Friday, March 13, 2009

Financial intermediation

Very interesting:
An intermediary can "add value" by reducing investors' risk in comparison to disintermediated investment, by for example, investing in a better-diversified portfolio than an investor would. An intermediary can very effectively reduce liquidity risks to investors, again by since idiosyncratic liquidity demands are themselves diversifiable. But risk reduction via these techniques can never reduce risk to zero. In fact, investing via an intermediary can never alter the fact that 100% of invested capital is at risk — business performance is not uncorrelated and projects can fail completely. Also, usually idiosyncratic liquidity demand occasionally become highly correlated, due to bank runs or real need for cash. Statistical attempts to quantify these risks are misleading at best, as the distributions from which inferences are drawn are violently nonstationary — the world is always changing, the past is never a great guide to the future for very long. Fundamentally, the value intermediaries can add by diversifying over investments and liquidity requirements is very modest, and ought to be acknowledged as such.

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