Why Do Financial Intermediaries Exist?

Because financial markets are far from being complete and perfect, financial intermediaries (FIs) exist. The existence of inefficiencies in direct financing permits FIs to exist. Fundamentally, direct finance is unable to solve the double-coincidence problem: The financial claims sold by debtors (deficit-spending units) must have the exact characteristics (risk, liquidity, maturity, and denomination) desired by creditors (surplus-spending units). Financial intermediaries that can solve this problem have the potential to exist. To survive, however, FIs must be able to make an economic profit. The profitable ones have developed the financial capital, human resources, and reputational capital that permit them to have lower information, contracting, and transacting costs or better revenue-generating functions or both than other players in the FSI. These advantages can be traced, in varying degrees, to potential benefits associated with specialization, firm size (economies of scale), and the diversity of the firm’s activities (economies of scope).

The end of danking as we know it?

Much has been written about the decline of banking and its loss of market share to mutual funds, commercial paper, and corporate bonds. Table 1-5 shows the levels, changes, growth, and market shares of total assets for selected financial sectors in the United States for the years 1978 and 1995. The declining market shares for U.S. banks and thrift institutions suggest «the end of banking as we know it». Since market share is only one aspect of an industry's performance, and not a very good one at that, it is important to understand exactly what is meant by the «decline» of banking and whether or not it means the end of banking as we know it. Although commercial banks' relative share of the total assets held by all financial services firms has declined, the dollar or absolute share has continued to grow because the size of the pie has grown (Panel B, Table 1-3). In this respect, banks are not stagnant nor in decline. Moreover, in terms of product and geographic expansion, banks are moving into the twenty-first century by diversifying with new products and expanding into regional, national or global markets.

Figure 1 Levels. Changes. Growth, and Market Shares of Total Assets for Selected u.S. Financial Sectors, 1978 and 1995

Panel A. Total Assets ($ trillions end of period)

Industry	1978	1995	Change	Annual Growth (%)
Commercial banking	1,2	3,5	2,3	6,5
U.S. banks	1,1	3,1	2,0	6,3
Foreign banks	0,1	0,4	0,3	8,5
Thrift institutions	0,7	1,2	0,5	3,2
Savings and loans	0,5	0,7	0,2	2,0
Savings banks	0,1	0,2	0,1	4,2
Credit unions	0,1	0,3	0,2	6,7
Life insurance cos.	0,4	1,5	1,2	8,1
Other insurance cos.	0,1	0,5	0,4	9,9
Private pension funds	0,3	0,7	0,4	5,1
Finance companies	0,1	0,6	0,6	11,1
Mutual funds	0,05	0,8	0,7	17,7
Money-market funds	0,01	0,5	0,5	25,9
Sec. brokers & dealers	0,03	0,2	0,2	-11,8
Total	2,88	9,6	6,7	7,3

Panel B. Market-Share Percentages: Then (1978) and Now (1995)

Industry	1978	1995	Selected Ranks
			1978	1995
Commercial banking	41,4%	36,4%	1	1
U.S. banks	37,9	32,3
Foreign banks	3,4	4,2
Thrift institutions	24,1	12,5	2	4/5
Savings and loans	17,2	7,3
Savings banks	3,4	2,1
Credit unions	3,4	3,1
Life insurance cos.	13,8	16,7	3	2
Other insurance cos.	3,4	5,2
Private pension funds	1,7	7,3	4	4/5
Finance companies	0,3	6,2
Mutual funds	1,0	8,3		3
Money-market funds	0,3	5,2
Sec. brokers & dealers	1,0	2,1
Total	100%	100%

Funding loans with deposits has been and still is the core business of commercial banking. The erosion of this core business captures the essence of the decline of banking and explains what analysts mean when they talk about the end of banking as we know it, i.e., in the narrow sense of funding loans with deposits. Because a strategy based solely on this core business has limited growth opportunities, many bankers are looking to expand into other businesses, such as investment banking, insurance, mutual funds, data processing, and information services. These narrow and broad views capture the basic distinction between traditional banking, which is in decline, and modern banking, which offers greater growth opportunities. Although «community banks», those with total assets under $1 billion, may find it difficult to tap many of the growth opportunities of modern banking, the need for basic banking services in rural markets suggests that many of them will survive. The delivery systems of modern banking are becoming more and more electronically based (electronic banking) as evidenced by international large-dollar payment systems, globalized ATM networks, and worldwide acceptance of credit cards. Home banking on the Internet (chapter 18) is one of the exciting developments in this area.

The consolidation of the banking industry refers to the decline in the number of commercial banks (e.g., from some 14,500 banks in 1984 to about 9,500 at the beginning of 1997). Many people regard this shrinkage as a symptom of the decline of banking. However, when an overbanked system is opened to greater competition, such a phenomenon is not unexpected. For many years regulation and lack of technological developments acted as shelters for commercial banks and thrift institutions, providing a protected environment that permitted many of them to exist without diversified portfolios. At various times deflation in energy, farm, and commercial real-estate prices decimated these portfolios, contributing еo the thrift and banking debacles of the 1980s and early 1990s.

In the late 1970s and early 1980s, the combination of volatile interest rates. greater competition, and technological advances made interest-rate and geographic restrictions obsolete. For depository institutions to compete with money-market mutual funds in the early 1980s, Regulation Q interest-rate ceilings had to be removed; the timing, however, was extremely bad, especially for thrift institutions. Although the 1990s started with a recession, financial distress, and a credit crunch, declining interest rates permitted depository institutions to recover with record profits by 1993 and continued strong performances over the next three years.

Table 1-6 presents some thoughts about banking's decline by bank regulators, consultants, and bankers. The fundamental question focuses on whether banking is a competitive vehicle to attract savings and investment from the American public. More specifically, when banks raise certificate of deposit (CD) rates, will consumer deposits flow back to banks? Have banks lost customer relationships along with the outflow of CDs? Think of the basic bank-customer relationship as consisting of deposits, loans, and other financial and information services.

Because the environment of the FSI is dynamic, banking as we have known it is changing. This does not mean that banks are dead. To survive, however, they must adapt to the changing environment of the FSI. On balance, the reports of banking's death are greatly exaggerated (Boyd and Gertler [ 1994] and Kaufman and Mote [1994]).