Intermediation versus disintermediation

And indirect finance versus direct finance

The traditional role of depository institutions has been to gather deposits and make loans – the intermediation function, also known as indirect finance because the process involves an intermediary between economic units that need funds and those the supply them. When an intermediary is not involved, the funding process is called direct finance and is illustrated by the issuance of commercial paper or corporate bonds by borrowers directly to investors. When the process of securitization is employed, pass – through finance occurs.

When the intermediation function is disrupted , disintermediation occurs, or a shift from indirect finance to direct finance. Disintermediation has occurred on both side of bank and S&L balance sheets as they have lost deposits to other FSFs, especially mutual funds, and as they have lost loans to the instruments of direct finance described above (e.g., commercial paper)

The Creation and Characteristics

Of Financial Claims (Contracts)

A financial claim (contract) is an asset to the holder and a liability to the issuer. When a financial intermediary is involved, the three relevant parties are

• The depositor, or creditor

• The intermediary or bank

• The borrower

Table 1-4 provides a schematic and balance sheets (“T-accounts”) that show the relationship among the parties. The person or enterprise agreeing to make future cash payments is the issuer of an obligation and has incurred a liability e.g., a bank issuing a certificate of deposit or a borrower agreeing to repay a loan. In contrast , the owner of a claim, the investor, expects to receive cash payments and holds a financial asset, e.g. , a depositor expecting payments of interest and principal or a bank expecting loan repayments. When a bank makes a loan or investment, it acts

Table 1-4 The Intermediation Process and the Creation of Financial Claims or Contracts

Panel A. The Players____________________________________________________

Depositor: Has a claim on the bank, an asset for the depositor

Bank: Issues a claim against itself, a liability of the bank

Bank: Makes a loan to a borrower, an asset for the bank

Borrower: Issues a claim against itself, a liability of the borrower.

Panel B. A Schematic View_______________________________________________

Intermediary

Panel C. Marginal T- Accounts_________________________________________

The Borrower The Bank** The Depositor

Cash (+) Debt(+) Loan(+) Deposit (+) Cash (-)

Or (loan) Deposit(+)

DDA*(+)

_____________________________________________________________________________________

Note: *DDA = demand-deposit or checking account. The depositor simply substitutes one asset (cash) for another (deposit) while the bank and the borrower “create” both assets and liabilities for themselves.

**When disintermediation occurs, banks lose loans to instruments of direct finance or lose deposits to competitors, e.g., mutual funds. When banks securitize loans, they originate loans and then sell them, thereby removing risk from the balance sheet.

as an agent for the depositor; the borrower simultaneously issues a claim against itself in the form of a promise to repay the debt plus interest (hence the term “promissory note” or any promise to pay).

Intermediation involves separate financial contracts (e.g., deposits and loans) in which the bank assumes the variable cash flows and timing differences between the two contracts. The uncertain net cash flows associated with the underlying contracts capture the risks of banking. Innovations in contracting technologies, such as floating – rate loans and securitization, provide tools for managing these risks.