A Theory of Financial Intermediation
By Arnold Kling
Fundamentally, financial intermediation is about enticing investors to buy securities backed by investments whose risks the investors cannot fully evaluate. The intermediary, such as a bank, hedge fund, or ordinary corporation, specializes in evaluating risk. The investor who buys securities from the intermediary looks to the past performance of the intermediary as well as to concise summaries of the risk of those securities. The ratings of “AA” or “A+” by bond rating agencies are just one example of these concise risk summaries.
…At each step in the layering process, some of the detailed information about the underlying risk is ignored. Instead, investors rely on summary information. It is this use of summary information that makes these investments liquid — that is, it enables them to be bought and sold by many investors. As an intermediary layer is added, while the amount of detailed risk information is going down, liquidity is going up. The result of this process is that the ultimate borrower — in this instance, the home buyer — pays a much lower risk premium than would be the case in the absence of liquidity.
This is a theory of financial intermediation that I do not believe you will find in the economics literature. I think it is an important theory with interesting implications. It
explains the booms and busts to which the economy is subject, as exemplified by the bank runs of the Great Depression, the 1996-2000 euphoria/crash of dotcom stocks, and the recent boom and bust in subprime mortgage lending.
Financial innovations, such as credit scoring for mortgage loans, allow intermediaries to make better risk decisions. At first, when an innovation is unproven, few investors are comfortable with it, and the reduction in risk premium is slight. Over time, investors gain confidence in the track records and disclosure methods of the intermediaries, and this lowers the risk premium. Occasionally, a combination of investor overconfidence and poor disclosure practices causes this process to overshoot. Risk premiums get too low, somebody gets burned, and the market corrects. At the point of correction, the flaws in disclosure practices become evident, and the market shuts down until new methods are developed and investors recover their confidence in intermediaries.
If I wanted to publish this theory in a professional journal, I would first have to dress it up in mathematics. This would mean coming up with a way to describe the difference between complete information and a summary of information. That is not so easy. It would involve coming up with a way to describe the advantages of specialization, something that was easy for Adam Smith to describe in words but which is not so easy to describe in math (I think of Paul Krugman as being one of the few to try). For my theory of financial intermediation, the specialization has to be in information acquisition and summarization.
So, putting this model into formal terms would be a challenge. The reward for meeting this challenge would be publication. Maybe that is worth it. But my conjecture is that formalizing the model would not add to its value, and conceivably it could send the interpretation of the theory in the wrong direction. I would argue that the formalization of Keynes’ theories served to emasculate it of the interesting notion of a conflict between the desire to hoard and the desire to create.
Also, apropos recent discussions on our blog of the villain/victim paradigm, my essay challenges the media characterization of a financial executive as a villain.
UPDATE: more on risk, transparency and the mortgage market, along with the macroeconomic impact and policy responses, from Fed Chairman Ben Bernanke.