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Lecture 2: The nature of financial intermediation: The issue of why financial intermediaries exist is a puzzle for the “complete markets” paradigm of Arrow and Debreu. As we describe in this lecture, the reasons why intermediaries such as banks exist is related to the various market failures which vitiate the complete markets paradigm. In particular, there is the key issue of imperfect information which makes financial institutions such as banks key channels for intermediating between savers and borrowers. We cover the key concepts of liquidity insurance and delegated monitoring in this context

Why intermediation? Definition: Intermediate between providers and users of financial capital Besides banks - pension funds, insurance companies, securities firms (differ in terms of assets. liabilities, matching). - But in an Arrow-Debreu “complete markets” world, financing of firms and governments by households occurs via financial markets – no transactions costs, full set of contingent markets, no credit rationing, Pareto optimal allocation and no role for intermediaries - Moreover, (Modigliani-Miller) financial structure is irrelevant as households can construct portfolios offsetting actions of intermediaries and intermediaries cannot add value

- Corollary - markets are not strong form efficient or banks would not exist. Banks rather assist market efficiency as their information spills over. Why do intermediaries exist? (1) Transactions costs restricting scope for direct financing, or incomplete information means financial markets cannot be complete in an Arrow Debreu sense (theories of intermediation) (2) Banks and other financial intermediaries offer services to which transactions are the visible counterpart (industrial organisation approach) 2 aspects of intermediary activity: Distinguish brokerage (bringing together transactors with complementary needs) and...

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