2: Financial Intermediation
Where two people arrange a loan between themselves, they are interacting directly - and without an intermediary. But in the present day, most financial transactions are handled through one or more intermediaries. A person deposits their funds into a bank, another person borrows money from the bank - borrower and lender never meet, and each has a separate agreement with the bank, which serves as their intermediary.
The value of an intermediary to the lender is convenience and security. He does not need to advertise that he has funds to lend, does not need to write and sign a loan contract, and does not even take on the risk that his borrower will not repay. The bank manages all of this for him.
The value of the intermediary to the lender is convenience. He does not need to seek out someone from whom to borrow money and provide his creditworthiness to a stranger. He can establish his reputation with a bank, who can secure multiple loans for him.
There is brief mention of the hype about P2P lending, in which internet companies threaten to eliminate banks and enable borrowers and lenders to interact directly. These services, however, have not been very popular and are likely to remain a novelty because there is value in having intermediaries.
In addition to facilitating interaction and absorbing risk, banks help to resolve different kinds of disparities.
There are often disparities in size between deposits and loans. The bank can fund a large loan by consolidating the capital of many small depositors, or it may use a single large deposit to fund a number of smaller loans. It can do this by handling borrowing and lending in aggregate amounts rather than specific sums.
There are also disparities of maturity: a depositor may want his funds returned at any time, but a borrower expects to pay off his loan in regular installments. By aggregating the loan payments, the bank can ensure that the interests of both parties are satisfied - that even though a large sum is tied up in a thirty-year mortgage, a given depositor can withdraw his funds today.
There are also disparities of nature: there may be more lenders who want to fund auto loans than mortgage loans, but a banker can better manage the kinds of loans to satisfy the demands of creditors while managing risk and returns for their depositors across a broader range of loans.
In any transaction, there is asymmetric information: a person wants to buy a stock because they believe it to be worth more in the future, another person wants to sell the same stock because it would be worth less. They have this difference of opinion because each of them has different information about the company they are investing in (or divesting of) - and only one of them can be right. The party whose information is most correct gains a benefit, to the detriment of the party whose information is incorrect.
Where lenders and borrowers interact with one another directly, there is a great disparity of information, generally in favor of the borrower who knows his own capacity and willingness to repay the loan. To do the necessary background research on the borrower requires skills, knowledge, and cost that most small-scale lenders are unable to apply. A professional intermediary can make it his business to be well-informed, and can more accurately gauge the risk of a borrower than can an private lender.
There's a brief mention of adverse selection - in which the least trustworthy individuals are the most eager to get their hands on other peoples' money. A professional intermediary is better able than an amateur lender to determine how to price loans for certain borrowers - setting the rate that is high enough to compensate for the actual risk, but not so high that the loan is unattractive to qualified borrowers.
There's another mention of moral hazard, a principle that suggests that a person will be more likely to act irresponsibly if someone else will bear the cost of his reckless behavior. A borrower may be reckless with borrowed funds or inattentive to his agreement to repay per the terms of the agreement. A professional intermediary is better equipped to monitor its borrowers and take action if they show signs of delinquency.
(EN: What's not mentioned here is the positive side of moral hazard. A person is more likely to make their money available when an intermediary takes the risk of not being repaid.)
In commercial enterprises, "leverage" refers to an organization's ability to make a profit on borrowed capital in exchange for assuming the risk that its profits will be less than expected. In general, the value of leverage decreases as the amount of money increases. A company might earn 8% on the first million of capital, 6% on the second million, and 4% on the third million. If it can obtain a loan at 5%, it profits by borrowing two million, but not three.
For bankers, the amount of leverage does not decrease so long as there is sufficient demand for capital. it earns the same percentage on its loans regardless of the amount of profit that its borrowers are able to make with the funds that they borrow. However, it's also noted that leverage increases risk, and a bank that overextends may find itself in financial jeopardy.
But under normal circumstances, a bank's ability to stabilize the return on leverage is a benefit to a financials system because it can make more extensive and efficient use of capital than can independent individual lenders.
Credit and Liquidity Risk
The main risk that banks absorb for their depositors is credit risk - which is the risk that people who borrow money will not repay it. Because the bank guarantees depositors' funds regardless of the performance of its loans, the depositors' funds are safe - and with FDIC coverage, the depositors funds are safe even if a large number of borrowers default and the bank becomes insolvent.
Liquidity risk is the risk that you will not have money when you need it. A person who makes a loan must wait in the borrower to repay according to the loan agreement (small amounts monthly) but can find himself in a bind if he needs his money back sooner. Banks are better able to manage the aggregated loans to ensure capital is available on demand - and to be able to convert an outstanding loan into capital by selling it to another bank if needed.
There is a brief and sketchy bit about rate risk, which represents an opportunity cost. If a lender loans money to a borrower and then discovers an opportunity to lend it out at a better return (such as when interest rates rise), he is unable to take advantage of that opportunity. Financial intermediaries are better equipped to assess interest rate risk or to adjust their portfolio of loans when the landscape changes.
And Other Risks
There is more about risks that the bank or intermediary takes on for lenders - it's superficial and abstract, but here it is:
- Market Risk - The risk that investments will pay less than expected
- Inflation Risk - The risk that money on loan will lose more value over its term than is compensated by interest
- Operational Risk - The risk of damage to the bank itself from employee fraud, natural disasters, and the like
- Settlement Risk - The risk that payments will not be received in time to settle financial obligations of the organization
- Currency Risk - The risk of loss that occurs when a loan is denominated in a foreign currency that weakens during the term of the loan
- Political Risk - The treat that the government may take action that will negatively impact the bank
(EN: I sense that the author is jogging through these and not taking much time to consider whether the risks faced by a bank would have been visited upon an individual lender.)