1.1 Financial institutions

Secondly, the larger the volume of deposits which a rm controls, the larger the

assets it will also be holding. The larger the volume of assets it has, the greater the

scope available for arranging those assets in such a way that a proportion matures

at regular intervals. It may well be, as with building societies, that each individual

asset (mortgage loan) is long term and illiquid when rst acquired, but with a very

large number of such loans on its books a society can ensure that there is a steady

ow of maturing loans. In the last paragraph we saw that large size reduced the risk

of an unforeseen outow of deposits; now we can say that if there were such an

unforeseen outow, large size helps to ensure a steady ow of funds from which

to meet it. The more accurate the assessment of net ows, the smaller the propor-

tion of assets that have to be held in very liquid form and the greater the degree

of potential maturity transformation.

Let us repeat then, the behaviour of nancial rms is similar in that they engage

in maturity transformation and they are able to do this for reasons which stem from

their size.

The second function which intermediaries perform in the creation of liquidity is

risk transformationor more precisely risk reduction. Risk comes in a number of forms.

One can think of risk in terms of ‘default’ – the possibility that the lender is not

able to meet the terms on which it was issued. This may mean an inability to meet

interest payments or even an inability to repay the lender at the end of the period.

On the other hand, one may wish to emphasise the different ways in which some

sort of default may arise. One might then distinguish between ‘capital’ risk – the

possibility that when the lender comes to dispose of the asset its value differs from

what had been expected – and ‘income’ risk – the possibility that the asset pays a

return which differs from what had originally been expected or, more subtly, the

possibility that its return relative to that on other assets differs from expectations.

Notice that we describe ‘risk’ here as the possibility that actual outcomes differfrom

expectations. Risk does not mean that outcomes have to be worsethan expectations.

Risk transformation:The reduction in risk that can be achieved by diversication of

lending and by screening of borrowers.

Financial intermediaries are able to reduce risk through a number of devices. The

two principal ones are diversication and specialist management. We shall see that

economies of scale are present here, too, as they were with maturity transformation.

It seems intuitively obvious that holding just one asset is more likely to produce

unexpected outcomes than holding a collection or ‘portfolio’ of assets. We are all

familiar with the danger of ‘putting all our eggs in one basket’. This is the basis on

which savers are encouraged to buy units in a unit trust or to save through a life

assurance policy. The managers of the funds can collect the income from a large

number of small savers and then distribute it among a much wider variety of securities

than an individual saver could possibly do. Precisely the same process is at work with

deposit-taking intermediaries. A bank or building society accepts a large number

of small deposits, creates a large pool and then distributes that pool among a large

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Chapter 1 • Introduction: the nancial system

number of borrowers who use the loans for many different purposes. (The pool also

enables the intermediary to adjust the size of loans to the needs of borrowers which

will usually be much larger than the size of the average deposit.) Clearly, the larger

the size of the institution, the larger its pool of funds. Since the cost of setting up a

loan, or buying securities, is more or less constant regardless of size, large loans and

large security purchases have lower unit transaction costs than small ones. A large

institution therefore has the advantage that it can diversify widely even though it

deals in large investments.

Diversication:The holding of many (rather than a few) assets.

Precisely why and how diversication leads to a reduction in risk is a complex,

technical question. Our intuition tells us that it must be something to do with the fact

that assets do not all behave in the same way at the same time and that therefore the

behaviour of one asset will on some occasions cancel out the behaviour of another.

The key certainly does lie in the fact that there is less than perfect ‘correlation’

between movements in asset prices and returns. What is harder to understand is that

by combining assets in a portfolio one can actually reduce the risk of the portfolio

below the average risk of the assets which comprise it. We deal with this issue more

formally in Appendix I, but Box 1.5 provides a simple illustration of the risk-reducing

effect of diversication.

In addition to being able to pool investors’ funds and distribute them across a wide

diversity of assets, intermediaries offer the risk-reducing benet of specialist expertise.

It is extremely difcult, and therefore costly, for individual savers to research the

status of those to whom they might be tempted to lend. Most quality newspapers

contain a business section which, especially at weekends, devotes space to company

news and share prices, sometimes even offering ‘tips’. Even so, in cases like this where

information about the borrower is available, it is likely to be of poorer quality than

that which an intermediary can acquire through continuous management of funds.

And here again economies of scale are at work. As more information (or experience)

is acquired it becomes easier to spot the essential characteristics of borrowers and their

projects which make them high, medium or low risk and sources of high, medium

and low returns.

Transaction costs:The time and/or money used in carrying out the exchange of assets,

goods or services.

The third contribution which intermediaries can make to liquidity is their reduc-

tion in transaction costs. At one extreme, one can imagine the costs, pecuniary and

otherwise, of direct lending where an individual lender has to search for a borrower

and then arrange for an individually negotiated, legally binding contract to be drawn

up. More realistically, one can imagine the costs to a lender of trying to diversify

modest savings through numerous holdings of equities on each of which a minimum

commission has to be paid. Even assuming a ‘buy and hold’ policy where no further

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