financial intermediation

J. H. Boyd From The New Palgrave Dictionary of Economics, Second Edition, 2008 Edited by Steven N. Durlauf and Lawrence E. Blume Back to top

Abstract
This article deals with the process of financial intermediation: that is, savings and investment flows that are intermediated through organizations such as banks and insurance companies. There are five major topics: stylized facts about financial intermediary organizations and markets; the history of thought about financial intermediation; the theory of financial intermediaries, with an aside on equilibrium credit rationing; the regulation of financial intermediation; and trends in recent research and open research questions. Back to top

Keywords
asset transformation; bank runs; banking crises; banks; corporations; default risk; deflation; delegated monitoring; deposit insurance; discount window; equilibrium credit rationing; ex post monitoring; financial intermediaries; financial intermediation; financial markets; fractional reserve banking; Friedman rule; Great Depression; information economics; interest rate risk; liquidity; monetary policy; payment services; private information; safety net (financial); savings and loan industry Back to top

Article
Back to top 1 Preliminaries and introduction Writing an article such as this requires making some tough decisions about what to include and what not. Many deserving topics in financial intermediation have not been mentioned at all and I cannot begin to cite all the good papers that deserve reference. Primarily, I rely on two excellent survey articles, one that focuses on theory (Gorton and Winton, 2003), and another that focuses on empirics (Levine, 2005). I received helpful comments from Doug Diamond, Jack Kareken, Ross Levine and Ed Prescott; however, they are totally absolved from any errors that remain. It is the convention to distinguish between financial markets and financial intermediaries. A financial market is a market in which investors acquire direct claims against ultimate borrowers, usually in the form of debt or equity. A financial intermediary (FI) is a firm that substitutes its own liability for that of some ultimate borrower. That is, an investor lends to the FI and, in turn, the FI lends to an ultimate borrower. I adopt this standard convention even though the distinction is often imprecise. (For example, debt and equity claims are rarely traded directly between the

ultimate claimants. Even these are intermediated.) Next, let us turn to some facts about FIs. The assets of FIs are almost exclusively financial claims. FIs do not have many physical assets, except buildings and computers, and they produce no physical products; thus they are service firms. Important and easily recognizable examples of FIs would include commercial banks, savings and loan associations, credit unions, life insurance firms, property and casualty insurers, consumer finance companies, and mortgage bankers. Back to top
Banks largest

Commercial banks (hereafter banks) are the most important class of FIs, and this has been true for centuries. In developing economies, banks often play a dominant role and may be, essentially, the only game in town. Even in the United States, with its highly developed financial markets, banks accounted for about 14.2 per cent of financial intermediary assets, which is the largest private share, followed by mutual funds at 12.4 per cent (Board of Governors of the Federal Reserve System, 2005). This size factor helps explain why banks have been the most-studied class of FI by a wide margin. Banks are also especially important and heavily studied because they create money and thus are the conduit for monetary policy. This article follows the norm and devotes a disproportionate amount of its attention to banks. Back to top
Heavily regulated

FIs are heavily regulated relative to non-financial firms. Most of this regulation is advertised to promote safety and soundness, meaning that its stated intent is to reduce the frequency of failures and other problems in the industry. There are four basic forms of regulation: minimum capital requirements, examination by regulatory authorities, portfolio restrictions on asset holdings, and restrictions on who can own or manage an FI. In many countries, there has been a trend towards less intensive regulation of FIs since the mid-1990s, but in these four forms regulation remains obtrusive relative to most industries. Back to top
A large industry

The FI industry is relatively large. Especially in developed economies, the FI sector is a significant part of the economy, with a substantial share of measured output. In the United States, for example, the total value-added of financial intermediaries (essentially profits, wages and salaries) amounts to about 8.1 per cent of GDP. This makes the US FI sector much larger than (say) the agricultural sector, whose share of total value-added is about one per cent (Bureau of Economic Analysis, 2006). Across countries, there is a strong correlation between size and quality of the FI sector and the level of economic development. This relationship is an important topic in development economics but such issues are not considered here. (See financial structure and economic development.) Back to top
Organizational form

In most countries the dominant form of organization for FIs is the corporation; however, there are important exceptions. In particular, many FIs are organized as mutuals or cooperatives. With this alternative form of organization, there is no separate class of shareholders or equity owners, as would be the case in a corporation. For example, in mutual life insurance companies the policy holders are also the owners. In mutual savings and loan associations, the depositors are the owners. These alternative organizational forms are common in the United States, Europe and many other parts of the world. Back to top
Recent trends

