Modern Financial Systems: Theory and Applications

CHAPTER 6

Intermediation and Internal Governance

This chapter examines the capabilities of intermediary and internal governance mechanisms and the deal attributes each is best equipped to govern. Since early financial system theories do not explain how both intermediaries and financial markets can coexist, the chapter first examines how intermediaries can and do create value. Current explanations hold that, as banks raise deposit funds for subsequent relending, they create value through providing liquidity services, delegated monitoring, and information production.

Historically, bank loans have been governed on the books of the originating banks, using capabilities chosen primarily according to the attributes of the loans. As will be shown later, bank governance capabilities are more interactive, and less arm’s-length, than the capabilities of financial markets. Starting in the 1990s, banks increased their “originate and distribute” activities (essentially securitization as introduced in Chapter 5). Along with these new functions banks have also become much more active in risk trading, both by hedging loan default risks and by assuming new kinds of risks in response to client demand. The nature of intermediation has been profoundly transformed by these changes, and at times the importance of governance has been underemphasized as the transformations occurred. At later points the book reviews these developments further and reiterate the importance of governance even when new forms ...