Arnold Kling  

What do Financial Intermediaries Do?

Leaning Against the Wind... Two Interesting Things James H...

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.

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COMMENTS (6 to date)
shayne writes:

Thank you for this post, Arnold! You're a good teacher - and this post compelled me to think a bit harder about this situation.

Right now, the Fed/Treasury are falling all over themselves to pump liquidity into the markets as a remedy for real or supposed financial crisis. You correctly ask whether the Fed/Treasury is in fact solvent themselves - and the question is absolutely relevant. But I suggest it may become even more relevant and acute in the more immediate future.

As soon as this "crisis" abates (estimated to be sometime late 2009-early 2010) the Fed is going to be tasked with mopping up all of this excess liquidity (cash) in order to stave off the inflationary effects. The only mechanisms I am aware of that the Fed (or any other entity) has of doing so is to trade Treasury obligations for the cash - or devalue the currency. It also can only compel its member banks to trade cash for Treasuries. It has no jurisdiction to compel any foreign entities to do so. Given your question about the CURRENT solvency of the U.S. (current debt, future Medicare obligations, etc.), as well as the current actions/problems, it becomes highly questionable in my mind whether anyone who isn't compelled to do so will be willing to trade cash for Treasury obligations NEXT YEAR or even now.

A fairly thorough analysis of the holdings of U.S. Federal Reserve coupons (U.S. currency) versus trading those coupons for Treasury obligations may well yield the result that holding the coupons is preferable - even if doing so contributes to a de facto devaluation of the coupons. And that de facto devaluation will be entirely out of the control of the Fed. That will let folks know what a real financial crisis is. I hope some folks outside the U.S. come to the determination that the U.S. is "too big to fail". But it appears that is becoming increasingly costly AND unlikely.

Bob Knaus writes:

Arnold - good post, thanks!

You allude to one major reason for the replacement of transparency by trust... information overload. We simply don't have time to be familiar with the creditworthiness of all the bank's loans, even if we had the inclination.

The other major reason is privacy. A banker has access to privileged information. Few businesses would apply for a loan if they knew their finances and business plan were to be posted on the Internet. Few homebuyers would apply for a mortgage if their credit rating and tax returns received similar treatment.

This is the key difference between a bank holding bad debts, and the government holding them. We expect governments to be transparent. Either the Fed and Treasury will need to air a lot of laundry out, or they will need to get rid of it fairly soon.

Dear Arnold,
I second the compliments of the two first commenters. One major difference, though. You're incorrect in saying, "the only intermediary we trust is the Fed/Treasury." I think you should speak for yourself. I don't trust them. See my article, "Who is 'We'" for the pernicious effects of using "we" when that is not the correct usage.


PJens writes:


I echo the above in complimenting this post.

I say though that the federal government can not only collect taxes and print money, but it can does borrow money too. Much has been written about the US Bond market. The bottom line is that as long as US Bonds are being bought and sold, essentially the line of credit is still open.

Marcus writes:

PJens, I believe Arnold explicitly pointed that out when he wrote, "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."

They can borrow because people are willing to lend them money. People are willing to lend them money because they can collect taxes and print money.

Oskar Shapley writes:

Good straightforward explanation.

I'd add that because of financial innovation (CDOs, etc.) what we had were several layers of intermediation. This put more capital into the system, drove down the rates, but has made the system opaque for the original capital providers. Half of the investors were foreign funds, which was a bad choice on their part.

If the investor is a local California resident, he is closer to the California real estate market and he can verify the situation with his own eyes. Foreigners are too far away, information-wise. AFAIR, the guys from PIMCO send their own investigators down to mortgage agencies to verify whether the approval process was sound. What they saw has terrified them and they decided no to invest into any of this.

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