Since the mid-1990s, the FI sector has experienced substantial change. The main trends worldwide are towards consolidation (a smaller number of larger firms), diversification (a larger set of financial activities or products offered at the same FI), and internationalization (operating across borders). Almost every part of the world has participated in these developments, excepting sub-Saharan Africa (De Nicol et al., 2004). Back to top 2 History of thought on financial intermediation In the 1960s and 1970s, the economic analysis of FIs was largely focused on banks, and these were viewed essentially as black box organizations that turned high-powered money (bank reserves) into money. At that time, most intellectual interest in banks derived from their role in creating money, and their being the conduits for monetary policy. In some sense, the study of banking was in those decades incidental to the study of monetary policy and macroeconomics. There had been an earlier literature on FIs that showed great depth of understanding, but in a non-mathematical, descriptive context. Scholars such as Bagehot, Goldsmith and Schumpeter wrote about, and clearly understood, information asymmetries, liquidity, and so forth. When ambitious scholars, such as Tobin (1969) or McKinnon (1973), tried to incorporate FIs into Keynesian models before the profession had invented the mathematical tools to formally model information and liquidity, the crucial intuitive insights about the role of FIs were absent from the models. Thus, finance became money, and money was simply a stock associated with real capital. In the mid-1980s a new body of thought emerged and was largely attributable to the seminal work of Diamond (1984) and Diamond and Dybvig (1986). Other significant papers at about that same time included Williamson (1986) and Boyd and Prescott (1986). This new approach to studying financial intermediation stressed that FIs are firms that produce valuable economic services of a variety of kinds, and explicitly modelled the nature of those services. This literature was careful to model the profit, share price, or utility-maximizing behaviour of FIs subject to appropriate constraints, and much of this work was done in general equilibrium. More importantly, almost all this work and the large literature that followed featured environments with private information private in the sense that different agents were endowed with different knowledge. This was a major deviation from the previously studied world of Arrow Debreu, in which markets are frictionless and perfectly competitive, and all relevant information is common knowledge. It was a critical innovation because in the

environment of ArrowDebreu FIs are irrelevant (cannot increase welfare). In that world FIs are just not very interesting to study in a serious way, and they werent. Sequence was also very important in the development of the modern FI literature. Since the post-1983 FI literature almost exclusively employed models with private information, this meant that development of the literature depended on, and naturally followed, advances in information economics thanks to the pioneering work of Akerlof, Hurwitz, Stigler and others. Most likely, this is why earlier efforts to force FIs into Keynesian macro models were a failure; the required tools simply had not yet been invented. In the next section, I briefly review some of the modern FI models developed in the 1980s and subsequently. Later, in Section 5, I discuss some areas in financial intermediation where, in my judgment, there remain important gaps in our knowledge. Back to top 3 The theory of financial intermediation Banks and other FIs are firms that take in funds (FI liabilities) through a hypothetical front door, and put out funds (FI assets) through a hypothetical back door. They produce no physical products. To survive, they must earn a profit, meaning that the average rate of return on their assets must exceed the average cost of their liabilities. This spread between asset returns and liability costs must be large enough to cover operating costs (primarily wages and salaries), and to earn a rate of return to equity investors. That FIs earn such positive profits has always troubled critics of the industry (of which there have always been many), who may conclude that FIs are somehow exploiting consumers or businesses. In fact, FIs are permitted to earn these positive interest rate spreads because they provide valuable economic services to the economy, and it is costly to provide these valuable economic services. Let us next consider these services. One important function, offered by banks but not other FIs, is payment services. This is the creators of money banking function that the old literature stressed, virtually to the exclusion of other FI functions. When we need to execute transactions, we use cash and coin, paper checks, credit cards, and wire transfers. All of these transaction tools are generally provided by banks and for obvious reasons they are economically important. Another important function of FIs is that they are brokers in the sense that they bring together large numbers of ultimate borrowers and lenders. When they bring these groups together, FIs substitute their own liabilities for those of ultimate borrowers, and this is what ultimately distinguishes FIs from financial markets. This process has been given many names in the literature (asset transformation is common) and understanding it is key to understanding what FIs actually do. Hypothetically, consider one single bank depositor, a wealthy individual, and one single bank borrower, a small business. The bank depositor might have lent directly to the small business through the stock or bond market. Instead, by assumption, he or she lends to the bank in the form of a deposit. In turn, by assumption, the small business borrows from the bank in the form of a commercial loan. The bank places itself in the middle of the exchange and becomes the counter-party to the others. Why is this valuable? The answer is that bank liabilities typically have different attributes from ultimate borrower liability attributes, ones that are crafted to be desirable to the bank liability holders. If they are made better off, they are willing to lend at a lower rate than they would have required to lend directly. Thus, this process of asset transformation can, and usually does, make both borrowers and lenders better off.

