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«What do ®nancial intermediaries do? a,* b Franklin Allen, Anthony M. Santomero a The Wharton School, University of Pennsylvania, Room 2336, ...»

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The growing importance of securitization is especially obvious in the transformation of the traditional mortgage as shown in Fig. 6. Formerly, a bank originated, funded and serviced the mortgage until it was repaid. Now, one ®rm may originate the mortgage. Another ®rm may fund the mortgage, or pool the mortgage with others and partition the anticipated ¯ow of income Fig. 6. Securitized mortgages as a pecent of total mortgages, 1980±1998 (Source: Board of Governors of the Federal Reserve System, ``Flow of Funds Accounts'', various years).

278 F. Allen, A.M. Santomero / Journal of Banking & Finance 25 (2001) 271±294 from the pool into marketable securities that will appeal to particular groups of investors around the world. Another ®rm may insure the pool of mortgages to facilitate this process. The servicing of the mortgage may be allocated to yet another specialist ®rm that has data processing expertise. The consequence is that mortgages will be funded at lower cost than if an intermediary were obliged to hold mortgages to maturity and what was once an illiquid bank asset is transformed into a highly marketable security. This unbundling can be executed so smoothly that the mortgagee may be entirely unaware that it has taken place.

These techniques have been successfully applied to many other kinds of credit transactions, including credit card receivables, auto loans, and small business loans. And, the trend has now reached the standard commercial loan, with the advent of and growth in the emerging CLO, collateralized loan obligation, market.

Banks are also losing ground on the liability side of their balance sheets. As the baby boom generation matures, and inherits or accumulates wealth, consumer demand is shifting from credit products to savings products. This trend is apparent in most industrial countries, but is somewhat further along in the US because of the demographics associated with the post-war, ``Baby Boom'' generation. In the US, over the next 20 years the population under age 50 will remain the same as it is today, but the population older than 50 will double.

For the latter group, asset accumulation in anticipation of retirement is of tantamount importance and it has made this market the fastest segment of household wealth accumulation. The traditional bank entry in the competition for consumer savings ± the time and savings account ± is deservedly losing ground here to mutual funds that have much leaner cost structures and can o€er signi®cantly higher returns. Accordingly, bank time and savings deposits have declined steadily relative to ®xed-income mutual funds since 1980 as shown in Fig. 7. 2 New technology ± often introduced by nonbanks ± is jeopardizing even the fundamental role of banks in facilitating payments. Many mutual fund families and most brokerage houses o€er cash management accounts that permit individuals to arrange for their salaries to be automatically deposited in their cash management accounts from which routine payments can be made automatically and irregular payments may be made by check or phone 24 hours a day. Personal checks may be routinely drawn on the money market account. In addition, money market accounts can be linked to a credit card that also functions as a debit card at automated teller machines for cash needs. Although payments through the account are cleared through a bank, the role of 2 See Santomero and Ho€man (1998) for even more evidence of this trend away from banking institutions.

F. Allen, A.M. Santomero / Journal of Banking & Finance 25 (2001) 271±294 279 Fig. 7. Bank time and savings deposits decline relative to ®xed-income mutual funds, 1980±1997 (Source: Investment Company Institute Mutual Fund Fact Book, 1998; and Federal Deposit Insurance Company, Historical Statistics on Banking, 1997).

the bank is a regulatory artifact, not an essential part of the transaction or the deposit type relationship between the intermediary and its customer.

AmericaÕs love a€air with credit cards has also eroded a central role of demand deposits in the payment system. With some 500 million credit cards outstanding, 3 the number of transactions using credit cards continues to rise, approaching 17 trillion by 1997. 4 These payment vehicles are now issued primarily by monoline organizations or distributed nationally by mass mailing.

This is quite di€erent than the usual multi-product banking relationship and serves to further erode the previously unique role of the local bank and its deposit products. The continued expansion of e-commerce suggests that this type of vehicle will become even more important over time for transaction purposes than the traditional demand deposit and the paper check. The net result of all this is that the relative importance of checkable deposits is declining, as are balances held in this form; see Fig. 8.

