Fundamentally, the value intermediaries can add by diversifying over investments and liquidity requirements is very modest, and ought to be acknowledged as such.
I think that intermediaries add value in other ways. One is by evaluating risks. I do not have time to learn how to evaluate oil drilling projects. Instead, I invest in a oil company.
Another way intermediaries add value is by monitoring the behavior of risk-takers. How do I know that the entrepreneur is not keeping a hopeless business going so that he can collect a salary? How do I know that the entrepreneur is not keeping secret a tremendous success, taking most of the payout for himself and cheating me as an investor? I pay the intermediary to monitor the entrepreneur. This "delegated monitoring" idea comes from Doug Diamond.
So how does the financial sector seem to offer risk-free assets against risky projects? I think "constructive ambiguity" is the right phrase. The government provides subsidies in the form of literally priceless deposit and liquidity backstops, but those are explicitly limited. Banks work to diligently to increase both the level of insurance and degree to which assets are perceived to be insured by becoming so large that social costs of a bank default on even notionally risky assets are thought to exceed the costs to government of paying out on insurance policies to which it never agreed. Even a very careful observer cannot tell a priori whether many assets offered are genuinely riskless or not, that is to what degree the risk-free status of bank assets is due to subsidy, and to what degree to subterfuge. But there is an ingenious tinkerbell aspect to the risk status of bank assets: If, with a bit of subterfuge, risky assets can be sold as riskless assets, then the social costs of default rise, since asset holders will not have privately managed the risk that the asset might fail. The increase in social costs created by a mischaracterization of a risky asset as riskless, however, alters the likelihood that an asset will be de facto insured. There is a game theoretic equilibrium, that works to the advantage of intermediaries and their customers on both sides of the funding stream, whereby banks offer assets in large quantities as though they are risk-free, and investors accept and treat those assets as risk-free, and by believing together in what is formally not true, they create costs to the sovereign so [sic?] larger if it is not true that if the sovereign makes it true. This is an equilibrium, a predictable outcome, not an aberration. And it does happen all the time.
What I think he is saying is that intermediaries take advantage of the fact that governments hate to see financial collapse. Even without explicit government insurance, intermediaries will try to pretend to be low-risk, taking the view that if they fail the government will bail them out. With explicit insurance, however, intermediaries have another option, which is to try to fool the regulators into believing that they are staying within risk boundaries, when in fact they are taking risks at taxpayers' expense.
So what is the best institutional design? Waldman lists a number of possibilities. His fourth one is:
Prefer equity to debt arrangements. All business risks must eventually be borne by investors. Debt financing concentrates enterprise risk among equity holders, and enables debt-holders to manage their investment risk less carefully. Risk-management by private investors reduces the social cost of failure that compels government bailouts.
That seems to me to be on the right track. But there is much to chew on in his entire post.