For banks, the general direction of such asset transformation is well understood: bank liabilities will typically have shorter maturity than bank assets, and will be more liquid and less risky. As will become apparent, a key ingredient to this process is that the banks borrow from a large number of creditors, and lends to a large number of borrowers. Back to top
Shorter maturity

Bank liabilities often have shorter average maturity (or duration) than bank assets, and ceteris paribus this may make bank liabilities relatively more attractive to savers. Such maturity mismatching exposes banks to an interest rate lottery and the risk that interest rates will increase, in which case they will suffer capital losses. Bank creditors are partially protected against interest rate risk by the bank's equity, at least until that is exhausted. The degree of interest rate risk exposure naturally depends on the magnitude of the assetliability maturity mismatch, and on how volatile are interest rates. In the 1970s, the US savings and loan (S&L) industry experienced massive losses due to interest rate risk, losses so large as to bankrupt much of the industry as well as its government insurer, the Federal Savings and Loan Insurance Corp (FSLIC). The S&Ls maturity mismatch was substantial, and interest rates had become extremely volatile by historical standards. However, the savings and loan industry should not be blamed for this sad experience. Government regulations essentially forced this industry to borrow short and lend long. Since the mid-1990 banks and other FIs have become clever in finding ways to hedge interest rate risk in the forward, futures and swap markets. (Of course, someone still has to bear the aggregate risk.) Also, there is some evidence that, in the United States at least, FIs have in recent years become less willing to expose themselves to interest rate risk. As a practical matter, however, it is difficult to accurately measure the maturity mismatch of banks, and standard duration methods may not work very well for this industry. That's because a substantial proportion of bank liabilities are in the form of demand (checking) deposits. For these liabilities, the technical maturity is instantaneous but the true maturity is much longer, depends on economic conditions, and must be empirically estimated. Back to top
More liquid

Bank liabilities, especially deposits, are more liquid than bank assets. This is another desirable form of asset transformation since, ceteris paribus, lenders like to hold liquid assets. The liquidity provision function has been heavily studied by scholars, and the seminal reference on the topic is Diamond and Dybvig (1986). Now, liquidity is hard to define, let alone understand, and it may help to consider a simple theoretical environment, similar in some ways to the more complicated environment studied by Diamond and Dybvig (1986). Imagine a world in which there are only two assets: gold coins and land. By assumption, gold coins are perfectly liquid and can be spent at any time but earn no rate of return. Land, on the other hand, is highly productive but illiquid. It is hard to sell land in an emergency, and possibly it can't be sold at all. All agents in this economy have a known, say one per cent, chance of an emergency, the occurrence of which is independent across agents. In an emergency, agents desperately want to have all their wealth immediately so they can consume it. Now, consider the problem facing individual agents. If they put all their wealth in coins (land) they will do

well 1 (99) per cent of the time; however, they will do very badly 99 (1) percent of the time. Common sense suggests that the best strategy will be to split up their holdings, and if you guessed that you would be right at least for most preferences. Even then, however, agents are not doing as well as they potentially could in either state of the world. Next, assume a bank is organized, which offers each individual a deposit account that can be redeemed in gold coins on demand. Further, assume the bank puts 1 per cent of its assets in gold coins and 99 per cent in land. Now, if the bank deals with a sufficiently large number of depositors, it will have enough coins to just cover withdrawals and all the remaining can be invested in highly productive land. Everyone is better off than they could have done on their own account. This kind of an arrangement is usually referred to as fractional reserve banking. The key to its smashing success is diversification across a large number of depositors, and the fact that depositor withdrawal demands are independent. Now, as Diamond and Dybvig are quick to point out, this idealized solution may not always work out in practice. Suppose, for example, that emergency withdrawals become correlated, perhaps because there is a war. Then the bank can easily run out of coins, fail on its obligations, and land must be inefficiently liquidated. Even worse, just a false rumour of war could send too many depositors to the bank and cause it to fail. This sort of occurrence is called a bank run and these have been quite common both historically and in recent times. In an imperfect world where withdrawals may be correlated and bank runs are possible, every bank faces a fundamental and unpleasant trade-off: if it holds a high fraction of gold coins (reserves) risk of insolvency will be low, but the average rate of return on its assets will be low. If it holds a high fraction of land (earning assets) its average rate of return on assets will be high, but its risk of insolvency will be high. There is a large literature on this topic, much of which is referenced in Gorton and Winton (2003). Back to top
Less risky

