Contemporaty Financial intermediaries CH1

CHAPTER

u

1

Basic Concepts

‘‘Practical men, who believe themselves to be quite exempt from any intellectual inXuences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.’’
John Maynard Keynes: The General Theory of Employment,
Interest and Money, 1947

Introduction
The modern theory of Wnancial intermediation is based on concepts developed in
Wnancial economics. These concepts are used liberally throughout the book, so it is important to understand them well. It may not be obvious at the outset why a particular concept is needed to understand banking. For example, some may question the relevance of ‘‘market completeness’’ to commercial banking. Yet, this seemingly abstract concept is central to understanding Wnancial innovation, securitization, and the oV-balance sheet activities of banks. Many other concepts such as riskless arbitrage, options, market eYciency, and informational asymmetry have long shaped other subWelds of Wnance and are transparently of great signiWcance for a study of banking. We have thus chosen to consolidate these concepts in this chapter, to provide easy reference for those who may be unfamiliar with them.

Risk Preferences
To understand the economic behavior of individuals, it is convenient to think of an individual as being described by a utility function that summarizes preferences over

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diVerent outcomes. For a wealth level W, let U(W ) represent the individual’s utility of that wealth. It is reasonable to suppose that this individual always prefers more wealth to less. This is called ‘‘nonsatiation’’ and can be expressed as U0 (W) > 0, where the prime denotes a mathematical derivative. That is, at the margin, an

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