[CROSSTALK]. So when I say other intermediaries there are 2 that are most significant quantitatively in the US, okay. Pension funds and insurance companies. Okay, so this is about inter-mediation. If you look at the balance sheet of a pension fund okay. What it, and, and you can, I have links in the lecture notes to the full funds and you can see these, these links. but here it's the conceptual stuff that's important. You'll see they have these pension liabilities which is the promised pension benefits here. Typical pension funds in 1960 were defined benefit plans so they were promises to pay workers some fraction of their final income. So there's, they're a long term promise and for the rest of your life it's like an annuity. So pension benefit promises. Okay. And to, and to hedge those liabilities okay, they tended to buy long term assets, in particular equities. Pension funds were a big holder of equities. Insurance companies, okay, have these sort of contingent liabilities, you know, these insurance policies. You know, if your house burns down, I promise to pay you, if you die, I promise to pay your spouse, you know those sorts of things. Insurance policies on this, on, on as, as contingent liabilities here. And as assets they, they tend to be big holders of bonds. Okay. These are intermediaries. Between who? Well, who are the benefit. These are households, who are, who are on the other side there, right? Pension benefit promises are promises to households. And here equities, okay, these are liabilities of some business somewhere, okay. This pension is stand, this pension fund is standing in between businesses and households. Just like Badget's bank, that we were showing Same with the insurance company these bonds are issued by some corporation somewhere. Okay. And these insurance policies are to the benefit of some household somewhere fire insurance and so forth. So they're intermediaries also. Not like banks. This isn't money. These are insurance policies right. These, this is pen, pension benefits but they're intermediaries. And they were getting much, very large. and they are very large today. Accumulating these kinds of assets here. Equities and bonds. So, they were very big in funding, American development. They became very big in funding development, more so than banks. Okay. So that the importance of banks The [UNKNOWN] during 1918 became relatively less important later on because of these other intermediaries that are doing this. [UNKNOWN] and Shaw are emphasizing in these chapters, circa 1960. The importance of intermediation of this kind, and also the banking kind, for economic development in the United States and why are they, why are they, what are they emphasizing? They're saying, the problem that these institutions are solving, is the following problem okay? That the kinds of assets that household want to hold They way they want to hold their wealth, okay, is different than the kind of liabilities that businesses want to issue. You know, businesses want to borrow for a long time, households want to hold money. Okay. How, how are we going to, how are we going to have any development like that? If the businesses need to borrow for a long time in order to fin, finance the, the capital development of the nation. And households really insist on liquidity, how are we ever going to ever finance the capital development on the nation? bingo, let's have an intermediary that faces both ways. It says to households " I'll give you what you want." Okay. You want monetary liabilities, I'll be a bank. I'll have deposits." and face business and give them what they want. Okay, you want ten year loans? I'll give you ten year loans. You know, okay. And similarly here. Households want insurance, okay. Households want pensions, fine. Lets give them what they want. Businesses want to issue bonds. Businesses want to issue equities. Fine, we'll give them what they want. So the image, the vision in Gurly and Shaw is that this indirect finance. Is key for economic development, because otherwise, it, it, otherwise, otherwise, this disjuncture between the desires of households and the desires of businesses, could get in the way. Could get in the way. If, if businesses had to issue bonds directly to households, they couldn't sell them. The, the households wouldn't want to buy them. This is what they're thinking circa 1960. They don't have so much of a liquidity problem. So, the question is about the liquidity problems of, of, of pension funds and insurance companies. these policies, have actuarial quality to them. That's the idea that That not everyone's house is going to burn down at the same time. and these bonds are, you can sell these bonds in market liquidity, right, if, if you need to. So if there's a hurricane, okay, and you need, and a lot of these, a lot of these contingent liabilities come, come into the money, okay. Then you have to sell some bonds in order to pay off the insurance policies. So that, that the liquidity of insurance companies depends on the liquidity of bond markets. To be able to sell them. And here, the same is sort of true of equities, but you're thinking about the equities