Financial Intermediation and Shadow Banking: Information and Liquidity Functions

Abstract

Financial intermediaries—banks, insurance companies, money market funds, hedge funds, and other entities that stand between ultimate savers and ultimate borrowers—perform essential economic functions: maturity transformation (borrowing short and lending long), liquidity provision, credit screening and monitoring, and risk transformation. Diamond and Dybvig’s (1983) foundational model in the Journal of Political Economy explained why demand deposits—contracts where banks promise full nominal repayment on demand—are simultaneously valuable (providing insurance against unpredictable liquidity needs) and inherently fragile (subject to self-fulfilling bank runs when depositors fear other depositors are withdrawing). Diamond’s (1984) delegated monitoring model explained why banks exist as information-producing intermediaries: costly state verification of borrower repayment makes bank lending more efficient than direct capital market finance when borrower information is private. The 2007–2009 financial crisis revealed that ‘shadow banking’—maturity transformation and credit intermediation outside the regulated banking system—had grown to create systemic vulnerabilities comparable to traditional bank fragility. This paper reviews financial intermediation theory, the shadow banking system’s growth and vulnerabilities, and the post-crisis regulatory response.