Financial Intermediaries

Financial Intermediaries


Financial intermediaries issue (indirect) debt of their own to buy the (primary) debt of others. Their issues attract funds from alternative expenditures by nonfinancial spending units on consumption, tangible investment, or primary debt. Their lending directs the flow of funds to expenditure by borrowers on consumption, tangible investment, or primary debt. They intermediate between the sources of funds that flow to them and the ultimate users of these funds.

The intermediaries may be identified by their balance sheets, which show a high proportion of financial to tangible assets and of indirect debt to equity. Their income statements report high ratios of income from interest and dividends to total income and of expense for interest and dividends to total expense.

There are bank (monetary) intermediaries and nonbank (nonmonetary) intermediaries. The former are commercial banks and the central bank, together constituting the monetary system, which issues indirect debt, subject to unique regulations, in the form of money. The indirect debt which is issued by nonbank intermediaries is not used as a means of payment.

Both types of intermediary are to be distinguished from other institutions that transmit funds from ultimate lenders to ultimate borrowers. These other institutions do not issue their own indirect debt in soliciting funds. They include security dealers, brokers, and exchanges.

Types of intermediary . The principal nonbank financial intermediaries in the United States are the following:

Depositary intermediaries
Credit unions
Mutual savings banks
Savings and loan associations

Insurance and pension intermediaries
Casualty and miscellaneous insurance companies
Fire and marine insurance companies
Fraternal insurance organizations
Government retirement, pension, insurance, and
social security funds
Group health insurance
Private life insurance companies
Private noninsured pension funds
Savings bank life insurance departments

Finance companies
Mortgage companies
Personal finance companies
Sales finance companies

Investment companies
Closed-end companies
Face-amount certificate companies
Industrial loan companies
Open-end companies

Agricultural credit organizations
Federal land banks
Livestock loan companies
National farm loan associations
Production credit associations

Government lending institutions
Banks for cooperatives
Federal Home Loan Banks
Federal intermediate credit banks
Federal National Mortgage Association
Federal Savings and Loan Insurance Corporation

This list is not complete; it omits such domestic intermediaries as the American Express Company, the Export-Import Bank, small business investment corporations, and pawnbrokers, as well as international intermediaries in which the United States participates, including the International Monetary Fund and the International Bank for Reconstruction and Development. (Detailed classifications of intermediaries in the United States may be found in the following sources: “A Quarterly Presentation of Flow of Funds …” 1959; Goldsmith 1958, pp. 50-55; Goldsmith & Lipsey 1963, vol. 1, pp. 27–36.)

Nonbank intermediaries may be classified in many ways. In terms of proprietorship, they may be governmental or private, and the private organizations may be stock, unincorporated, mutual, or cooperative. They may be primary, dealing with the general public, or secondary, dealing with other financial institutions. Grouped according to assets, they may be lenders principally on real estate, for example, or agricultural products or consumer durables. Grouped according to liabilities, they may borrow mainly at short term or at long term, and their obligations may or may not carry insurance benefits. They pay their creditors interest, dividends, capital gains, or indemnities. They vary in regional distribution, rate of growth, cyclical stability, degree of concentration, and tax status. Each of them reflects an opportunity for private enterprise to profit from transmission of funds between lenders and borrowers or a governmental desire to supplement private financial arrangements.

Growth in the financial system of the United States has consisted partly in proliferating types of intermediary. At the beginning of the nineteenth century, commercial banks and private insurance companies were available for the deposit and borrowing of funds. Savings banks and savings and loan associations were operating before mid-century, and by 1880 there were mortgage companies. The pace and quality of economic growth in the first two decades of the twentieth century were especially congenial to financial innovation: to this period one may credit the postal savings system, credit unions, finance companies, investment companies, and federal agencies for agricultural credit. Pension funds and various additional federal lending agencies, especially in the area of mortgage finance, were generated by the circumstances of the 1920s and 1930s. International intermediaries have been the notable innovations of the 1940s and 1950s (Goldsmith 1958, chapter 4; Kuznets 1961, pp. 304-305). It is one aspect of relative economic maturity that the pace of innovation in financial intermediaries has diminished. Existing intermediaries introduce adaptations in service which seem to provide a sufficient flow of funds at full employment and at an acceptable rate of growth in national income.

