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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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4. FINANCIAL INTERMEDIARIES AS PRODUCERS OF LIQUIDITY 190

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190 Financial Intermediaries as Producers of Liquidity 4. Financial Intermediaries as Producers of Liquidity 4.1 The Existence of Fundamental Uncertainty So far in this study the existence of financial intermediaries has been explained in terms of the existence of asymmetrical information and of problems relating to the enforceability of contracts. However, there is another factor which is fundamental to real-world economies (as opposed to the standard model of neoclassical economics), and that is the existence of fundamental or true uncertainty in the Knightian (Knight 1921, p. 233) sense. True uncertainty results from the possibility of two kinds of events: the unforeseen, and the unforeseeable. In the former case, individuals have either incorrectly assessed the initial probability of the occurrence of such events, or at least, not made sufficient allowance for it in their decision-making. Ultimately, the argument that people can misjudge the "true" probabilities of events is based on the assumption that there is a limit to the degree to which individuals can behave rationally. This kind of (true) uncertainty may, among other things, be grounded in the individual himself and, more specifically, the possibility that preferences may change over time. The second important case which gives rise to true uncertainty and, as a consequence, to surprises, is the possible existence of events that are in principle unforeseeable. By this we mean (fundamental) changes in the technological, economic and social environment239 which are attributable to innovations of all kinds. By definition, innovations cannot be precisely anticipated, and therefore subsequent development...

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