Financial Intermediation Theories

Use two theories of financial inter-mediation to explain the existence and role of banks. Critically discuss and compare the two theories. Refer to at least two journal papers in your coursework

Financial Intermediation Theories


The theories of financial intermediation are based on asymmetric information, transaction costs, liquidity assurance, and borrowings. The theories are developed to account for the existence and role of financial intermediaries, the banking institutions. Recent developments in the role of these financial institutions have made it difficult to reconcile the theoretical assertions with the real practices. Most financial intermediation theories are focussed on banking roles that are not considered crucial in the current developed financial system (Scholtens and Van Wensveen, 2000). The current paper focuses on a critical analysis of the financial intermediation theories that have been developed to explain the existence and role of financial intermediaries. Their effectiveness in explaining the critical functions of the financial intermediaries is also presented.

Arrow-Debreu and Diamond and Dybvig Theories

Arrow-Debreu model is one of the traditional intermediation theories that fail to acknowledge the role of financial intermediaries in an economy. According to the theory, households and firms interact in a perfect market where intermediaries play no role in the allocation of resources. The households in the perfect market can construct portfolios thus offset the position of the financial markets rendering them valueless (Allen and Santomero, 1997). A perfect market has the following conditions: financial securities in the market are homogenous; there is no competitive advantage at the level of the participants, all participants have full access to information, and there is no transaction cost for participating in the market (Scholtens and Van Wensveen, 2000). Based on the identified characteristics, the proponents argued that consolidation of funds and acquisition of portfolio can be attained without the involvement of the financial intermediaries.

On the contrary, the imperfection arising due to information asymmetry has resulted in the development of a different view on the existence and role of the financial intermediaries. According to Brealey et al. (1977), the possibility of having equal access to information by all players in any market is limited. As such, there is an emergence of some transaction costs to make the information accessible to a person in need. The banking institution plays a role in eliminating such costs and ensuring that the participants in the market receive the desired services (Diamond, 1984). The Diamond and Dybvig model justify that the financial intermediaries have a significant role to play in the financial market. The theory indicates that banks act as authorized agents who create liquid deposits to the participants in the market. The role of the banking institution is to offer information on the availability of liquid cash for borrowers and the provision of a chance for saving to the creditors (Diamond, 2007). The financial intermediaries also play a role of tracking the granted loans and evaluating the factors that can influence the possibility of the depositors to withdraw their savings before maturity, financial intermediaries, therefore, play a role of creating liquidity, monitoring the performance of granted loans, and engage in the enforcement of loan covenants.

Comparison and Critique of the two Theories

The Diamond and Dybvig model contradicts the assertion of the Arrow-Debreu theory by pointing out that such perfect markets are non-existence. As such, the banking intermediaries have a significant role to play in meeting the needs of the participants of the financial markets. According to Andrieş (2009), the information asymmetry creates imperfections in the marketing presenting a scenario where not all participants have access to the financial securities, competition is heightened at the participants’ level, and borrowing conditions are not similar to all participants. As a result, there would be a transaction cost to purchase any offers in the market. The financial intermediaries play a significant role in eliminating some if not all of the possible transaction costs, justifying its vital role in the financial market.

The assertions of the two theories do not hold in the current financial market. Apart from being regarded as irrelevant by the Diamond and Dybvig model, Arrow-Debreu model has also been criticized by some scholars who view it as impractical in the current financial systems (Hodgson, 1992). Arguing that intermediaries have no role to play in financial markets since efficient allocation of resources is supported is unreasonable. Historical and current development has indicated that banks have played a major role in all economies. The banks have been involved in the conversion of household savings into real investments. Also, the recent transformation in the financial markets through the introduction of new financial products and derivative movements have further justified that financial intermediaries have a role to play. According to Dixit (2015) no extensive use of the new financial product has been reported by the households, rather the financial intermediaries have been fully involved in their management. A direct shift from direct participation in the financial markets to interaction through the intermediaries ascertains the significant role of banks in the financial sector.

Other theories such as Diamond and Dybvig model have also supported the relevance of the banks. However, the assertions of the theorists are still not focussed on the current crucial role of the financial intermediaries. The Diamond and Dybvig model asserts that intermediaries work as agents and monitors to overcome the issue of asymmetric information (Werner, 2016). While the argument is correct, it’s relevant in the current financial has declined. Significant changes in the operations of the banking institutions have been reported creating a clear distinction between the theoretical assertions and what is observed in practice (Diamond and Kashyap, 2016). Risk management activities have become important roles of the banks yet are lacking in the theories. The description of how the banks are performing hedging activities lacks in the two theories. The modification of the theories is therefore vital to improve their effectiveness and accuracy in explaining the existence and roles of the banks.


Models have presented contradictory assertions on the role of the banks. While Arrow-Debreu model argues that financial intermediaries have no role to play, Diamond and Dybvig model argues that they play a significant role in the financial markets especially in addressing the problems of financial asymmetry. However, all the assertions in the two theories do not focus on the current crucial role of the banks. Significant changes in the role and operations of the financial intermediaries have been reported, presenting the need for the modification of the theories such that they effectively explain the existence and roles of the banks as currently evident in practice.






Reference List

Allen, F. and Santomero, A.M., 1997. The theory of financial intermediation. Journal of Banking & Finance21(11), pp.1461-1485.

Andrieş, A.M., 2009. Theories regarding financial intermediation and financial intermediaries–a survey. The USV Annals of Economics and Public Administration9(2), pp.254-261.

Brealey, R., Leland, H.E. and Pyle, D.H., 1977. Informational asymmetries, financial structure, and financial intermediation. The journal of Finance32(2), pp.371-387.

Diamond, D.W, 2007, Banks and liquidity creation: A simple exposition of the Diamond and Dybvig model. Federal Reserve Bank of Richmond Economic Quarterly. 93(2). pp.189−200.

Diamond, D.W. and Kashyap, A.K., 2016. Liquidity Requirements, Liquidity Choice, and Financial Stability. Handbook of Macroeconomics2, pp.2263-2303.

Diamond, D.W., 1984. Financial intermediation and delegated monitoring. The review of economic studies51(3), pp.393-414.

Dixit, A., 2015. Market Completion. The Economics of Derivatives, p.33.

Hodgson, G.M., 1992. The reconstruction of economics: is there still a place for neoclassical theory?. Journal of Economic Issues26(3), pp.749-767.

Scholtens, B. and Van Wensveen, D., 2000. A critique on the theory of financial intermediation. Journal of Banking & Finance24(8), pp.1243-1251.

Werner, R.A., 2016. A lost century in economics: Three theories of banking and the conclusive evidence. International Review of Financial Analysis46, pp.361-379.