Bank liabilities are on average less risky than bank assets, and obviously this tends to make bank liabilities ceteris paribus more attractive. Now, bank liabilities can be less risky than the representative bank loan for a variety of reasons. One is that banks often place some fraction of their assets in default-risk-free government securities. A second reason is that banks raise part of their funds in the form of equity, and the bank's shareholders must suffer a total loss before liability holders lose. A third reason is that banks hold portfolios of different kinds of loans that are diversified by industry and geography, so that their loan portfolio is less risky than its individual components. A fourth reason is that in most countries bank deposits are fully or partially insured by government. In addition, banks are very good at determining to whom to lend, and in setting loan terms for those who are funded. This topic has been heavily studied in the FI literature and the reader can find many studies under the headings adverse selection, sorting and screening in Gorton and Winton (2003). In most of these models, some loan applicants are better credit risks than others, applicants know their own types, and are willing to misrepresent (say theyre good when theyre bad). FIs do not know the applicants types, although it is conventional to assume that everyone knows the underlying distribution of applicant types. The FI's objective is to accept (reject) good (bad) applicants where possible. In some but not in all cases, it is possible to adroitly

choose terms of lending such that good applicants voluntarily sign up, and bad applicants withdraw. In other cases, the best strategy is simply to accept (reject) all applicants. Another important aspect of lending, and an aspect at which FIs excel, is monitoring borrowers after they have received the money. This ex post monitoring has also been heavily studied in the FI literature. Once they have the money, borrowers may take actions that reduce their probability of repaying, or events beyond their control may have the same effect. To protect their interests lenders normally pre-specify loan covenants that state what happens in such cases, and they monitor borrowers to enforce these covenants. An example that homeowners will understand is a residential mortgage: to protect its interests, the lender must be sure that property taxes are being paid, and that the house is fully insured. Now, it is often the case that loans are large relative to the wealth of individual agents in the economy. This naturally occurs because many production technologies exhibit economies of scale. For example, an automobile plant must be of a particular size to be efficient, and few if any agents can fund such an investment with their own wealth. Therefore, to fund a loan often requires obtaining financing from several agents simultaneously. Unless FIs are present there is a coordination problem among the several lenders, and it is a problem first studied by Diamond (1984) and Williamson (1986). Monitoring of borrowers is costly, and no one wants to do it if they don't have to. Now, for simplicity, assume that there are just two lenders for a given loan, lender A and lender B. Now, A (B) may assume that B (A) will monitor, in which case neither lender actually does. This is obviously undesirable because their interests are not being protected. Alternatively, lender A and lender B might both be conservative, assume the other is unreliable, and monitor themselves. In that case there would be redundant monitoring which is unnecessary and wasteful. Clearly, what is needed is an arrangement in which all lenders agree to have ex post monitoring done by a single, efficient delegated monitor. What is critical, if such an arrangement is to work, is that the delegated monitor finds it in its own interests (incentive compatible) to actually do the work as promised. Otherwise, it might be necessary to monitor the monitor, which obviously would be inefficient, too. Diamond (1984) and Williamson (1986) showed that efficient ex post monitoring can be achieve by a bank that pools funds from many depositors and uses the proceeds to make many loans. Back to top
Summary

In a world in which different agents have different information sets FIs earn a positive interest spread between their average asset returns and average liability costs, in return for providing valuable services. They are brokers between ultimate borrowers and ultimate lenders, and they provide payments services. They transform ultimate financial claims in the sense that their liabilities have different attributes from their assets. Typically, their liabilities are shorter in maturity, more liquid and less risky; thus, such liabilities are more desirable to savers. This process of asset transformation is not without risk. FIs are exposed to interest rate risk and particularly vulnerable to unexpected interest rate increases. We discussed the case of the US savings and loan industry and its devastating exposure to interest rate increases. Due to their liquidity provision, banks are exposed to the risk of bank runs. Bank runs have been common historically, and still have occurred with some frequency in the modern wave of

