Four Reasons Financial Intermediaries Fail

♪ [music] ♪ [Tyler] Modern economies rely
upon financial intermediaries to bridge the gap
between savers and borrowers. Much like our real bridges, it’s only when
the metaphorical bridges of financial intermediation crumble that we recognize
just how dependent we are on them. Many businesses rely on credit
to operate and to grow. So when the credit dries up, they go bankrupt
and lay off workers, or at the very least
they find it harder to keep on growing. Individuals rely on borrowing
to invest in education, housing, and to get their car fixed
so they can still get to work even if they don’t have
enough cash on hand to pay for needed repairs. When these bridges fail,
we can better appreciate how difficult it is to thrive in economically
underdeveloped countries. The woes we experience temporarily
during a crisis, well, they’re just a taste
of what is often a more permanent state of affairs
in many of the poorer nations. Most people in many poor countries
don’t have access to a system that gives them
a safe and cheap place to invest and grow their money. Nor do they have
an avenue to borrow money and invest in their businesses
at reasonable cost. That’s one reason why many
of these economies fail to grow. So why does financial intermediation
fail to get built well in many poorer countries? Why does intermediation
sometimes get built and then crumble? Like the rest of the economy, a strong financial system
relies on good institutions. There are four primary reasons why financial intermediation
might fail: insecure property rights,
controls on interest rates, politicized lending, and finally,
runs, panics and scandals. First up is —
insecure property rights. When you deposit
your money in a bank, you expect to be able
to take your money out. That seems pretty straightforward. But it’s not always the case. For example in Cyprus, government authorities
confiscated some bank deposits during the financial crisis of 2013
in order to try to alleviate their massive
government budget shortfall. In Argentina and Brazil,
deposits have been frozen so that they
could not be withdrawn. Some of those banks
eventually went under and depositors never really
recovered their money. This can happen
in stock markets as well. The Russian government
confiscated or restricted the value of share holdings
in Yukos, a private energy company. In all of these examples, insecure property rights
scare savings away and that causes
intermediation to fail, leaving borrowers
without access to lending. Intermediation can also break down
in less dramatic ways. Many places, for instance,
have laws in place to limit the interest rate that someone
can be charged for a loan. These are called usury laws. You might think it’s outrageous
to pay 20% or more in interest on a loan. I’ve seen loans for 50, 100%. Is that always bad? Well, it’s not quite so simple. If an interest rate is just
the price of borrowing, then what’s a legal limit
on that price? A price ceiling. And we know from economics, price ceilings typically
don’t work well. In other videos, we’ve covered how price ceilings
on gasoline in the 1970s caused massive shortages
and very long lines at gas stations. Likewise, usury laws
force an interest rate to be below
the equilibrium interest rate. And that’s going to mean
there will be more borrowers who want to borrow
at that controlled rate than there will be lenders
willing to lend. This means a funds shortage, and a drop
in the overall quantity of lending. So, usury laws typically
hamper the flow of money over the bridge
and prevent exchange between willing savers
and borrowers. We talked previously about
how banks play an important role in assessing risk and lending funds to those who can
pay the money back. Of course, many banks do
make a fair number of bad loans, but over time
competition drives the banks who are worse at lending
out of business, while the banks who are better
at assessing credit risk — they are more profitable
and they grow. However,
this isn’t always the case. We’ve previously labeled Japan
as an economic growth miracle, as the country
exploded in prosperity in the second half
of the 20th century. However, more recent times
haven’t been so dynamic. With Japan experiencing
the famous “Lost Decade” from 1990 to 2000, where their economy
barely grew at all. To some extent, the stagnation
has unfortunately continued. Part of the problem in Japan
was due to the failure of their financial intermediaries. There were banks in Japan
that were insolvent — in essence dead, — but they were propped up
by the government, turning them into zombie banks. Now, propping up these zombies
disabled the competitive process that over time moves resources
and funds to the better banks who are better able
to evaluate, risk, and lend, and thus it kept funds away from the better
and more profitable companies with the brighter futures. That’s what zombies will get you. Government involvement in banks, whether through bailouts
or direct ownership or intervention — it also tends to lead to money
being lent to those who are politically connected. So rather than scanning
the landscape for loan candidates based on economic merit, bank managers tend to direct money
based on political connections. We can see this failure
of intermediation in the data. The larger the fraction
of government ownership of banks, the worse a country does in terms
of both growth of GDP per capita, and growth in productivity. Trust is a vital part
of the financial system as well. Banks maintain fractional reserves, meaning that they don’t have
enough cash on hand to give every depositor
his or her money back if they all were to come
and wish to withdraw the money within a short period of time. If depositors lose trust
in banks’ ability to give them back their money, they’ll rush to the bank
to pull out their deposits, causing what is called a bank run. A bank run can cause banks
to fail or suspend operations, which in turn leads
to a rash of business failures due to a credit crunch. Bank runs were seen
in the American Great Depression, and they were one
of the primary reasons almost half of the banks failed
during that time. In response,
the U.S. government created the Federal Deposit
Insurance Corporation, or FDIC, to try and prevent
further bank runs. The FDIC ensures that depositors
can get their money back, even if their bank fails. We’ll talk more
about the Great Depression in our section on business cycles. Trust issues
are not limited to banks. Scandals such as those connected
to Enron, WorldCom, and Bernie Madoff
shook the trust of investors when they happened. If investors think that
most managers are mainly looking to rip them off rather than build
long term capital growth, that will scare investors away. So we’ve covered four
common causes of failure in financial intermediation. Which of these came up
in the Great Recession of 2008? That’s the topic
we’ll turn to next. [Narrator] If you want
to test yourself, click “Practice Questions.” Or, if you’re ready to move on, you can click,
“Go to the Next Video.” You can also visit to see our entire library
of videos and resources. ♪ [music] ♪

