Modern Financial Systems: Theory and Applications

CHAPTER 16

Principles of Intermediation

Theories of financial intermediation stress that intermediaries both produce information and create liquidity. Parts One and Two of this book introduced the idea that intermediaries produce information relevant for governance of their asset portfolios, and in this part we look more closely at the economics of operating intermediaries.

INTRODUCTION

This chapter models domestic intermediation as a portfolio problem subject to regulatory and liquidity constraints. The chapter studies risk-return trade-offs, the theory of bank capital, determinants of intermediary size, and the economics of intermediary information processing. The model is then applied to such domestic operating issues as gap management, the evolution of interest rate risk management, default risk management, liquidity management, and capital management.

A STRATEGIC MANAGEMENT MODEL

A financial intermediary can be regarded as an investment portfolio operated to generate income for the owners of its common equity (Pyle 1971, Hart-Jaffee 1974). The portfolio theory introduced in Chapter 14 argues that investors strive to generate as large a return as possible for a given degree of risk. Accordingly, this chapter examines the effects of portfolio composition and portfolio trading strategies on the risk-return trade-offs generated by an intermediary.

In applying portfolio theory to analyzing intermediary operations, it must be recognized that most financial intermediaries’ ...