Financial Intermediation

Recall that the financial problem facing households is how best to invest their funds. The relative smallness of most households makes direct investment intrinsically difficult. A small investor obviously cannot advertise in the local newspaper his or her willingness to lend money to businesses that need to finance investments. Instead, financial intermediaries such as banks, investment companies, insurance companies, or credit unions naturally evolve to bring the two sectors together. Financial intermediaries sell their own liabilities to raise funds that are used to purchase liabilities of other corporations.

For example, a bank raises funds by borrowing (taking in deposits) and lending that money to (purchasing the loans of) other borrowers. The spread between the rates paid to depositors and the rates charged to borrowers is the source of the bank's profit. In this way, lenders and borrowers do not need to contact each other directly. Instead, each goes to the bank, which acts as an intermediary between the two. The problem of matching lenders with borrowers is solved when each comes independently to the common intermediary. The

CHAPTER 1 The Investment Environment 11

Table 1.7 Balance Sheet of Financial Institutions*


$ Billion

% of Total

Liabilities and Net Worth

$ Billion

% of Total

Tangible assets


Equipment and structures

$ 528



$ 3,462





Mutual fund shares



Total tangibles

$ 628


Life insurance reserves



Pension reserves



Money market securities



Bonds and mortgages



Financial assets




Deposits and cash

$ 364


Total liabilities



Government securities



Corporate bonds






Consumer credit



Other loans



Corporate equity






Total financial assets



Net worth









"Column sums may differ from total because of rounding error.

Source: Balance Sheets for the U.S. Economy, 1945-94, Board of Governors of the Federal Reserve System, June 1995.

"Column sums may differ from total because of rounding error.

Source: Balance Sheets for the U.S. Economy, 1945-94, Board of Governors of the Federal Reserve System, June 1995.

convenience and cost savings the bank offers the borrowers and lenders allow it to profit from the spread between the rates on its loans and the rates on its deposits. In other words, the problem of coordination creates a market niche for the bank as intermediary. Profit opportunities alone dictate that banks will emerge in a trading economy.

Financial intermediaries are distinguished from other businesses in that both their assets and their liabilities are overwhelmingly financial. Table 1.7 shows that the balance sheets of financial institutions include very small amounts of tangible assets. Compare Table 1.7 with Table 1.5, the balance sheet of the nonfinancial corporate sector. The contrast arises precisely because intermediaries are middlemen, simply moving funds from one sector to another. In fact, from a bird's-eye view, this is the primary social function of such intermediaries, to channel household savings to the business sector.

Other examples of financial intermediaries are investment companies, insurance companies, and credit unions. All these firms offer similar advantages, in addition to playing a middleman role. First, by pooling the resources of many small investors, they are able to lend considerable sums to large borrowers. Second, by lending to many borrowers, intermediaries achieve significant diversification, meaning they can accept loans that individually might be risky. Third, intermediaries build expertise through the volume of business they do. One individual trying to borrow or lend directly would have much less specialized knowledge of how to structure and execute the transaction with another party.

Investment companies, which pool together and manage the money of many investors, also arise out of the "smallness problem." Here, the problem is that most household portfolios are not large enough to be spread across a wide variety of securities. It is very expensive in terms of brokerage and trading costs to purchase one or two shares of many

12 PART I Introduction different firms, and it clearly is more economical for stocks and bonds to be purchased and sold in large blocks. This observation reveals a profit opportunity that has been filled by mutualfunds offered by many investment companies.

Mutual funds pool the limited funds of small investors into large amounts, thereby gaining the advantages of large-scale trading; investors are assigned a prorated share of the total funds according to the size of their investment. This system gives small investors advantages that they are willing to pay for in the form of a management fee to the mutual fund operator. Mutual funds are logical extensions of an investment club or cooperative, in which individuals themselves team up and pool funds. The fund sets up shop as a firm that accepts the assets of many investors, acting as an investment agent on their behalf. Again, the advantages of specialization are sufficiently large that the fund can provide a valuable service and still charge enough for it to clear a handsome profit.

Investment companies also can design portfolios specifically for large investors with particular goals. In contrast, mutual funds are sold in the retail market, and their investment philosophies are differentiated mainly by strategies that are likely to attract a large number of clients. Some investment companies manage "commingled funds," in which the monies of different clients with similar goals are merged into a "mini-mutual fund," which is run according to the common preferences of those clients. We discuss investment companies in greater detail in Chapter 4.

Economies of scale also explain the proliferation of analytic services available to investors. Newsletters, databases, and brokerage house research services all exploit the fact that the expense of collecting information is best borne by having a few agents engage in research to be sold to a large client base. This setup arises naturally. Investors clearly want information, but, with only small portfolios to manage, they do not find it economical to incur the expense of collecting it. Hence a profit opportunity emerges: A firm can perform this service for many clients and charge for it.

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