Financial Disintermediation

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.