest sectors of the German economy. 1 Its role as an industry contributing to income and aggregate demand is sufficient reason in itself for economic research to focus attention on the firms that make up this sector. Moreover, banks form the medium through which monetary policy is effected, and a large part of the capital needed for investments flows through this sector, which enables the banks to play a key role in influencing the allocation of capital: " ... the power to allocate capital is one of the most significant powers in any economic system. It is the power to determine which enterprises will prosper and which will not" (Taylor 1977, p. 143). However, standard economic theory maintains that in a decentralized economy the allocation of capital is a function performed by the market. How, then, can we explain the fact that this allocation takes place not only via the market but also through the medium of firms - or, to rephrase the question, why do financial intermediaries exist? In order to answer this question, we must first define the term "financial intermediary" and then proceed to analyze the role played by financial intermediaries in the capital allocation process. Financial intermediaries intervene between economic units with a surplus (financiers or lenders) and those with a deficit of funds (investors or borrowers or entrepreneurs). Here we can distinguish between two basic types of financial intermediary....

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