banking crises. Finally, all FIs are exposed to default risk when their loans or other investments do not pay off in a timely manner. Back to top 4 An aside on equilibrium credit rationing When economists began studying intermediation environments with private information, in which agents could withhold the facts, intentionally deceive one another, and so on, all manner of new and interesting results were obtained. One seminal model of financial intermediation featured an outcome called equilibrium credit rationing (Stiglitz and Weiss, 1981). In such cases, at the equilibrium rate of interest there is excess demand in the sense that some would-be borrowers are denied access to credit. This is quite at odds with a classical market equilibrium, and immediately raises the question, why don't lenders just increase the rate of interest to a level at which demand equals supply? A variety of answers to this question can be found in the literature, reflecting the different environments that have been shown to produce equilibrium credit rationing. For one example, assume that credit applicants are of two types, good and bad, and that lenders take account of borrower heterogeneity in their rate setting. Then, it can be the case that for sufficiently low interest rates both good and bad will borrow, but above some threshold rate r* good types become unwilling to borrow. In such cases lenders may find it optimal to set the rate at r* even though there is excess demand at that rate. A second example is an environment with moral hazard in the form of a bad action that borrowers may take ex post (such as increasing the risk of their investment project). For some parameterizations, when rates are below a threshold r+, borrowers will not take the bad action, but above r+ they will. As in the case above, it may be optimal for lenders to set the rate at r+, thus avoiding the bad action, and resorting to credit rationing. These first two environments are with private information: however, a third one can result in equilibrium credit rationing even when all information is public. Imagine that default by borrowers results in a deadweight loss for example, an out-of-pocket bankruptcy cost. Then, the probability of costly default directly depends on the rate of interest, and the higher that rate is the higher the default probability is. Increasing the rate of interest increases the expected rate of return to lenders in good (non-default) states, but also increases the probability of default which is costly to both parties. Depending on the distribution of possible returns facing borrowers, it may be that raising the rate beyond some threshold r is futile in the sense that the marginal cost exceeds the marginal benefit. In these cases, rates above r are harmful to both parties and will never be observed in equilibrium. Yet it may also be true that r-plus is too low to clear the market, and equilibrium credit rationing will again be observed (Williamson, 1986). Arguably, equilibrium credit rationing is a topic where theory leads measurement. There has not been a lot of good empirical work on credit rationing per se, primarily because it is so hard to do right. Credit rationing equilibria are off the usual demand and supply curves that econometricians like to estimate, and they may exhibit nasty jumps, discontinuities, and so on. If the theorists are right, however, and credit rationing is popping up all over, more empirical work would be useful, especially in the area of finance and development. Back to top 5 Regulation

Banks and other FIs are, almost without exception, rather heavily regulated. This is true in virtually all countries and has been true for centuries. There are at least three reasons for this special and obtrusive regulatory treatment. First, banks are the conduit for monetary policy, and problems in banking are likely to interfere with monetary policy conduct. Second, it is widely believed that bank failures may result in negative externalities (social costs). And third, governments may find it irresistible to control a critical industry that creates money and allocates a large fraction of investment capital. Some recent work has emphasized the importance of political economy issues for regulation, in particular arguing that it is unlikely that bank regulation can contribute positively to social welfare in economies with weak and/or corrupt governments (Barth, Caprio and Levine, 2006). The Great Depression was a difficult time for banks in the United States and many other countries, and during the late 1920s and early 1930s there were literally thousands of bank failures worldwide. Many of these were associated with bank runs and panics. In response, many nations substantially beefed up their regulation of FIs and put in mechanisms such as deposit insurance to reduce or eliminate the prevalence of bank runs. For example, the Federal Deposit Insurance Corporation was created by US federal legislation in 1933. Beginning in the mid-1930s, the industry stabilized (at least in developed nations), and went through a period of relative calm that lasted for about three decades. Many observers believed that these policy interventions had solved the problem of instability in banking; but that was not to be. Beginning in roughly the mid1960s, a new wave of banking crises affected well over 100 nations. Banking crises some of them severe have been recently experienced in developing and developed economies alike. No one knows for sure what has caused this interesting historical sequence of events in banking, but many scholars have emphasized that policy interventions intended to stabilize the industry may have actually had opposite effect. In most countries, banks have access to emergency borrowing from the government (a Discount Window), and have some form of government insurance to protect depositors. Additionally, there is a common practice known as too big to fail whereby governments will prop up their very largest FIs if they get into trouble. This package of interventions is widely referred to as the safety net, and it has been very heavily studied. Most of the literature on this topic concludes that, whatever the benefits of a safety net, it also distorts bank incentives in a perverse way. Depositors and other bank creditors don't care how much risk the bank takes (they are protected by government), and normal market riskconstraining mechanisms become ineffective. In the presence of a safety net, banks may have an incentive to take on more risk ceteris paribus than otherwise; indeed, they may even become risk lovers who intentionally seek out investments with low expected returns and high variance. It's not hard to see why this is so. If an FI has very risky investments and these payoff, all the profits go to FI shareholders. If they don't payoff the FI goes broke, but the resulting losses are mostly absorbed by government. In essence, this is a heads I win tails you lose gamble. Perhaps the most dramatic evidence of this distortion turned up during the U.S. S&L crisis. At that time, many S&Ls were obviously bankrupt but could not be closed down since their federal deposit insurer, the FSLIC, had run out of money. Many such institutions gambled for redemption by taking extreme risks. If they were lucky enough they might survive, and if not well, they were already broke. As of 2007, solving the problems associated with the safety net is arguably the most vexing policy issue facing FI regulators and scholars of that industry. Many regulatory interventions, such as restrictions on asset holdings, attempt to control FIs behaviour