Dimensions of intermediation in the U.S. At the end of 1963, financial assets held by nonbank intermediaries amounted to one-fifth of all financial assets in the national balance sheet—to about $510,000 million in an aggregate of $2.42 billion. In terms of their portfolios, they were three-fifths larger than the monetary system. The bulk of their assets, approximately $360,000 million, was financed by indirect debt to consumer households and nonprofit organizations. This debt amounted to one-third of the financial assets in those sectors.

The distribution of financial assets among the types of nonbank intermediary is unequal. Intermediaries in the insurance and pension categories accounted for one-half of all intermediary assets at the end of 1963, savings and depositary institutions for one-third, and the remainder was widely dispersed among other categories.

Nonbank intermediaries do not grow at a uniform rate. The reason is that they sell indirect debt in specialized forms to different classes of savers, buy primary debt at different terms from different classes of investors, encounter dissimilar regulatory restraints and stimuli, and experience diverse changes in technical conditions of producing the service of intermediation. Each responds uniquely to the phases of short and long cycles in real economic development; to changes in life expectation and age distribution of the population; to variations in the price level, in the distribution of income between sectors, and in relative growth rates for various kinds of real capital. During a recent decade, 1948-1958, growth among intermediaries varied from 521 per cent for credit unions to 35 per cent for mutual savings banks (Goldsmith et al. 1963, vol. 2, pp. 114-115; see also Friend 1963, pp. 666-667; 1964, pp. 16-45).

Theory of financial intermediation . Nonbank financial intermediaries participate in four markets. They are net buyers on markets for primary securities; on markets for money balances—to be held as reserves of liquidity either voluntarily or by regulatory rule; and on markets for productive factors—labor in particular, but also capital goods and land. They are sellers on markets for their own issues of indirect debt—in such forms as savings and loan shares, savings bank deposits, and pension claims. (See Patinkin 1956.) This last market will be discussed first. (We neglect here operations by intermediaries on foreign exchange markets and the bearing of intermediation on international balances of payments.)

Markets for nonbank indirect financial assets (NIFA). Demand for NIFA, issued by nonbank intermediaries as their own indirect debt, comes mainly from consumer households. Consumers demand NIFA as a component of their personal wealth along with such other components as money balances, primary securities, business equity, housing, and durable goods. NIFA are relatively more important in the personal wealth of consumers at medium income levels than of consumers at extremes of the income distribution.

Consumers add to their portfolios of NIFA by saving, borrowing, and displacing funds from alternative assets. NIFA qualify as a superior, or luxury, good in the consumer budget.

Economists have experimented with many forms of demand function for NIFA (Brown & Friend 1964, pp. 125-128; Tobin & Brainard 1963). Demand rises with the real rate of interest paid by intermediaries relative to rates of return on other assets. It rises with permanent disposable income, and apparently it responds to intermediaries’ advertising. It is depressed by risks involved in holding NIFA and increased by insurance against these risks. These are typical arguments in demand functions for NIFA, but others are relevant for particular assets. A stock market boom intensifies demand for shares in investment funds. Age distribution of consumers is significant to demand for insurance. Growth in union membership enhances demand for uninsured pension fund claims.

Demand for NIFA is confronted by conditions of supply—a supply function for individual intermediaries and for the industry. (Studies of the supply function include Hensley 1958; Trade Association Monographs for the Commission on Money and Credit1962.) The supply of NIFA offered by intermediaries varies inversely with the rate of interest on NIFA. At each such rate of interest, supply tends to rise as rates of interest on the primary securities that intermediaries hold rise. It is the spread between primary (lending) rates and NIFA (borrowing) rates that creates opportunity for profit in intermediation. Since, in the long run, the primary rate tends to vary with the marginal productivity of tangible wealth, the supply of intermediation is responsive to opportunities for real investment.

Because intermediation incurs costs for wages and depreciation, its supply is depressed by increases in wage rates and in prices of capital goods and is increased by technological advance that economizes labor and capital. Increases in risk and uncertainty of investment in primary securities, which typically are at long term, and of the much more liquid NIFA debt, which is typically at short term, inhibit the supply of NIFA. Conditions of supply in intermediation are affected, perhaps more profoundly than in any other industry, by governmental intervention in the form of subsidy, special tax terms, and sundry regulatory devices. The net effect of governmental intervention in the United States has probably been to stimulate both supply and demand. The justification may be that there are external benefits of intermediation that wholly free markets would not realize.

