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Topic question: How does disintermediation of banks impact financial market?FINANCIAL MARKET – BAFI 3182Assessment Task 3- Research PaperTopic chosen: DISINTERMEDIATIONLecturer’s name: HUY PNATran Nguyen Gia BaoSI declare that in submitting all work for this assessment I have read, understood and ag...

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FINANCIAL MARKET – BAFI 3182 Assessment Task 3- Research Paper Topic chosen: DISINTERMEDIATION

Topic question: How does disintermediation of banks impact financial market?

Lecturer’s name: HUY PNA Tran Nguyen Gia Bao S3751302

I declare that in submitting all work for this assessment I have read, understood and agree to the content and expectations of the ‘Assessment declaration’

Conts 1.

Abstract.........................................................................................................................................2

2.

Introduction...................................................................................................................................2

3.

Literature review............................................................................................................................3 3.1

Brief description of the role of financial intermediaries........................................................3

3.2

Rise of disintermediation.......................................................................................................4



What is disintermediation?....................................................................................................4



The reasons for disintermediation.........................................................................................4

3.3

Impacts on financial markets.................................................................................................6

a.

Firms investors and borrowers...............................................................................................6

b.

Deterioration of traditional bank roles..................................................................................7

c.

Structural change in banks.....................................................................................................8

d.

Rise of shadow banking.........................................................................................................9

e.

Decentralised autonomous organisations (DAOs)................................................................10

4.

Conclusion and Limitations..........................................................................................................11

5.

References...................................................................................................................................12

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1. Abstract This paper examines the trend in disintermediation of banks and its impacts upon financial markets. The main focus is on the review of existing literature by investigating the views and studies by other authors regarding the disintermediation topic. My findings comprise of some theories about the drivers of disintermediation, including the technological progress and the lack of trust people have on financial intermediaries. There are many implications disintermediation has on financial markets. Some findings include the fall in traditional bank roles, the structural change in the existing banking institutions, the rise of ‘shadow banking’ and other decentralised autonomous organisations (DAOs) that are expected to replace banks in the future. Other findings include the cost saving that investors and borrowers enjoy for not paying bank fees. This paper is purely conceptual since it mainly discussed the literature review of existing studies done by other authors about this topic.

2. Introduction Nowadays, with the advancement in technology, the roles played by financial intermediaries seem to be subdued. Around the world, we have witnessed a reduction in the number of banks. In the US alone, physical banks are slowly replaced with digital platforms where people can borrow and lend funds in an efficient and cost-effective way. Such a process, disintermediation, has started to infiltrate the financial markets. In fact, the popularity of disintermediation has sparked concerns about the permanent replacement of conventional bank, which threatens the job prospects of many individuals and diminishes the fundamental functions of the financial institutions. However, will the financial sectors be solely negatively affected by such a trend? In this paper, I will explore different aspects of disintermediation in order to answer one of the most probably asked questions, ‘How does disintermediation of banks impact financial market?’ In the first part of the paper, I will briefly describe the role of financial intermediaries by analysing some theories proposed by different authors regarding the functions of banks and financial institutions (Part 3.1). Next, I will define the term ‘disintermediation’ and provide reasons for the rising trend of disintermediation in recent years (Part 3.2). This is followed by

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a range of literature review regarding the developments that drive disintermediation. Then, I will explain the impacts of such a trend on the financial market (Part 3.3). This is the most crucial part of the paper since numerous studies and theories will be discussed and evaluated in order to analyse the change disintermediation has created upon the financial market. Finally, I will conclude the paper and suggest some limitations that may influence my research findings (Part 4).

3. Literature review 3.1 Brief description of the role of financial intermediaries To understand the impacts of disintermediation upon financial markets, it is necessary to first examine the roles of financial intermediaries in the market. According to a theory proposed by Freixas and Rochet (2008), four main functions of intermediaries are ‘asset transformation, liquidity and payment services, monitoring and information processing, and risk management’. One aspect of asset transformation is ‘maturity transformation’. Early research done by Marty (1961) showed that banks can transform ‘illiquid liabilities’ issued by firms into highly ‘liquid instruments’ held by customers. This is supported by recent studies conducted by Caprio (1995) and Mahdi (2008) who emphasised the role of banks in matching maturity preferences between lenders and borrowers. These authors pointed out that borrowers, including firms, prefer less liquidity than the lenders, who are mainly savers and investors. Banks can offer long-term loans to borrowers while ensuring their short-term liabilities to the lenders. Although Caprio (1995) comprehensively explained the maturity matching function of the intermediaries, his study was mainly conducted in transitional economies where the financial institutions and the process of lending-and-borrowing were primitive. Therefore, the function of intermediaries was still limited. In contrast, research done by Marty (1961) and Mahdi (2008) are extended to include all developed economies, hence, the role of intermediaries could be seen easily, rendering their findings more reliable. Another role of intermediaries is risk reduction. Geithner (2008) found that by diversifying the loans given out, banks can create a well-diversified portfolio, which minimise 3

