1345 words (3.8 double-spaced pages)
- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -
Disintermediation refers to: (1) the investing of funds that would normally have been placed in a bank or other financial institution (financial intermediaries) directly into investment instruments issued by the ultimate users of the funds. Investors and borrowers transact business directly and thereby bypass banks or other financial intermediaries. (2) The elimination of intermediaries between the first case providers of capital and the ultimate users of capital, withdrawal of funds from financial intermediaries such as banks, thrifts, and life insurance companies in order to invest directly with ultimate users.
In America, most mutual savings banks are located in the Northeast, and are owned by their depositors and borrowers. A mutual savings bank does not issue capital stock. Profits are distributed to the owner/customers in proportion to the business they do with the institution.
The Mutual Savings Bank Crisis of the 1980s was the first of the banking crises addressed by the FDIC in the 80s. The crisis was brought on by new options in the financial services market that caused disintermediation. In order to rescue the mutual savings industry, the FDIC was forced to experiment with a number of different regulatory attempts. Many mutual savings banks including Richard Parsons's Dime Savings Bank were forced to submit to assisted mergers and demutualization. The mutual savings crisis management served as a training ground for the Savings & Loan and Commercial Banking Crises.
While there has been a general trend toward bank disintermediation and a greater role for financial markets in many countries, the pace has differed and there are still important differences across financial systems. The results support the view that these differences in financial structures do affect how households and firms behave over the economic cycle. In financial systems characterized by a greater degree of arm's length transactions, (1) households seem to be able to smooth consumption more effectively in the face of unanticipated changes in their income, although they may be more sensitive to changes in asset prices. In financial systems that rely less on arm's length transactions, firms appear to be better able to smooth investment during business cycle downturns, as they are better positioned to access external financing based on their long-term relationships with financial intermediaries. However, when faced with more fundamental changes in the environment that require a real-location of resources across sectors, financial systems with a greater degree of arm's length transactions appear to be better placed to shift resources to take advantage of new growth opportunities. There is also evidence that cross-border portfolio investors appear to allocate a greater proportion of their holdings in countries where the arm's length content of the financial system is higher, which may contribute to the financing of current account deficits.
Disintermediation is the removal of intermediaries from a process, supply chain or market. The disintermediation of capital markets is particularly important in an investment context.
Disintermediation of capital markets
Disintermediation has become increasingly important in financial markets, largely as a result of the increasing use of securities to raise capital from capital markets, rather than from banks.
Banks usually act as financial intermediaries for debt, borrowing from depositors and lending to borrowers. By selling securities such as bonds, instead of borrowing, a borrower can borrow directly from investors, by-passing the banks. The greater use of a wider range of financial instruments such as asset backed securities and convertibles (in addition to the traditional types of security such as bonds and debentures) have encouraged this.
More disintermediation reduces the amount of business available for commercial banks. It also increases the size of capital markets and generates more business for investment banks (advising on the issue of securities) and, indirectly, for other investment businesses (brokers, fund managers, stock exchanges etc.).
Borrowers can hope to borrow at lower cost as a result of disintermediation. Investors lose the safety of bank deposits but then they also should get better rates of return. Investors take on some extra risk which can be controlled through the usual mechanisms of diversification and the selection of appropriate investments. At the same time disintermediation eliminates the banks' interest margin and this benefit is shared by investors, borrowers and investment market intermediaries and advisors.
Decline of Traditional Banking: Financial Innovation and Financial Disintermediation.
1. Money market mutual funds - competition for bank deposits from investment banks. Market really exploded in the late 70s. Req Q fixed int rates on savings accounts at 5.5% when market rates were over 10%. Massive financial disintermediation.
2. Junk Bonds - Bond market competes with commercial banks for corporate borrowing. Before 1980, only investment grade bonds were issued. Investment grade requirements are very strict. Only blue-chip, well-established companies had access to the bond market. Small, medium, lesser known, younger firms could not issue bonds, they had to go to a bank for a commercial loan.
Investment grade bonds that were downgraded below investment grade, were classified as "junk bonds", companies were "fallen angels."
Possible reason for no, non-investment grade bond market: Information was too costly. Once information costs were reduced, high yield bond market opened up.
Michael Milken and Drexel-Burnham opened up the bond market by opening up trading in high-yield bonds, not for "fallen angels" but for firms that had not reached investment grade status. Most of the computer revolution was financed with "junk bonds." MCI, other well known companies started with junk bonds.
The equity of the firm that was holding "junk bonds" was always riskier than the debt. No one calls it "junk equity." Even DJI stocks probably are riskier than the average junk bonds.
Junk bonds: alternative for long term bank loans.
3. Commercial paper - alternative to short-term bank credit. It is another form of financial disintermediation, made possible by information revolution - easier to assess credit risk.
Pension funds and money market funds provide the supply of credit for commercial paper. Commercial paper and money market mutual funds grew together. Money market funds started getting lots of funds to invest; commercial paper provided the ideal short term money market instrument - liquid, low risk, short term.
4. Securitization - transforming illiquid financial assets into standardized, liquid, marketable securities. Financial innovation resulting from information technology lowering transaction cost. It is another example of financial disintermediation.
Residential mortgage industry gradually became securitized starting in the 1970s. Now 2/3 of home mortgages are securitized. Single mortgage - not very marketable. Why?
Banks and mortgage companies started packaging mortgage loans in large bundles/portfolios, selling ownership interests in the portfolios as securities in amounts of $100,000. Mortgage-backed security. Example, NBD Bank has a $10m portfolio of mortgages - sell 100 $100,000 mortgage-backed securities to investors: individuals, pension funds, insurance companies, etc. NBD would service the loans for a fee, collect the interest and principal, and pass the payments on the owners of the securities. They would also make a profit on the sale of the securities. Example: loan portfolio yields 8.5%, banks sells to investors to yield 8%, get more than 100% of portfolio value.
GNMA pass-through mortgage security - investor buys a certain percentage of a loan portfolio, a pro rata direct ownership position, instead of a fixed dollar amount or a non-ownership debt obligation.
CMOs - collateralized mortgage obligations. Developed in the 1980s as another financial innovation. Solution to the unpredictability of payoff data. CMOs were sold as different classes (tranches) that determined the order of payoff. Class 1 got paid off first, like a short term bond, and the other classes got paid next, etc. CMOs are like a combination of short, medium and long term bonds. Can be sold to suit investors needs.
Securitization also developed in other areas: auto loans, credit cards, computer leases, etc.
1. As a result of financial disintermediation, financial innovation, deregulation, etc. there has been a decline of traditional banking. Commercial banks and S&L's share of total financial intermediary assets has gone from 58% in 1960 to 32% in 1996.
2. Financial innovation and loophole mining lead to circumventing regulation.
3. Information technology has changed banking by facilitating innovation.
4. Costly information and transaction costs are a barrier to trade. Lower information costs leads to economic efficiency.
5. Information technology has decentralized power, and has made regulation obsolete.
6. Regulation protects the status quo.
How to Cite this Page
"Financial Disintermediation." 123HelpMe.com. 28 Jul 2016