There is a separate industry of firms supplying each variety of NIFA. These industries are imperfectly competitive, and some of them satisfy the specifications of oligopoly. Governmental restrictions on freedom of entry of new firms are accountable for some loss of competitive impulse. In addition, there is reason to suspect the existence of internal economies of scale for the intermediary firm that are not compatible with free competition. The evident imperfections of competition have led to numerous governmental restraints on the structure of the intermediary industry and its market behavior.

Taken in conjunction, the demand and supply functions for nonmonetary intermediation determine the volume of NIFA and their market rates of interest. These functions determine the spread between primary rates and NIFA rates and the gross profit to intermediation. The gross profit, adjusted principally for labor and capital costs, determines net profit, which, in relation to profit opportunities elsewhere, regulates the desired flow of equity funds into the industry. It is equity funds, in turn, which help to provide the factor of safety for NIFA that induces consumer households to invest in these assets at yields below primary rates of interest.

Markets for primary securities. Nonmonetary intermediaries are net buyers of primary securities: they acquire securities with funds that flow to them on the market for NIFA and, in much smaller volume, sell primary securities of their own, mainly equities, to finance increases in their net worth. The latter may be dropped from consideration here with the generalization that they increase in response to governmental capital requirements, to gains in intermediaries’ net earnings, and to general advances in prices of common stocks.

Historically the development of intermediaries has been a necessary condition for broad and active markets in primary securities. Intermediation supports an infrastructure of security exchanges, dealers, and brokers. Reciprocally, efficient market facilities for primary securities reduce the operating costs, risks, and uncertainties of intermediaries’ portfolios. (For illustrations see Basch 1964, chapter 6; Nevin 1961, chapter 4.)

By supplying attractive media for savings and by support of markets for investors’ issues of primary securities, nonbank intermediation facilitates division of labor between saving and investment. One result is that primary securities accumulate in amounts that are relatively large in comparison with national income.

Aside from stimulating the organization of security markets and growth in primary securities, intermediaries influence the allocation of savings among investment opportunities and, hence, the quality of primary securities. Successful intermediation depends heavily on arbitrage between opportunities to finance investment and to acquire primary securities. From the standpoint of society, such arbitrage promotes allocative efficiency in the saving-investment process. On markets for primary securities, one manifestation of allocative efficiency is uniformity in interest rates and other terms of lending for similar securities. Intermediation works against fragmentation of security markets.

By encouraging saving, and so accelerating growth of capital, intermediation tends to reduce interest rates on primary securities. To the extent that intermediation allocates savings efficiently, it results in a capital stock of high productivity and so tends to raise interest rates on primary securities. The net effect of intermediation on interest rates, in the long run, is probably to raise them.

Efficient nonbank intermediation increases the short-run stability of rates of interest on primary securities. Each increase in primary rates first widens profit margins in intermediation and then induces increases in rates paid on NIFA. Insofar as more attractive yields on NIFA stimulate saving and divert the public’s demand from money balances, the effect is to intensify the flow of funds through nonbank intermediaries toward purchase of primary securities. Conversely, short-period declines in primary rates may shrink the flow of funds toward purchase of primary securities. If intermediation does temper short-run fluctuations in primary rates, the result is a reduction in market-risk premia on primary securities. (For an alternative view see Minsky 1964.)

Markets for goods. Nonbank intermediation influences aggregate propensities to consume, the quality of consumption, and the stability of consumption. There is a dual effect on total consumption, since NIFA attract savings, while consumer credit, financed through intermediaries, facilitates consumption. Intermediation is important for the quality of consumption, partly because it changes relative costs to consumers of different classes of goods, partly also because it permits flexible adjustments in life-cycle patterns of consumption. Finally, intermediation is pertinent to temporal stability in consumption to the extent that changes in consumer stocks of NIFA and in consumer debt, as well as in yields and costs of NIFA and debt, lead to acceleration or deferral of consumer spending (Enthoven 1957-1964; [U.S.] Board of Governors … 1957).

Influences of intermediation can be traced through markets for goods other than consumption goods. As the savings outlet that provides the alternative to financing investment from internal sources, through direct issues of primary securities to savers, through the monetary system, and through government, nonbank intermediation participates in selecting investment opportunities and in shaping the structure of the capital stock. It is involved in allocating savings between private and governmental investment, between domestic and foreign uses. Furthermore, it is a factor in the short-run stability both of total investment and of components including housing and business inventory (Grebler & Maisel 1963).