unsystematic risks. Regarding the theory of diversification, Allen & Santomero (1997) believed that this strategy effectively reduces the percentage of bad debts across a huge loan portfolio, which mitigates the risks incurred to lenders. In another paper, Scholtens & Wensveen (2000) extensively explained how the intermediaries minimise the default risks with the use of their expertise knowledge and available information regarding the borrowers. This is consistent with the findings in Leland & Pyle (1977) and Chan (1983). These studies are valid in the sense that they all elaborate the role of intermediaries in nullifying the credit risks, which proves to be beneficial to the lenders. With the vital functions of financial intermediaries mentioned above, the trend in disintermediation will strongly disrupt the bank roles. Such disruption has many implications upon the market which I will explain in the subsequent sections.

3.2 Rise of disintermediation  What is disintermediation? According to Alinska & Czepirska (2016), disintermediation refers to the reduction in roles or total eradication of the middle parties in supply chain of goods and services. In finance, this term refers to the development that removes banks or any institutions and allow lenders to place their savings/funds directly to the borrowers. Marszałek (2016) extended the definition to include that disintermediation is also the withdrawal of funds from existing intermediaries in order to invest them directly.

 The reasons for disintermediation In recent years, we have witnessed an increasing trend in disintermediation. Fang et al. (2015) found the main reason for this phenomenon is that investors increasingly desire lower transaction fees and other additional costs, which promises higher returns. In fact, banks are driven by self-interest, hence they tend to charge high fee for the borrowers and keep the return low for the lender (Anderson & Makhija 1999). This is supported by the findings in Bos & Kool (2006) who argued that banks seek profits from the spread in their

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price quotes. Although the contexts for the 2 studies are different (the former was in Japan while the latter was in Netherlands), both authors well-presented the consequences of the spread on the returns for the lenders and costs for the borrowers. In fact, low bid-rate and high ask-rate respectively indicate low return for lenders, who wish to sell cash, and high cost for borrowers, who wish to buy cash. Schmidt et al. (1999) conducted research on banks in another context which is Europe and found similar results. Most lenders attained lower profit due to the high transaction fees paid to the banks and their low return rate. Similarly, borrowers suffered high borrowing cost and additional fees, which lower their overall returns as well. Therefore, firms are discouraged from investing in or borrowing from financial intermediaries, resulting in the rise of disintermediation. Another reason is due to the lack of trust in banks. Marszałek (2016) found that since the collapse of banks during the financial crisis 2009, the customers’ confidence in banks has dropped significantly. Lauteschlager (2015) attributed such a fall in confidence to several factors including numerous scandals in the banking sectors and the economic uncertainty. This led many people to switch to other forms of lending-and-borrowing, resulting in the rise of bank disintermediation. In the mentioned studies, both authors acknowledged that disintermediation did happen even before the crisis, however, it was further exacerbated in the post-crisis period. There are other studies attributing the rise of disintermediation to the technological progress. Zamani & Giaglis (2018) argued that the development of blockchain technology has led to the emergence of digital currencies such as Bitcoin, Ether and Litecoin. The authors find that these cryptocurrencies serve similar functions as fiat currency. However, they are more convenient in the sense that they are not controlled by a centralised banks or governments, which renders them easily used. This is supported by Cheah & Fry (2015) who believe that Bitcoin can be used in daily transactions. Their research provided empirical evidence for the widespread use of Bitcoin in business deals and online purchases. In another paper, Manning et al. (2016) described the benefits of blockchain technology in cryptocurrencies that render such digital currencies a popular choice by businesses and individuals. These authors emphasise the use of algorithm and codes in blockchain technology that helps such a system secure its data. Therefore, from the abovementioned studies, it can be argued that the rise of cryptocurrencies has discouraged the need for 5

physical banks. With blockchain technology, suppliers of capital are connected directly to customers in a digital way which is more efficient than intermediaries. This inevitably speeds up disintermediation process.

3.3 Impacts on financial markets The financial markets include the roles of lenders and borrowers as well as the intermediaries such as banks. The focus of this paper is analysing how the three abovementioned parties are influenced by the trend in disintermediation. These parties are interrelated, hence the impacts upon one may influence the others.

a. Firms investors and borrowers Numerous studies have shown that with the removal of banks, investors are able to gain higher returns because they are not required to pay fee and carry. Moreover, they will not be vulnerable to the bank spread. Early research was done by Benston & Smith (1976) who collected data upon the returns that savers could get if they invested in banks. They would then compare with the control group which consisted of those who invested directly without intermediaries. The authors realised that the control group could get higher returns. Additional evidence can be found in Carruthers & Kim (2011) and Moenninghoff & Wieandt (2013) who investigated the benefits of direct investment. These authors suggested that disintermediation allows investors to save upon the transactional fees and other administrative costs, which eventually yields higher returns. This is further supported by Fang et al. (2015). While Benston & Smith (1976) focused mainly on short-term investors, Carruthers & Kim (2011) and Moenninghoff & Wieandt (2013) provided a more-balanced approach by examining both short-term and long-term cases. This enhances the reliability of their studies and strengthens their results. However, a drawback of direct investment is that investors may lack the skills in portfolio management. Fang et al. (2015) found that intermediaries are proven to be better than direct investors in terms of transaction-related activities and monitoring capabilities. Therefore, direct investors may underperform, resulting in the fall in returns. In fact, an early study by Rubinton (2011) pointed out that investors may not be well equipped with skills and knowledge in handling capital. Investors also face difficulty in hedging themselves 6

