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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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SUMMARY AND OUTLOOK 230

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230 Summary and Outlook Summary and Outlook Why do banks exist, or more generally: why do third parties interpose themselves as intermediaries between final borrowers and final lenders? In a perfect Arrow-Debreu world, intermediaries are not needed to fulfill the functions cited in the literature, namely the transformation of maturities, lot sizes and risks, because a complete set of contingent contracts for all possible states of the world allows the economic units to make provisions for all eventualities. Any explanation of the existence of financial intermediaries must therefore take as its point of departure deviations from the conditions under which this model world is valid. However, various kinds of friction alone are not sufficient to explain the existence of financial intermediaries. These frictions can be, and indeed are, overcome by using the appropriate instruments. It is only when the reduction of transaction costs incurred in the application of these instruments is also assumed to be a goal of the economic units that an explanation for the existence of financial intermediaries becomes possible. Of the major deviations from the conditions of the Arrow-Debreu world, the most relevant contingencies are asymmetrically distributed information, problems concerning the enforceability of contracts, and fundamental uncertainty. In Chapter 1, we assumed that firms have various qualities which cannot be observed by the lender. This informational asymmetry ex ante, i.e. prior to conclusion of a contract, may - in the absence of any kind of mechanism for solving the problem - cause the market to collapse due...

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