This is “Competition Between Markets and Intermediaries”, section 2.7 from the book Finance, Banking, and Money (v. 2.0).
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Why do investors (savers) sometimes choose to invest in intermediaries rather than directly in financial markets? Why do borrowers sometimes choose to reduce their liquidity and capital constraints via intermediaries and sometimes via markets? Markets and intermediaries often fulfill the same needs, though in different ways. Borrowers/securities issuers typically choose the alternative with the lowest overall cost, while investors/savers choose to invest in the markets or intermediaries that provide them with the risk-return-liquidity trade-off that best suits them.
Return is how much an investor gets from owning an asset. It can be positive (yipee!) or negative (d’oh!). Risk is variability of return. A “risky” asset might pay off big or be a big loser. A “safe” asset will probably return something mundane and expected. Liquidity is the speed with which an asset can be sold at something close to its real market value. A highly “liquid” asset, like a Federal Reserve note, can be exchanged instantaneously at no cost. A “liquid” asset, like a Treasury bond, can be sold in a few minutes for a minimal fee. An “illiquid” asset, like a house in a depressed neighborhood, may take months or years to sell and cost several percent of its value to unload.
Risk is a bad thing, while return and liquidity are good things. Therefore, every saver wants to invest in riskless, easily saleable investments that generate high returns. Of course, such opportunities occur infrequently because investors bid up their prices, thus reducing their returns. (As we’ll see in another chapter, the higher the price of an investment, the lower its return, ceteris paribusAll else equal..) To keep returns high, some investors will be willing to give up some liquidity or to take on more risk. For example, they might buy securities not backed by collateral (assets like buildings, businesses, or safe financial instruments like T-bills that the borrower promises to forfeit in case of defaultNon- or partial payment of a loan, bond, or other payment obligation.). As a result of the competition between investors, and between borrowers, the financial system offers instruments with a wide variety of characteristics, ranging from highly liquid, very safe, but low-return T-bills and demand deposits, to medium-risk, medium-liquidity, medium-return mortgages, to risky but potentially lucrative and easily sold derivatives like put options and foreign exchange futures contracts.
Investors care about more than risk, return, and liquidity, but generally other considerations are secondary. For example, investors will pay more for investments with fixed redemption dates rather than ones that can be called (repaid) at the borrower’s option because fixed redemption dates reduce investors’ uncertainty. They will also sometimes pay a little more for instruments issued by environmentally or socially conscious companies and countries and less for those issued by dirty, rude ones.
In the fall of 2006, interest rates on conventional thirty-year home mortgages without a prepayment penalty (a fee charged to the borrower if he/she repays the principal early) were about 6.5 percent per year. But mortgages with otherwise identical terms that contained a prepayment penalty for the first seven years of the loan could be had for 6.25 percent per year. Why was that the case?
In addition to risk, return, and liquidity, investors are concerned about the uncertainty of repayment terms. They are willing to receive a lower return (ceteris paribus, of course) in exchange for a guarantee that a loan will not be repaid for a significant period of time.
As noted above, borrowers also compete with each other for the lowest cost methods of meeting their external financing needs. Obviously, borrowers want to pay as little for funds as possible and would like nothing better than to borrow huge sums forever, unconditionally, and at zero interest. Nobody wants to lend on those terms, though, so borrowers compete with each other for funds by offering investors higher returns, less risk, or more liquid instruments. They use whichever part of the financial system, markets or intermediaries, offers them the best deal. A company may sell commercial paper in the money market rather than obtain a bank loan, for example, if it is large enough and well-known enough to interest enough investors and market facilitators. A smaller, newer company, though, may find that a bank loan is much easier and cheaper to obtain.