against the potential default risks from the borrowers (Moenninghoff & Wieandt 2013). Therefore, many investors end up investing in low-credit rating assets about which they have little knowledge. This results in potentially low returns earned. With disintermediation, borrowers are also able to enjoy lower cost because the transactional fees are eliminated. Fang et al. (2015) argued that when the deficit units borrow money directly from the surplus units, the huge amount of cost is saved as borrowers do not need to pay the fees for intermediaries. This is supported by Xu (2015) and Ertan et al. (2018) who found that the cost saving has spurred many firms to directly obtain loans from the investors instead of banks. This signals a change in the flow of funds in the financial market. Initially, with intermediaries, funds flow from surplus units to financial institutions such as banks, followed by the deficit units. In recent years, the borrowers choose to obtain loans directly from the investors. Such change in the flow of funds may render the roles of banks obsolete. This will be explained in the next part.

b. Deterioration of traditional bank roles The functions of banks have reduced. Marszałek (2016) argued that the opportunities for banks to earn profits dropped since the demand for banking services decreased and the number of customers fell. This may have further consequences. As discussed above (Section 3.1), financial intermediaries play a huge role in matching maturity preference and reducing credit risks thanks to diversifying portfolio and specialised knowledge (Freixas & Rochet 2008). Therefore, with disintermediation, these functions will be overlooked. In other words, banks may fail to conduct such functions, resulting in the disruption to the entire financial system. In fact, with lower deposits received, the process of giving out loans is hindered. Khan et al. (2019) found that in developing countries, banks are no longer be able to match maturity preference between borrowers and investors since their capital is limited due to low deposits. Similarly, Buch & Golder (2000) argued that in Germany, credit availability from banks fell due to the trend towards disintermediation and the rise of foreign competition. This early research greatly implies the impacts of disintermediation upon the banks functioning in giving out loans. Although there are still limited studies about the credit crunch, Buch & Golder (2000) and Khan et al. (2019) research create a clear overall picture 7

of how disintermediation leads to the fall in credit availability. However, it should be noted that the credit crunch here refers largely to the fall in physical issuance of loans by banks. Nowadays, credits can be obtained from many sources and not banks alone, one of which is decentralised autonomous organisations (DAOs) (see Part e below)

c. Structural change in banks As a result of disintermediation which largely reduces banks’ profit, existing banks have to change structures and behaviours so as to reduce risks and obtain higher profits (Khan et al. 2019). According to Berger et al. (2001), large banks become unwilling to lend funds to small firms because such companies are considered ‘informationally opaque’ and risky. This reduces credit expansion in the economy and these borrowers find it hard to obtain loans from the banks. In addition, Berger et al. (2001) also found that most banks modify their portfolio structure by purchasing and selling existing loans instead of providing new loans to less well-known borrowers. These banks would gain the advantage of lower risks and higher profits. Another finding in Khan et al. (2019) revealed that banks even take part in ‘credit risk’ trading using credit derivatives. By doing so, banks can pass on the credit risks to the 3 rd party while still retaining the legal title to the assets. Since 2000, the market of credit derivatives has grown tremendously as most banks are obsessed with low risks and high profits (Morrision 2005). Such a growth deepened further after the financial crisis and the trend towards disintermediation seemed to support such a market. It is reasonably so because traditionally, banks reduce credit risks by diversifying portfolios (as explained in Section 3.1). Nowadays, with disintermediation which causes many customers to turn away from banks, these financial institutions face difficulty creating a well-diversified portfolio to enjoy low risks (Minton et al. 2006). Therefore, banks have to utilise credit risk trading based on their current limited and risky loans. This contributes to the rise of credit derivatives market. With this, however, Morrison (2005) found that banks become willing to take more risks, which is contradicted to their initial purposes. It seems ironical that banks take advantage of credit derivatives to hedge themselves against risks and yet, the use of such instruments entice banks to take more risks. This is supported by Instefjord (2005) who found substantial empirical evidence regarding the downsides of credit derivatives. The author pointed out that such derivatives make the acquisition of further risks more 8

attractive to banks, which may destabilise the banking system. When banks are taking more risks, there is a growing concern regarding how much risks can be diverted away and how much still retains with the banks. Therefore, it is obvious that the behaviour of banks is influenced by the rise of credit derivatives market. Another structural change happening is that banks also raise their capital requirements to reduce risks. Martynova (2015) found that disintermediation generates low profitability ...