«What do ®nancial intermediaries do? a,* b Franklin Allen, Anthony M. Santomero a The Wharton School, University of Pennsylvania, Room 2336, ...»
In contrast, in the US and UK where ®nancial markets are more developed and accessible, intermediaries are unable to engage in such intertemporal smoothing. If they were to do this, investors would withdraw their funds completely and invest them in markets instead. Here, risk must be dealt with through cross-sectional risk sharing. As a result, risk management takes the form of investing in derivatives and other similar kinds of strategy, rather than carrying reserves over from one period to another.
This theory implies that the signi®cant development of ®nancial markets in the US over the past 25 years is consistent with the transformation of the banking industry there. Prior to that time ®nancial markets provided much less competition to intermediaries, and banks would have been able to manage risk by building buers of liquid reserves and intertemporally smoothing. However, as competition from ®nancial markets increased this was no longer possible F. Allen, A.M. Santomero / Journal of Banking & Finance 25 (2001) 271±294 291 and intermediaries had to manage risk in dierent ways. The increase in the importance of cross-sectional risk sharing led to the use of derivatives and other similar techniques for risk management. These developments forced banks to move away from their traditional borrowing and lending activities and develop new fee-based sources of revenue. They have been suciently entrepreneurial and innovative that they have managed to hold their own.
A number of unresolved puzzles or at least open issues remain. In Section 3 we discussed the portfolio holdings of households in dierent countries. We pointed out that there are signi®cant dierences between the US and UK on one hand, and Japan, France and Germany on the other. However, there is a parallel literature that addresses ®nancial sector dierences in terms of the ®nancing of ®rms. There are a number of studies of this, including the work of Mayer (1988, 1990), Bertero (1994), Rajan and Zingales (1995), and Corbett and Jenkinson (1996). The perspective gained from this literature is much less clear than the results reported here.
Data issues appear to be a large part of the problem. Two sources of information have been used in the sources of corporate ®nancing literature. One uses accounting and market data, and focuses on the capital structure of ®rms (see, e.g., Rajan and Zingales (1995) for an excellent example of this type of study). There are a number of problems with this type of approach, not the least of which is to reconcile accounting data from dierent countries. In addition, it does not distinguish between internal and external ®nance, which for many topics concerned with ®nancial systems is important. The alternative method, which has been widely adopted, is to analyze sources and uses of funds data from national accounts. This approach was pioneered by Mayer (1988,
1990) and has subsequently been used by Bertero (1994) and Corbett and Jenkinson (1996). These studies have the advantage that the data sets used are reasonably comparable and internal and external ®nance can be compared.
These studies, based on sources and uses of funds statements, look at the net ®nancing from various sources and work out how investment was funded.
Table 1 from Bertero (1994) for France, and Corbett and Jenkinson (1996) for
the other countries, gives the results of such a study for the period 1970±1989.
It can be seen that internal ®nance is by far the most important source of funds by far in all countries. Bank ®nance is moderately important in most countries but particularly in Japan and France. Bond ®nance is only important in the US, and equity ®nance is either unimportant or negative (i.e., shares are being repurchased in aggregate) in all countries.
How can these results be reconciled with the data on composition of household portfolios? One would expect that in the long run household portfolios would re¯ect the ®nancing patterns of ®rms. Since internal ®nance accrues to equity holders one might expect that equity would be much more important, particularly in Japan, France and Germany. There are of course many dierences in the two data sets. For example, household portfolios consist of ®nancial assets and exclude privately held ®rms, whereas the sources and uses of funds data include all ®rms. Nevertheless, it seems unlikely that such dierences could cause such huge discrepancies.
There is no widely accepted resolution to this apparent discrepancy. However, in a recent paper Hackethal and Schmidt (1999) argue that it results from an apparently innocuous assumption in the methodology used in these studies.
This is the assumption that the proceeds from new bank ®nance are ®rst used to repay old loans and then are used for funding investment. It is similar for other sources of funds such as bonds and equity. The only exception is internal ®nance where there is nothing to be repaid. This distorts the measurement of the sources of ®nance toward internal ®nance and makes it seem more important than it is. When they correct for this distortion they ®nd ®gures much more in line with the portfolio data reported here.
Another puzzle relates to the sheer size of risk trading activity in the ®nancial markets, as captured by open positions and notional volumes of foreign exchange and derivative trades. It seems always incredulous to assert that such large volumes are necessary to merely transfer risk between interested ultimate parties. However, here too measurement problems may be at the heart of the controversy. The way in which volume is measured in standardized markets may be the real problem. It should be remembered that risk trading is a dynamic activity associated with the need of at least one party to alter the state contingent return to a ®nancial transaction. As circumstances change, osetting trades may be conducted or a number of alternative subsequent trades may be added to further alter the ®nancial returns facing a counterparty.
Over time many of these trades are osetting, with net positions only a small fraction of the total. Yet, most of these risk trading activities are conducted in the broker-dealer market, rather than on formal exchanges. For example, most foreign exchange, swaps and credit derivatives are broker-dealer transactions.
This fact is important when it comes to measuring the overall volume of activity, as broker-dealer transactions are measured in gross notional amounts outstanding. In the case of exchange transactions the results are netted and F. Allen, A.M. Santomero / Journal of Banking & Finance 25 (2001) 271±294 293 only net positions are reported. This has led to an overstatement of overall risk trading and a gross overstatement of true outstanding positions. Whether a more accurate measure of volumes will satisfy those that contend that trading volume exceeds simple risk management needs is still open to question. Our only point here is that the current measures clearly overstate the activity in question.
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