Financial intermediation and the market for credit

This chapter reviews the services produced by financial intermediaries (FIs) and their role in the allocation of credit. For FIsto provide valuable qualitative asset transformation (QAT) services, they must take on unavoidable risks. These risks create potential instabilities in the financial services industry and give rise to a rationale for regulatory intervention to stabilize the industry. However, the level of risks assumed by an FI is manipulable, and it is difficult to tell which risks are essential for QAT and which risks are speculative in nature. Regulation intended to enhance the stability of the industry can create perverse private incentives for individual FIs to take excessive risks, paving the way for further regulatory intervention to monitor/control these incentives. Hence, regulation and the raison d'etre for the existence of FIs are intertwined. While this observation suggests that a completely unregulated banking system may be a myth, it does not make a case for highly intrusive regulation either. Recent work on a borrower's choice of financing source from a menu consisting of venture capitalists, banks and the capital market suggests that the manner in which these financing sources (banks in particular) are regulated is likely to affect the services they provide and hence the allocation of credit in the economy.