Measurements of national income originating in nonbank intermediation are ambiguous. It may be estimated that saving by these institutions on their own account is less than 1.5 per cent of national saving in the United States, that their tangible investment is about 0.25 per cent of national investment, and that they employ about 1.5 per cent of the civilian labor force. Their impact on markets for goods and factors is mainly indirect, through the saving-investment decisions of other sectors.

Market for money. There has been intensive debate regarding the effect of growth and innovation in NIFA, and of changes in their yields, on the demand for and the supply of money. The central issue has been the degree of substitutability between NIFA and money balances in the asset portfolios of consumer households especially, but also of business firms.

If demand for money is negatively elastic to yields on NIFA, changes in these yields resulting from a monetary policy that raises (lowers) the rate of growth in the supply of money may raise (lower) growth in demand for money and so offset the intended effects of monetary policy on markets for goods, factors, and primary securities. Since substitutability of NIFA for money is not perfect, interference from NIFA with monetary policy may presumably be overcome by sufficiently large and timely adjustments in the money supply. Alternatively, interference of NIFA with monetary policy might be overcome by bringing within the orbit of monetary control those nonbank intermediaries which issue NIFA most closely resembling money.

If NIFA are near substitutes for money, traditional monetary controls can also be obstructed by responses of nonbank intermediaries. There are other implications. For example, if commercial banks must be restrained more tightly over long periods or subjected to more vigorous and volatile control for short periods because nonbank intermediaries weaken monetary discipline, there is discrimination against banks. The discrimination may be criticized on grounds of equity or because it undermines the capitalization and solvency of banks. If banks dispose of savings differently than do nonbank intermediaries, the discrimination may also be criticized for its allocative effects on the stock of capital. (The literature concerning effects of nonbank intermediation on monetary controls is very large. It includes Commission on Money and Credit 1961, pp. 78-81; Gurley & Shaw 1960, chapter 6; Johnson 1962; Great Britain, Committee on the Working of the Monetary System 1959, pp. 129–135.)

Equilibrium of the market for money, at a relatively stable price level, appears to be an important prerequisite for development of nonbank intermediation and of NIFA, even with priceescalator provisions. Inflation is a tax not only on money balances but also on the real value of NIFA as well, and correspondingly diminishes real demand for NIFA. Furthermore, inflation often concentrates savings in sectors of the community that prefer other dispositions of savings than NIFA. International data suggest that non-monetary intermediation lags where inflation is habitual and erratic.

Integration between nations, in monetary and trade institutions and policies, has important implications for nonbank intermediation, with regard both to markets for NIFA and to intermediary portfolios of primary securities. For example, one can expect innovations in NIFA, such as Euro-currencies, and international arbitrage by intermediaries, such as investment funds, that will tend to unify markets for savings.

Regulation . Nonbank intermediation is typically subject to intensive governmental regulation and intervention. At the extreme, there is government ownership and management. Short of this limit, regulation and intervention include subsidy and other stimulants as well as various restraints on private enterprise in intermediation.

There are seven common objectives of regulation: to increase propensities to save, to guide the allocation of savings to investment, to limit short-period instability of growth, to strengthen the solvency of intermediaries, to improve intermediaries’ operating efficiency, to correct the distribution of income and wealth, and to stabilize the balance of payments. (The last will not be discussed here.)

The basic technique of accelerating savings through nonbank intermediaries is to intensify demand for NIFA, relative to consumption, at given levels of national income. Rates of interest may be raised on NIFA, innovations introduced, savers’ safety guaranteed. For these objectives, competition may be intensified among intermediaries, tax concessions granted to them, deposits insured, and portfolio limits relaxed.

Regulation of intermediaries is traditionally concerned with savings allocation. For the benefit of housing or, say, investment in agriculture and small business firms, regulation has provided incentives for intermediaries that guide savings to desired ends. Programs to overcome regional lags in development have included subsidized allocations of loanable funds through intermediaries. Measures against restraint of competition among intermediaries are partly concerned with allocative efficiency.

Nonbank intermediaries have contributed at times to short-period turbulence in the saving-investment process. Measures to correct their influence toward overinvestment include minimal requirements for liquidity and net worth. Measures to correct their influence toward underinvestment include guarantee of their portfolios and provision of rediscount facilities.

