The utility functions of borrowers and lenders differ in a number of ways. Borrowers often require quite large quantities of funds whereas the lender generally will only have smaller amounts of surplus funds; in other words, the capacity of the lender is less than the size of the investment project. For example, the purchase of a house is likely to require more funds than can be provided by any individual lender. Thus, the bank will collect a number of smaller deposits, parcel them together and lend out a larger sum. This is called 'size transformation'.
Second, the lender usually wants to be able to have access to his funds in the event of an emergency; that is, he/she is wary of being short of liquidity. This results in the lender having a strong preference for loans with a short time horizon. Conversely, the borrower wishes to have security of his/her funds over the life of the project or investment. Consider the example of investment in new plant and machinery with a life of 15 years. Assume also that funds are required for the full life of the plant but loans are only available with a maturity of 3 years. This would necessitate the borrower having to renew the loan or find alternative lending facilities every 3 years or five times over the life of the project. Banks can fulfil this gap
1 A third category of financial intermediary is a broker who acts as a third party to arrange deals but does not act as a principal. This type of financial intermediary while important is also not relevant to our discussion.
by offering short-term deposits and making loans for a longer period. The extreme example of this process is housing loans, which have a typical life of 25 years, whereas the financial intermediary will support this loan by a variety of much shorter deposits. This is called 'maturity transformation'. An illustration of the degree of maturity transformation carried out by banks can be gleaned from the balance sheets of UK-owned banks. As at 31/12/033 their ag gregate balance sheets showed that 36% of sterling deposits were sight deposits; i.e., repayable on demand. This contrasts with the fact that 58% of sterling assets were for advances; i.e., a much longer term. Banks are able to carry out maturity transformation because they have large numbers of customers and not all customers are likely to cash their deposits at any one particular time. An exception to this occurs in the case of a run on the bank where large numbers of depositors attempt to withdraw their funds at the same time.
The final type of transformation carried out by banks is 'risk transformation'. Lenders will prefer assets with a low risk whereas borrowers will use borrowed funds to engage in risky operations. In order to do this borrowers are willing to pay a higher charge than that necessary to remunerate lenders where risk is low. Two types of risk are relevant here for the depositor: default and price risk. Default risk refers to the possibility that the borrower will default and fail to repay either (or both) the interest due on the loan or the principle itself. Deposits with banks generally incur a low risk of default. This is not completely true as there have been a number of bank bankruptcies, but even here in most countries the depositor will regain either the total or a substantial proportion of the deposit in the event of bank bankruptcy because deposits are insured. Price risk refers to variation in the price of the financial claim. Bank deposits are completely free from this risk as their denomination is fixed in nominal terms. Consequently, lenders are offered assets or financial claims which attract a low degree of price risk5 in the absence of the failure ofthe bank.
On the asset side of banks' balance sheets, price risk is absent except in the case of the failure of the firm or individual; i.e., default. In such instances the value of the loan depends on how much can be obtained when the firm is wound up. Similarly, in the case of securitization of loans the market value may differ from the value of the loans on the books of the financial intermediary. Hence, the main risk for the banks is default. How do banks deal with the risk of default of their borrowers? One important method for retail banks is by pooling their loans. This is feasible
2 25 years is the normal length of the mortgage when taken out, but, in fact, the average real life of a mortgage is considerably less due to repayment following purchase of a new house or just to refinance the mortgage by taking out a new one.
3 Source: Bank of England Abstract of Statistics, Table B1.2. www.bankofengland.co.uk
4 It may be objected that some bank-lending is by way of overdraft, which is also of a short-term nature. On the other hand, most overdrafts are rolled over. In any case there are serious problems involved in recalling overdrafts, not least of which is the potential bankruptcy of the borrower and consequent loss for the bank.
5 Note, however, that bank deposits are subject to real value risk since variations in the general price level will alter the real value of assets denominated in nominal terms.
since retail banks will have a large number of loans and they will endeavour to spread their loans over different segments of the economy such as geographical location, type of industry, etc. By diversifying their portfolio of loans in this way, banks are able to reduce the impact of any one failure. They are able to reduce the risk in their portfolio. Banks will also obtain collateral6 from their borrowers, which also helps to reduce the risk of an individual loan since the cost of the default will be borne by the borrower up to value of the collateral. Banks can also screen applications for loans and monitor the conduct of the borrower — this aspect is considered more fully in Section 3.4. Banks will also hold sufficient capital to meet unexpected losses and, in fact, they are obliged to maintain specified ratios of capital to their assets by the regulatory authorities according to the riskiness of the assets. By all these means the bank can offer relatively riskless deposits while making risky loans.7 Wholesale banks will also reduce risk by diversifying their portfolio, but they have also one additional weapon in their hands. They will often syndicate loans so that they are not excessively exposed to one individual borrower.
As we have seen above, banks can engage in asset transformation as regards size, maturity and risk to accommodate the utility preferences of lenders and borrowers. This transformation was emphasized by Gurley and Shaw (1960), and we need to consider whether this explanation is complete. In fact, immediately the question is raised why firms themselves do not undertake direct borrowing. Prima facie, it would be believed that the shorter chain of transactions involved in direct lending/ borrowing would be less costly than the longer chain involved in indirect lending/ borrowing. This leads to the conclusion that, in a world with perfect knowledge, no transaction costs and no indivisibilities, financial intermediaries would be unnecessary.
In fact, these conditions/assumptions are not present in the real world. For example, uncertainty exists regarding the success of any venture for which funds are borrowed. Both project finance and lending are not perfectly divisible and transaction costs certainly exist. Hence, it is necessary to move on to consider the reasons borrowers and lenders prefer to deal through financial intermediaries. One of the first reasons put forward for the dominance of financial intermediation over direct lending/borrowing centres on transaction costs — Benston and Smith (1976) argue that the 'raison d'etre for this industry is the existence of transaction costs', and this view is examined in Section 3.3. Other reasons include liquidity insurance (Diamond and Dybvig, 1983), information-sharing coalitions (Leyland and Pyle, 1977) and delegated monitoring (Diamond, 1984, 1996). These are dealt with in Sections 3.3—3.5, respectively.
6 'Collateral' refers to the requirement that borrowers deposit claims to one or more of their assets with the bank. In the event of default, the bank can then liquidate the asset(s).
7 Risk is often measured by the variance (or standard deviation) of possible outcomes around their expected value. Using this terminology the variance of outcomes for bank deposits is considerably less than that for bank loans. In the case of bank deposits the variance of price risk is zero and that for default risk virtually zero.
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