17 Replies to “Four Reasons Financial Intermediaries Fail”

  1. There is a fifth reason why intermediation (if not intermediaries themselves) fails. Iatrogenic disease.
    That's when regulation grows beyond necessity, as when politicians seek to use the financial system for social engineering.
    When constraints exceed free variables, we have over-determined equations. This situation guarantees contradictions and therefore arbitrage opportunities.
    Today in the US, the financial sector is bigger than optimal. A simple example. Corporate income tax treats debt and equity inconsistently. So bankers find it more profitable to arb the definitions (high yield or trust preferreds anyone?) rather than do the hard work of finding and managing credit opportunities.
    Same thing with trading. Finance is the handmaiden of commerce and industry. Investors need the opportunity to get out of investments (liquidity) while issuers/borrowers need committed capital to function. Investment banks manage this difference in preferences by finding substitute investors for those who wish to get out; the investor doesn't know or really care if investors swap places. That's the after-issuance service of trading that investment banks typically provide issuers. That service merits a profit margin both for the service and costs of inventory and capital.
    But today, trading is a profit center in its own right and the banks seek to extract further margins from both investors and issuers. Hence the rise of high frequency trading, where banks intrude between buyers and sellers and scrape off a small but nearly riskless skim, in great numbers so that small nips add up.
    Here's an interesting take on the idea we waste too much human capital on such unproductive uses:

  2. India has around 19 banks in which the government has a majority stake, yet the country is among the fastest growing economies. Can you explain this anomaly ?

  3. Please do a video on the lost decade of Japan instead of leaving a footnote.

    Also, Paul Krugman claimed that the Great Recession of USA was very much like Japan's lost decade, but the reason Japan had a lost decade instead of getting back on its feet was that they failed to recapitalized their banking system, a mistake that USA didn't do and made the bank bailout. One problem I have is that this video about zombie banks is very logical but Krugman's suggestion that the bank bailout in 2008 was useful also sounds logical. But that would imply Japan should have propped up the banks so that their counter parties and depositors don't lose. I can't figure out which is right.

  4. How you have the audcity to call yourself university when you are teaching total crap.
    There are so many errors with thus presentation it is not possible to covet in a comments section.

    You are still teaching the common and debunked concept that banks act as intermediaries, they do not.
    They do not need savers money to make loans.

    Banks attract savers money only for liquidity puroposes

    Moreover, when you give your money to a bank it ceases to be your money. You have lent your money to the bank and you become a creditor to that bank.

    When a bank lends money it creates that money , out of nothing, buy issuing a security ( basicaly an IOU from the borrower) They are not lending their or your money. They like to perptuate this myth of being an intermediary so as to justify the chargiging of ineterst on a loan.

    To claim that usuary is good and that there should be no cap on interest charged on this created money makes me suspect that you and your organization is just a PR front for the commercial bank ineterest.

    With reference to Japans situtaion I suggest you read or watch Dr Richard Werners "Princess of Yen" for the truth of how the Japans economy was manipulated into a finacial bubble so as to bring about structual change to Japans banking sector and bring it into line with US and western neo liberalism


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