In the traditional economics framework, the effect and
role of financial intermediation always be ignored. It only be mentioned and be
paid attention to when analysed the money creation process. The concern and
focus of the financial intermediation started from financial development theory
at the middle of 20th century. Gurley and Shaw (1955) believed that
financial intermediation played a significant role in transmitting the loanable
funds between spending units. But the financial development theory only
concerned the function of financial intermediation in the aspect of its
relationship with the development of economic growth, it was on premise of existence
of financial intermediation, rather than questioning why it existed in a micro
view. With the development of information economics and transaction cost
economics, the financial economists had come up with some theories of financial
intermediation. In this essay, the author will use the transactions cost theory
and the liquidity insurance theory to explain the role and existence of
financial intermediation, discuss and compare two theories in a macroscopic
Benston and Smith (1976) believed that the financial
intermediation will not exist in a perfect market without frictions of
transactions cost, information cost, or indivisibilities. In the real life,
these frictions are inevitable. Without the existence of the financial
intermediation, the financial transaction may not be accomplished because the transaction
costs are too high.
Thompson and Matthews (2014) has concluded the costs
into the following categories:
1. Search Cost
The search cost involves costs that the transactors
seeking for the agency who will take an opposite position. The agents need to obtain
the essential information about lenders and borrowers to the transaction,
negotiating with both party, and facilitate the relevant contract.
2. Verification Costs
The lender need to assess the proposal for which the
funds required, and the verification cost involved in this process.
3. Monitoring Costs
Once the transaction is made, the lender will need to
monitor the process of borrowers and make sure the funds are used in accordance
with terms agreed. A moral hazard aspect arise here as the borrowers may be
utilize the funds for the purposes which are not specified in the contract
4. Enforcement Costs
The enforcement costs arise from the lender should the
borrowers act against the terms and conditions of contract.
Thompson and Matthews (2014) believed that the fall in
the total costs incurred above will be greater than the charge levied by the
banks. Some banks used IT technology such as internet bank and mobile banking ed IT technology to reduce the research cost,
reserves of individual consumers acting indepently. to reduce the research cost. The
contractual arrangements were easily implemented through standard forms of
contract, which reduced the transaction cost because the new contract did not
have to repeat negotiation process with each loan (Thompson and Matthews,
2014). The financial intermediations can reduce the total transaction cost by
achieving the economics of scale, and achieve risk sharing by investment
diversification. Costs are reduced by the size and maturity transformation.
Also, the monitoring cost is likely to be reduced obviously if the monitoring
process is conducted by one financial intermediation rather than N investors on M loans.
Diamond and Dybvig (1983) came up with famous DD
model, from the view of liquidity transformation function to prove the
existence of the financial intermediation (mostly depositary financial
intermediation). The DD model has been presented in 3 periods, T=0, T=1,
T=2. The investors were unsure when
they would require funds, but the decisions were made in T=0 and ran during nest two periods. Consumers were classified into
2 classifications, those who consumed early in period T=1, and those who consumed late in period T=2. The early consumption produced lower output, therefore, it’s
clearly to consume at period 2. The introduction of banks offered fixed returns
to solve the problem by pooling resources together, and made large payment to
early consumers and small payments to late consumers. Thus, the banks acted as
insurance agent to depositors,
The DD model argument was based on the portfolio
theory, which suggested that the total liquid reserves needed by bank will be
less than the total reserves of individual consumers acting independently. In
the DD model, the financial intermediation provides the liquid deposit contract
to lenders and provides illiquid loan to borrowers, thus, the financial
intermediation undertakes the liability of the liquidity transformation
function of transforming illiquid asset by offering liquid liabilities.
Therefore, the banks (the financial intermediation) act as liquidity insurance
The transaction cost theory pay attention on analysis
of remedy for financial markets shortcoming, the main point focus on “why does financial intermediation exist with
respect to financial markets.” However, the liquidity insurance theory does
not only start from point of analysis of the remedy, it pays more attention on
factors such as liquidity insurance, risk management, reducing cost, etc. It
starts from point of view that investors need financial intermediation as an
intermediation to take part in financial activities in a more efficient way. It
focuses on analysis of “why does
financial intermediation exist with respect to the investors.” In this sense, the two theories are not
interchangeable, they are complementary to each other.
Scholtens and Wensveen (2000) has questioned and
supplemented the traditional financial intermediation theory, they believed the
financial intermediation theory should give up the analysis paradigm of static
perfect market, and should adopt more dynamic method. The financial
intermediation cannot be treated as a simple and passive agent, the existence
of financial intermediation does not simply for reducing transaction cost, offsetting the information asymmetry or other
reflections of imperfect markets. The financial intermediation should actively
take part in innovation of financial products, and participate in the financial
transformation—creating values for investors through transformation of
financial risks, maturities, scale, locations and liquidity insurance. They believed that the value creation should
be the main power of development of contemporary financial intermediation
theory, therefore, contemporary financial intermediation theory should focus on
In summary, the article lists and explains two
financial intermediation theories, one is transaction cost theory, the role of
financial intermediation of this theory is reducing total transaction costs to
attract investor, which can be represented the traditional financial
intermediation theory—the financial intermediations are simple and passive
agents. Another theory is liquidity insurance theory, the role of financial
intermediation of this theory is liquidity insurance agents, which can be
represented the contemporary financial intermediation—the financial
intermediations should focus on value creation.
Benston, G. and Smith, C. W. (1976). A
transaction cost approach to the theory of financial intermediation. Journal of Finance. 31(2). pp. 217-219.
Diamond, D. W. and Dybvig, P. (1983).
Bank runs, deposit insurance and liquidity. Journal
of Political Economy. 91(3). pp. 401?419.
Gurley, J. G. and Shaw, E. S. (1955). Financial
Aspects of Economic Development. American
Economic Review. 45(Sep). pp.516-522.
Matthews, K. and Thompson, J. (2014). The Economics of Banking. 3rd
edition. Chichester: Wiley, pp.40-46.
Scholtens, B. and Wensveen, D. (2000). A Critique on
the Theory of Financial Intermediation. Journal
of Banking and Finance. 24(2000). pp.1243-1251.