Lending and Borrowing

In general, portfolio diversification can reduce uncertainty without reducing expected return. Hence, risk averse lenders have an incentive to lend small amounts to many borrowers in order to reduce uncertainty. Bor­rowers, on the other hand, prefer to make as few transactions as possible. In practice, a lot of lenders are unable to achieve adequate portfolio diver­sification through the purchase of direct claims alone because of relatively large minimum denominations and/or high unit costs of small transactions. By engaging in denomination intermediation, a financial intermediary can satisfy both lender and borrowers, In effect, each lender lends very small amounts to a relatively large number of borrowers. Nevertheless, each borrower could borrow from just one financial intermediary. By providing more attractive lending and borrowing arrangements in this way, financial intermediaries increase the total volume of credit.

Maturity Intermediation

Other things equal, lenders would prefer financial claims possessing more rather than less liquidity. In general, the shorter the maturity of a claim, the more liquid it is. Overnight loans are almost perfectly liquid because of the repayment the next day. Demand deposits are perfectly liquid because they are repaid on demand. By definition, a perfectly liquid financial claim is money. Borrowers, on the other hand, might prefer to sell claims with a maturity covering the earning period of the investment; they would find any obligation to repay a loan on demand quite impracticable.

Financial intermediaries also attract business through maturity inter­mediation. They can use the law of large numbers to offer short-term claims to lenders while buying longer-term claims from borrowers. In this case, the law of large numbers applies to the probability of lenders all wanting their money back at the same time. If deposits and withdrawals are random events and independent from one another, the more accounts a bank holds, the smaller the probability of any given percentage of net with­drawals. With a sufficiently large number of accounts subject to indepen­dent and random deposits and withdrawals, a financial intermediary need set aside only a small percentage of its assets to meet net deposit with­drawals. The rest of the deposits can be used to buy longer-term financial claims. From the lender’s viewpoint, such maturity intermediation pro­duces indirect claims that are more attractive than the direct claims bought by the financial intermediary. However, maturity intermediation neces­sarily exposes the financial intermediary to interest rate or market risk.

Transaction Cost Wedge

Consider a situation in which there are no financial intermediaries. Lending, represented by the supply, is a function of the net return on savings. The net return is the market interest rate adjusted for risk and illiquidity. For example, from a 10 percent yield on direct claims, In the absence of financial intermediaries, lenders or suppliers of loans receive a net return on their savings of 6 percent while borrowers, investors, or demanders of loans pay a gross cost of 14 percent. This 8 percent wedge between gross cost and net return is reduced to 5 percent by financial intermediaries; they lower gross costs by eliminating borrowers’ transaction costs and they raise net returns by reducing lenders’ search and risk costs. The total volume of lending and borrowing rises from zero to one.

Financial institutions can reduce this wedge between gross costs of borrowing and net returns to lending. Through denomination and matu­rity intermediation, financial intermediaries might cut lenders’ risk and illiquidity premia from a total of 4 to 1 percent, for example. Borrowers’ transaction costs could be eliminated altogether. To cover their costs, fi­nancial intermediaries might offer loans at 12 percent and deposits at 8 percent. The wedge between the gross borrowing cost and the net return to lending is thereby reduced from 8 to 5 percentage points. In this example, borrowing increases as a result of the reduction in the gross cost from 14 to 12 percent. Lending rises too because of the increase in the net return from 6 to 7 percent.

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