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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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3. FINANCIAL INTERMEDIARIES AS INSTITUTIONS FOR THE ENFORCEMENT OF CONTRACTS 100

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100 Financial Intermediaries as Institutions for the Enforcement of Contracts 3 Financial Intermediaries as Institutions for the Enforcement of Contracts 3.1 The Problem of Contract Enforceability The Arrow-Debreu model of general equilibrium assumes that there is a finite set of states of the world. Everybody in that economy agrees on what states of nature can materialize in the future, though people may have different assessments about the likelihood of their occurrence. As the future unwinds, precisely which state of nature has materialized is observable in equal measure and without cost by all market participants as well as by third parties. In addition, it is assumed that contracts can be concluded without any costs. By implication, therefore, all contracts which are concluded in an Arrow-Debreu world are contingent contracts. Such contracts prescribe explicitly and unambiguously what is to happen, i.e. which goods are to be exchanged, which actions are to be taken, who must make payments or who is entitled to receive payments, etc., if the state of the world should materialize to which the contract refers. A similarly unambiguous specification of what shall happen in the future also characterizes the contracts discussed in Chapters 1 and 2. In contrast to the Arrow-Debreu model, however, in the models discussed above a contract is not concluded for - or conditional on - each individual state of the world. Rather, a single contract is concluded for all or several sets of states of the world, and these states may not be specified in...

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