but do not deal with the fundamental distortion of risk incentives. Other regulatory interventions such as capital regulation are intended to reduce FIs distortion of risk incentives, but may not be effective (Hellmann, Murdoch and Stiglitz, 2000). FIs have a natural tendency to try to get around all these regulations, pursuing strategies that render the regulations ineffective. On the other hand, getting rid of the safety net would have its own risks, and it is far from obvious how governments could ever credibly commit to a policy of no FI bailouts. This issue is probably best described as important but unfinished business. Back to top 6 Trends in recent research, and open research questions

1. As discussed earlier, the modelling of financial intermediaries has come a long way since the mid-1980s, and most modern macroeconomic models reflect that reality. Even so, there is still recent work that reflects old ways of thinking about FIs. To make this point I provide just one example: the ongoing discussions of the so-called Friedman Rule. This rule, in simplest form, calls for a monetary policy that produces a rate of deflation such that the real rate of return on bank reserves equals the rate of interest on real investment. Then, it is argued, banks will voluntarily hold all their assets in the form of reserves, and bank runs, crises, and so on will never happen. Bruce Smith (whose death in 2003 was a great loss to economics) makes it beautifully clear that this oncebeguiling idea should be relegated to the history of economic thought (Smith, 2002). Application of the Friedman rule may indeed result in risk-free banks. However, except for the provision of payments services, it precludes banks from making any of their valuable economic contributions detailed by Diamond (1984), Diamond and Dybvig (1986) and others, and as discussed earlier. 2. Boyd and Prescott (1986) have a theorem that financial intermediary coalitions composed of large numbers of agents can support allocations that cannot be supported with decentralized markets, and are efficient subject to resource and incentive constraints. As lamented by Green and Zhou (2001), virtually all subsequent theoretical research on FIs has studied decentralized (market) environments. Now, this could be just a matter of preferences amongst theorists as to the most interesting and tractable environment in which to study FIs. It's not, in my opinion, and this topic is of more than theoretical interest. BoydPrescott financial intermediary coalitions look (at some high level of abstraction) like mutual or cooperative FIs. It is fact that over several continents and many centuries mutual FIs seem to endogenously spring up with great regularity. When a class of arrangements is revealed preferred so often, there is probably a good reason for it. There has been some theoretical research on this topic, but arguably not enough. 3. Virtually all of our general equilibrium models with FIs force agents into discrete silos: for example, an agent must choose to become a producer (borrower), a consumer (lender), or an FI. In reality we often observe organizations that are both producers and financial intermediaries at the same time (for example, General Electric or Cargill). Moreover, we sometimes see firms radically change their blend of activities. For example, in a few years Enron evolved from a production firm to a financial intermediary. I am aware of only one study (Bhanot and Mello, 2006) that allows, in a serious way, for

endogenous choice of FI and non-FI activities in the same organization. More work along these lines could be useful. 4. As discussed, banks, even very simple ones, perform a number of economic functions simultaneously: brokerage, payments service provision, maturity transformation, liquidity provision, and default risk reduction. This is what we observe in reality and there is undoubtedly a reason. Yet our theoretical models tend to isolate these economic functions and look at them one at a time. Only a few studies have seriously looked at the jointness in providing even two services simultaneously (Kasyap, Rajan and Stein, 2002). This separation of functions is done for tractability, and even then our models can become complex. Putting all of these features in a model simultaneously becomes technically daunting, but it needs to be done. There are undoubtedly interesting interactions or synergisms among these activities, and we cannot learn about those by studying them individually.