In view of the declining role of the traditional intermediation business, it is not surprising to see that the importance of net interest income to both the banking sector and the economy as a whole has fallen in the US as shown in Fig. 9. Because this decline in the basic intermediation business is economically motivated and technologically driven, it is also likely to be irreversible.

Although the intermediation business has declined, banks have managed to prosper nonetheless, by shifting from traditional intermediation functions to fee-producing activities such as trusts, annuities, mutual funds, mortgage banking, insurance brokerage and transactions services. Fig. 10 shows how noninterest income has risen relative to ®nancial sector GDP. Notwithstanding the constraints on allowable bank activities in the US, imposed by the Glass± Steagall Act and the Bank Holding Company Act, banks have managed to develop new lines of business to compensate for the decline in the traditional intermediation business.

3 BIS (1998), Table 7.

4 BIS (1998), Table 12.

280 F. Allen, A.M. Santomero / Journal of Banking & Finance 25 (2001) 271±294 Fig. 8. Checkable deposits decline relative to money market mutual fund shares, 1974±1998 (Source: Investment Company Institute Mutual Fund Fact Book, 1998; and Federal Deposit Insurance Company, Historical Statistics on Banking, 1997).

Fig. 9. Net interest income less charge-o€s as a percent of ®nancial sector GDP (Source: Survey of Current Business; and Federal Deposit Insurance Company, Historical Statistics on Banking, 1997).

Overall, these changes in what banks do have allowed them to hold their own. As shown in Fig. 11, bank value added as a percentage of ®nancial sector GDP has remained about the same for many years. The di€erence is that banks have a very di€erent con®guration of earnings. 5 Spread income accounted for about 80% of bank earnings only a decade ago. Now, most large regional and money center banks earn more than half their income from fees and trading income.

5 Boyd and Gertler (1994) and Kaufman and Mote (1994) have both emphasized this point.

F. Allen, A.M. Santomero / Journal of Banking & Finance 25 (2001) 271±294 281 Fig. 10. Noninterest income as a percent of ®nancial sector GDP (Source: Survey of Current Business; and Federal Deposit Insurance Company, Historical Statistics on Banking, 1997).

Fig. 11. Bank value added as a percent of ®nancial sector GDP (Source: Survey of Current Business; and Federal Deposit Insurance Company, Historical Statistics on Banking, 1997).

The result is that banks in the US are markedly di€erent than they were even a decade ago. They are no longer the primary source of business and consumer ®nance. Neither are they the main repository of liquid savings for the ®nancial system. They have managed to restructure their businesses so that they are much less dependent on traditional intermediation income.

This discussion shows that the US ®nancial system has been altered over the

years in a very complex way. The changes that have resulted can be summarized as follows:

282 F. Allen, A.M. Santomero / Journal of Banking & Finance 25 (2001) 271±294 · Relative to nonbank intermediaries, the share of assets held by banks is declining.

· Bank assets are not declining relative to total ®nancial assets.

· There is a shift away from directly held assets towards nonbank intermediaries.

· The activities banks engage in have altered signi®cantly. They have moved away from the traditional role of taking deposits and making loans to ®rms and consumers to fee-producing activities such as trusts, annuities, mutual funds, mortgage banking, insurance brokerage and transactions services.

An important question concerns the extent to which the trends enumerated above are mirrored in other countries. In an important study, Schmidt et al.

(1999) have considered how the role of banks has changed in three relevant and important economies, viz., France, Germany and the UK. Fig. 12 shows how the ratio of householdsÕ claims on banks as a proportion of their total ®nancial assets has fallen in all three countries, but particularly in France. The same is true of the ®nancial claims of all non®nancial sectors on banks as shown in Fig. 13.

There is also a change in the way banks operate. Fig. 14 also drawn from Schmidt et al. (1999) shows how the ratio of liabilities of banks to nonbank ®nancial intermediaries compared to total ®nancial liabilities has risen significantly. At the same time, the ratio of securitized ®nancial liabilities of banks to total ®nancial liabilities has risen somewhat for France but only slightly for Fig. 12. Asset-IR of Households with Banks ˆ ®nancial claims of HHs on banks/total ®nancial assets of HHs (Source: Schmidt et al., 1999).

