What do Financial Intermediaries Do?
By Arnold Kling
When I wrote that
financial intermediation inherently replaces transparency with trust
some people found that comment enigmatic. So I’ll elaborate.
Suppose I have some savings, and I would like to invest them. I would like a nice return, but I prefer not to take risk.
Next, suppose that there are a lot of real estate developers with projects on the drawing board to build shopping malls. They all want to borrow money, and then pay it back with interest.
Some of the shopping malls will be economically viable. The developers will make money, and they will pay back their loans. Other developments will turn out to fail, and lenders will suffer losses.
If I lend to a developer myself, there are two problems. First, I have no experience in evaluating plans for shopping malls. I may make a bad choice. Second, I will be putting all my money into one mall. I would be better off with a diversified portfolio, where loss from an occasional failure is offset by profits from many successes.
I put my money in a bank, which does the evaluation and diversification for me. The bank picks a portfolio of shopping malls to back with the funds that it gets from me and other savers.
In a world of pure transparency, I “see through” the bank, and I know exactly how my money is being deployed. I know which developers it is lending to, and I know as well as the bank does the risk of each development. I hope that it is obvious why that world is totally unrealistic. Nonetheless, that world crops up constantly in two places: mathematical models in economics; and in the pleas of politicians and commentators that “we must have transparency!”
Instead of perfect transparency, what we get in the real world are a variety of specialized functions to monitor and insure intermediaries. Monitoring means that somebody examines the books of the company on a regular basis so that I do not have to. Accounting statements are a form of monitoring. Credit rating agencies are a form of monitoring. Government audits are a form of monitoring.
Insurance means that an intermediary that I trust a lot gets in between me and a borrower that I trust very little. I trust my bank to lend to developers that I would not lend to myself. In part, that is because I trust the FDIC, the government’s deposit insurance fund, to guarantee my money if the bank fails. That is what I mean when I say we substitute trust for transparency.
Recently a lot of mortgage-backed securities were circulating in markets. In part, this was because Freddie Mac, Fannie Mae, and AIG provided guarantees that those securities would not default. When people lost trust that Freddie, Fannie, and AIG had the resources to make good on all of those guarantees, the markets collapsed.
We don’t know for sure that those guarantees are not sound. What we do know is that savers are not willing to extend credit to Freddie, Fannie, and AIG at low enough interest rates for those companies to operate. So Ben Bernanke and Henry Paulson, acting on our behalf, are putting our money into those companies. You may or may not approve, but the fact is that investors right now are flooding the Treasury with money, offering Ben and Hank money at lower and lower rates.
We have chicken-littled ourselves to the point where the only intermediary we trust is the Fed/Treasury. Is this intermediary solvent? No. See Medicare. Is this intermediary transparent? No. What this intermediary can do is collect taxes and print money.