Measuring Financial Intermediation: A Model and Application to the Slovak Banking Sector

By Bod'a, Martin; Zimkova, Emilia | E+M Ekonomie a Management, July 2018 | Go to article overview

Measuring Financial Intermediation: A Model and Application to the Slovak Banking Sector


Bod'a, Martin, Zimkova, Emilia, E+M Ekonomie a Management


Introduction

Several factors may be earmarked as vital to smooth and successful working of a developed economy; and one of these factors is the financial system, which provides valuable services to the economy and its stability is always deemed imperative to the stability of the entire economy (e.g. Beck et al., 2014, p. 1-2). This laudatory statement is by no manner diminished by the fact that there is--at it happens--a scattered mosaic of opposing opinions to what extent a sound financial system is actually important to economic growth (Levine, 1997; Thiel, 2001). The key function of the financial system in an economy is "to channel savings to investment" (Thiel, 2001, p. 7), or--putting it differently--to connect agents with surplus funds to those who are in deficit, which are merely two different ways to describe the essence of financial intermediation. The definition is suggestive that financial intermediation should be assessed by comparing how surplus funds are matched against deficit needs. It is chiefly banks whose input to financial intermediation is traditionally most esteemed regardless of the fact that there are also other financial institutions such as insurance companies, asset management Arms or brokerage Arms acting as financial intermediaries. Hence, it is banks that the focus of this paper lies on.

Financial intermediaries, their reasons of existence or functions and behaviour have been explored deeply and debated in literature, and a number of models have been proposed to study their decision-making or behaviour (see e.g. Bhattacharya & Thakor, 1993; Freixas & Rochet, 2008). These models build on elements of microeconomic theory and attempt to inject a dose of rationality into the behaviour of different economic agents, shedding thus light on how they decide and how they time their decisions. Nonetheless, as these models answer different questions, they fail to describe the quality and success with which financial intermediation is accomplished. Following the definition of financial intermediation, the success of financial intermediation reposes in how successfully surplus funds are matched against deficit funds, or how well surplus funds are used to make up for deficit funds. To this end, usually simple ratio analysis is employed to assess financial intermediation, and this analysis in the case of banks relies on the loan-to-deposit ratio that relates the volume of deficit funds covered (in the numerator) and the volume of surplus funds collected (in the denominator). But this ratio, which is usually constructed on an annual basis, confronts the amount of loans made to the amount of deposits taken in a given year, which is the reason that it is merely a "positive" indicator. It misses several aspects of financial intermediation such as that there may be a mismatch in the quality of funds or maturities between the loans made and deposits taken, and says nothing about whether financial intermediation was performed at the most advantageous utilization of available resources in the production framework in which banks operate. The failure of the simple loan-to-deposit ratio to account for deviations from the most advantageous, yet attainable, relationship between loans and deposits incites interest of this paper.

In the absence of a methodology suitable for assessing the accomplishment with which commercial banks carry out their intermediation function, the goal of the paper is to explore possibilities of measuring financial intermediation. Centred on commercial banks and the banking part of a financial system, the paper proposes a simple framework for modelling and measuring the attainment in financial intermediation. The framework recognizes that commercial banks are economic agents that make free (yet perhaps regulated) decisions in the conditions of multi-input and multi-output production and captures these features of banking operations using the approach of Data Envelopment Analysis [DEA]. …

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