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Thursday, October 02, 2008

Financial Intermediation and the Financial Crisis

This discusses the difference between direct and indirect finance, and how indirect finance through financial intermediaries increases economic efficiency. The relationship between financial intermediation and the crisis is also noted.

In particular, I use a simple numerical example to talk about pooling and diversifying risk, pooling over time (i.e. borrowing short and lending long), and pooling small deposits to make large loans, and then relate the risk pooling and time pooling functions to the insolvency and illiquidity issues we are seeing in financial markets. I also briefly note two other functions of intermediaries, reducing transactions costs and reducing default risk, and note the failure of intermediaries to effectively assess default risk is a factor in the crisis.

It's fairly classroom like and somewhat elementary, but I hope it's useful to some of you. My main goal was to show how intermediaries pool and diversify risk (and how that makes the economy more efficient), how the mispricing of risk led to insolvency and liquidity issues, and how this disrupted the time pooling function making things far worse.

I also give an example (taken from here) at the very end of how mortgages can be sliced and diced into different risk categories.

    Posted by on Thursday, October 2, 2008 at 10:17 PM in Economics, Financial System | Permalink  TrackBack (0)  Comments (12)

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