Financial Institutions and Intermediation: Transformation and Asymmetric Information
Why intermediaries exist
Banks transform assets. They issue liabilities (deposits) that are liquid, small-denomination, and low-risk, and hold assets (loans, securities) that are illiquid, large, and risky. That is liquidity, denomination, and maturity transformation. Intermediaries also cut transaction costs through economies of scale and scope, and cut information costs through screening and monitoring.
Asymmetric information
Adverse selection happens before the contract: the borrowers most eager to pay a high rate are often the riskiest, so good borrowers can be driven out and lending shrinks. Remedies include screening, collateral, credit scoring, covenants, and credit rationing. Moral hazard happens after the contract: a borrower takes extra risk because the lender bears the downside, or a bank takes extra risk because deposit insurance absorbs losses. Remedies include monitoring, restrictive covenants, down payments, capital requirements, and supervision.
Types of institutions
Depository institutions: commercial banks, savings institutions (thrifts), and credit unions (member-owned, not-for-profit, tax-exempt). Nondepository institutions: insurance companies (life versus property-casualty), pension funds (defined benefit versus defined contribution), mutual funds (open-end versus closed-end), hedge funds, and finance companies. Securitization moved loans off balance sheets into special purpose vehicles funded by asset-backed securities, producing the "originate to distribute" model that weakened screening incentives before 2008. Disintermediation - funds flowing directly to securities markets when deposit rates were capped - shrank thrifts in the 1970s and 1980s.
Worked example
A bank funds $100 million of 30-year fixed mortgages at 5% with $100 million of deposits repricing daily at 2%. If market rates rise 2 points, deposit cost jumps to 4% while mortgage income stays at 5%, so the net interest margin collapses from 3% to 1%. The classic remedy is floating-rate loans or shorter asset duration - the savings-and-loan mismatch.
Traps
Reversing adverse selection and moral hazard; assuming deposit insurance removes risk instead of shifting it to the insurer; treating credit unions as for-profit; assuming securitization eliminates information problems rather than relocating them.