Page 1 of 14
Journal for Studies in Management and Planning
Available at
http://edupediapublications.org/journals/index.php/JSMaP/
e-ISSN: 2395-0463
Volume 02 Issue 10
October 2016
Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 8
Financial Intermediation: A Philosophical Approach
Iwedi Marshal
Department of Banking and Finance Rivers State University of Science and Technology Nkpolu- Port Harcourt, Nigeria.
Iwedimarshal@yahoo.com
Abstract
Philosophy of finance is an emerging field that
tackles issues at the intersection of finance and many
branches of philosophy such as ethics, political
philosophy, philosophy of science, and epistemology.
But in this paper emphasis was placed on the
philosophy of financial intermediation with special
focus on deciphering the process of financial
intermediation, why financial intermediaries exist
and the theories of financial intermediation. It
demonstrated how the main functions of financial
intermediaries such reduction of transaction cost,
information asymmetry, liquidity provision and
delegated monitoring among others have aided in
understanding how financial intermediation affect the
economy.
Keyword: Financial Intermediation, Financial
Intermediaries, Transaction Cost, Information
Asymmetry,
Philosophy
1. Introduction
Philosophy of finance is an emerging field
that tackles issues at the intersection of
finance and many branches of philosophy
such as ethics, political philosophy,
philosophy of science, and epistemology.
But in this paper we shall place emphasis on
the philosophy of financial intermediation.
Economic theory has traditionally focused
on the real sector of the economy and
disregarded the role of financial
intermediation. Effectively, in an Arrow- Debreu world, where markets are complete,
information is symmetric and other frictions
are not present, there is no room for
financial intermediaries. But, there are
numerous evidences that financial
intermediation does affect the economical
grows. This paper reviews the main
literature about these contradictory
statements (microeconomic theories of
financial intermediation).
In modern theories of financial
intermediation, the two most prominent
explanations for the existence of
intermediaries like depository institutions
are the provision of liquidity and the
provision of monitoring services. Diamond
and Dybvig (1983) assumed that by issuing
demand deposits, banks can improve on a
competitive market because these deposits
allow for better risk sharing among
households that face idiosyncratic shocks to
their consumption needs over time. The
importance of financial intermediaries in
this framework arises from an information
asymmetry: the shock that affects a
Page 2 of 14
Journal for Studies in Management and Planning
Available at
http://edupediapublications.org/journals/index.php/JSMaP/
e-ISSN: 2395-0463
Volume 02 Issue 10
October 2016
Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 9
household’s consumption needs is not
publicly observable.
Diamond (1984) finds a special feature in
financial intermediaries acting as delegated
monitors of borrowers, on behalf of the
ultimate lenders (depositors), in the presence
of costly monitoring. Financial
intermediaries exploit comparative
advantage (comparative to individual
lenders or specialized firms: rating agencies,
securities analysts, or auditors) in
information production because of
economies of scale and scope, which reduce
the cost of informational asymmetries and
its extent in the economy. Diversification
reduces the cost of delegating monitoring to
a financial intermediary. It is on this
pedestal that financial intermediation is
described as the mechanism by which
financial intermediaries, (such as banks)
channel funds from depositors to borrowers
(Sloman and Wride, 2009). This activity
thrives on the financial intermediation
abilities of financial institutions that allow
them to lend out money at relatively high
rates of interest while receiving money on
deposit at relatively low rates of interest.
However, the philosophy of financial
intermediation is a set of theories and ideas
related to its understanding. In this regard,
we must first start with the nature of
financial intermediation. Second, why
financial intermediaries exist? Thirdly are
the theories backing this economic
phenomenon.
Fig. 1 Process of Financial Intermediation
https://html2-f.scribdassets.com/g1gdk354w3hsgsg/images/3-38d9a4197b.jpg
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Journal for Studies in Management and Planning
Available at
http://edupediapublications.org/journals/index.php/JSMaP/
e-ISSN: 2395-0463
Volume 02 Issue 10
October 2016
Available online: http://edupediapublications.org/journals/index.php/JSMaP/ P a g e | 10
2. Why Financial Intermediaries Exist?
Financial intermediaries play an important
role in the economy by matching up lenders
and borrowers. Lenders direct a portion of
their financial wealth to bank deposits.
Borrowers seek loans to finance assorted
expenditures, including investment in the
mining and production activities. Banks act
as intermediaries, by ways of issuing debt
and equity to capitalize their intermediation
activities. Relative to direct lending banks
issue safe, demandable deposits, thus
removing the need for savers to monitor the
risk-taking behavior of the borrowers. Bank
intermediation allows lenders to have timely
access to their savings while also giving
borrowers the option to borrow for longer
period investment plans. The issue of
why financial intermediaries exist is a
puzzle for the “complete markets” paradigm
of Arrow and Debreu. The reasons why
intermediaries such as banks exist is related
to the various market failures which vitiate
the complete markets paradigm. In
particular, there is the key issue of imperfect
information which makes financial
intermediaries such as banks key channels
for intermediating between savers and
borrowers.
3. Traditional Neoclassical Theory of
Financial Intermediation
This is also known as the neoclassical model
of a perfect market, i.e. the Arrow-Debreu
world or the perfect market for capital. In
this Arrow-Debreu world, the following
standard must usually be satisfied:
No one participants can influence
prices in the market
Borrowing/lending conditions are
equal for all participant
There are no taxes
Absence of economics of scale
All financial securities are
homogeneous, divisible and tradable
There are no information and
transaction cost
All market participants have ex ante
and ex post immediate and full
information on all factors and events
relevant for the future value of the
financial instruments traded.
The traditional neoclassical theory is based
on the paradigm of complete and perfect
markets. This is a market where present
value prices of investments are well
outlined, information is symmetric and other
frictions are not present. Here, there is no
room for financial intermediaries, i.e.