F. Allen, A.M. Santomero / Journal of Banking & Finance 25 (2001) 271±294 283 Fig. 13. Asset-IR of all non®nancial sectors with banks ˆ ®nancial claims of NFS on banks/ total ®nancial assets of NFS (Source: Schmidt et al., 1999).

Fig. 14. Liability [Asset]-IR of banks ˆ ®nancial liabilities [assets] of banks of [from] NBFIs/ total ®nancial liabilities [assets] of banks (Source: Schmidt et al., 1999).

Germany and has stayed roughly the same for the UK. The trend observed in the US, therefore, is not unique to that country, and appears to be present in a number of relevant economies.

284 F. Allen, A.M. Santomero / Journal of Banking & Finance 25 (2001) 271±294

3. Di€erences in risk borne by households across countries AS argue that risk management has become one of the main activities of banks and other ®nancial intermediaries in recent years. The explosive use of derivatives by ®nancial institutions, which they document, is o€ered as one indicator of the fact that risk management has transformed the role played by institutions in the capital market. In contrast, Scholtens and van Wensveen (1999) argue that risk management has been at the heart of what ®nancial intermediaries do since their origin. Banks have always held risky assets and ®nanced them with relatively safe deposits. The key issue here appears to be how much di€erent is the role of banks in risk management across ®nancial systems and through time. In particular, how do the contracts used by households compare and how do the contracts used by ®rms di€er? Is there evidence that banks and other intermediaries deal with risk di€erently in the modern ®nancial system typi®ed by the US, compared to other ®nancial systems?

To shed light on this issue, Fig. 15 shows the di€erences in total assets ultimately owned by households, including both directly and indirectly owned assets, in the ®ve countries. In the US only 19% is held in the form of cash and cash equivalents which includes bank deposits. A signi®cant proportion, 31%, is held in the form of relatively safe ®xed income assets including domestic and foreign bonds, and loans and mortgages. The largest proportion, 46%, is held in risky assets including domestic and foreign equity and real estate. The UK is Fig. 15. Portfolio allocation of total ®nancial assets ultimately owned by the household sector (% of total) (Source: Miles, 1996, Table 5, p. 22).

F. Allen, A.M. Santomero / Journal of Banking & Finance 25 (2001) 271±294 285 similar with slightly more in cash and cash equivalents at 24%, signi®cantly less in ®xed income assets at 13% and substantially more in risky equity and real estate assets at 52%. In both countries households are exposed to substantial amounts of risk through their holdings of assets.

At the other extreme, households are relatively shielded from risk in Japan, in terms of the makeup of the portfolio of assets they ultimately hold. There, 52% of assets are held in cash and cash equivalents, 19% are held in ®xed income assets and only 13% are held in risky equity and real estate. Although not quite as safe as in Japan, householdsÕ asset holdings in France and Germany are much safer than in the US and UK. Cash and cash equivalents are lower than Japan at 38% and 36%, respectively, while ®xed income assets are substantially higher at 33% and 40%, respectively. The amount of risky assets is comparable to Japan at 16% for both countries.

It can be seen from these statistics that the proportions of risky assets held by households in the US and UK are much higher than in Japan, France and Germany. This does not necessarily mean that the absolute amount of risk borne by households is greater since more could be invested in ®nancial assets in Japan, France and Germany. Fig. 16(a) shows the gross ®nancial assets ultimately owned by the household sector in the ®ve countries in 1994. In the US the value of ®nancial assets relative to GDP is the highest at 3 but the UK Fig. 16. (a) Total gross ®nancial assets ultimately owned by the household sector (Source: Miles, 1996, Table 4, p. 21) and (b) Total gross ®nancial assets ultimately owned by the household sectorratio value relative to GDP (Source: Miles, 1996, Tables 4, p. 21).

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