The solvency of intermediaries has been an objective of high priority in regulation. The costs of insolvency that have seemed to justify intensive regulation include inequity to savers, misallocation of savings, and contagious economic instability. Measures to protect solvency include net-worth requirements, supervision of operations, limits on portfolio selection, and loan insurance. There is basis for argument that regulatory preoccupation with solvency has imperiled some other objectives, such as allocative efficiency.

Operating efficiency is not often a primary objective of regulation. Its purpose is to liberate real resources for other uses, to reduce spreads between rates of interest on primary securities and rates on NIFA, and to strengthen solvency. Economic operation can be essential for the comparatively primitive forms of intermediation that are appropriate in early stages of national economic development. It has counted heavily in the growth of such intermediaries in the United States as credit unions.

Distributive considerations enter into some regulatory techniques. The purpose may be merely to prevent inequitable incidence on some social classes of gains and losses from intermediation, or it may be to change the distribution of income and wealth. The first purpose is illustrated by regulation of insurance companies’ portfolios in the interest of beneficiaries, or of investment funds to limit conspiratorial gains of insiders. The second purpose is illustrated by various special credit arrangements for agriculture or war veterans or regions suffering a slow tempo of development.

These objectives of regulation have given rise, especially in the United States, to a complex apparatus of federal and state regulatory techniques administered by governmental departments, commissions, and institutions. Dissatisfaction with this apparatus has inspired intensive re-evaluation by both private and governmental bodies. The principal occasions in the United States were during the decade before World War I, during the 1930s, and in the early 1960s by the Commission on Money and Credit. There were other national investigations in the course of the 1960s: in Japan the Committee on Financial System Research; in the United Kingdom, Committee on the Working of the Monetary System; in Canada, Royal Commission on Banking and Finance.

These recent studies of regulations concerning both monetary and nonbank intermediaries had to do, in part, with irrationalities in regulatory agencies and techniques. They were also directed to goals of regulation and, for the first time, to possible benefits of applying a general theory and compatible techniques to regulation of various classes of intermediaries. There is no precedent for their attempts to define optimality in the financial superstructure of capitalism. They did not reach common conclusions on either principles or techniques of regulation.

International differences . There is notable diversity of nonbank intermediation between countries. First, NIFA per capita vary widely (Kuznets 1955; Goldsmith 1955). This is explained partly by differences in real income and wealth per capita, since income and wealth elasticities of demand for NIFA are high. It is explained, too, by differences in centralization of decisions to save and invest: economic centralism is not a fertile environment for nonbank intermediation. Again, NIFA appear to be high, relative to income, where price inflation has been modest and low where inflation has been rapid, chronic, and erratic. Non-bank intermediaries are relatively strong where the monetary system does not practice broad diversification of portfolios and indirect debt, where public debt is not finely differentiated, and where social security is not financed mainly from current government revenues. The evidence is that non-bank intermediation has been retarded by social instability and defects of legal structure. There are also imponderables of social framework, social mobility, and personal motivation that affect the pace of intermediation. Governmental assistance and foreign aid figure prominently in growth of NIFA.

Finally, development in intermediation varies between countries according to the accessibility and quality of complementary institutions. All of these and other factors relating to international differences can be classified according to their effects on conditions of demand and supply for NIFA. The quality as well as the scale of nonbank intermediation varies internationally. There is variation in primary securities acquired by intermediaries, in NIFA, and in institutional structure. One observes rough correspondence of qualitative with quantitative development: such intermediaries as investment funds appear where real income per capita is high; small cooperatives for agricultural credit, where income is lower. Still, the quality of intermediation is not uniform between countries at comparable stages of economic development. Differences in composition of wealth and output are partly responsible, and the form of political organization is pertinent. The distribution of income by level of income is another factor, as is the distribution of population by age and degree of urbanization. Within the orbit of capitalism, the social choice between alternative methods of mobilizing and allocating savings deeply affects the environment of nonbank intermediation. One can trace in the quality of intermediation the unique historical experience of each society that has given momentum to some intermediaries rather than others; the mores and traditions that condition savers for or against lotteries, perhaps, and for or against concentrations of financial power; the mobility of ownership in enterprise; and the geographic extent of the economic system. From differences in savers’ tastes to differences in technological conditions of intermediation and patterns of governmental intervention, there are numerous factors to explain the international diversity in intermediation. One may infer that optimal development of intermediation will have strikingly indigenous characteristics.




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