a, typically, they're investing in equities up until the point at which the pension actually the person retires. And whenever they retire, they convert some of these equities into, into bonds. Basically, they created annuity. So annuities. And they, they run this through an insurance company, typically. So that they'll turn it into, into bonds, essentially. An annuity is sort of like, it's natural to fund an annuity with bonds, because of the coupons are, are like the regular payments that you made to the annuitant here. but you know, it involves, again, market liquidity. If you couldn't sell these equities and convert them into bonds, you could never do anything. So, market liquidity is key. Shiftability is key. OK. For these intermediaries, just as it is for the banks. Okay, as [INAUDIBLE] had said. With whom by the way, became president of the Brookings Institution. So, I think this is one of the reasons that Brookings hired Gurly and Shaw there is this continuation of this American tradition of thinking about banking throughout the twentieth century. This way of thinking. Okay, the indirect finance works. Solves the problem of development because it gives both side what they want and you stand in the middle. This way of thinking is, it comes, it has one problem to it okay. or, one big problem. with lots of little symptoms of that, but the big problem is this. That the risk, okay, of your assets doesn't go away just because you promise somebody some other kind of liability. Somebody has to bear the risk. It doesn't go away. It either goes on to your liabilities, or if there's some guarantee of your liabilities, the person who guarantees those liabilities is the one taking the risk, that would be the government, okay, typically. and and if you don't appreciate this, finance and arbitrage will make you appreciate this. Okay. Because you will, you will be mispricing things. You will be imaging that somehow you can guarentee benefits, okay, even if you have risky assets here. That's not actually possible. If you have risky assets here then there's risk that you're not going to be able to pay these benefits okay and either that risk is shouldered by the sponsor of the pension funds, some particular corporation somewhere often these were corporate pensions or the government through the pension benefit guarantee corporation or by the pension benefits, beneficiaries themselves. That these promises are made, and then they're not kept, okay. That's, that's, that's bearing the risk. So, the risk doesn't go away, just because you, you don't tell these people what their pension benefits are being backed by. Okay.The risk is there. The evolution of inter-mediation in the United States since 1916 which you probably know about okay, has, has been to a hallowing out of this sort of indirect finance, and much more direct finance through mutual funds okay. So, we have stock mutual funds. Which hold equities, okay. Just like that. But instead of promising particular payments, okay, they just give you shares. Now if you have shares in Magellan and Fidelity. Okay? you have a share in a portfolio of assets. You have those assets do well. You, you benefit and if they don't do well, you don't benefit. So you're bearing the risk directly. The risks pass right through. That's what a mutual fund is, it passes right through. This is like direct finance. Even though this is sort of an intermediary in the sense that there's businesses on this side, and they're going to tell us what's on that side, okay. There's no actual risk shifting or anything. The risk is just passing right through. And similarly, bond mutual funds. Bond mutual funds. Which hold bonds. And issue shares in that portfolio of bonds, okay. This deve-, this development had big influence on determining these prices. And therefore the the profitability of this kind of, this kind of thing, as you know, patient funds no longer typically offer some fraction of your last income. What they give you is, is, is a 401K, which is basically that, okay. If you have a, a defined contribution pension plan, this is what you have. Okay, you are, you are realizing the risk. You see the risk. You see how many shares you have in Magellan. How many shares you have in, in Kinko's bond fund, or something like this, just to name 2 of the largest companies. This is not investment advice, okay? Thank you. The rise of finance, the rise of finance as a, as a set of ideas. Okay, is been about the replacement of that system with this system. Indirect finance with direct finance. Intermediaries that promise different things to different people, with mutual funds that promise the same thing to both sides, okay. It indirect demands is solving mismatches with quantities. Right, by, by putting them on as this balance sheet. By expanding their balance sheet. Mismatches and what, what lenders want and what borrowers want, it's solving with its own balance sheet. Modern finance solves it with prices. Okay. You don't want to hold bonds? Well, bonds will just have to fall in price until you do want to hold bonds, okay. You don't want to hold equities? We'll, equities will just have to fall in price until you want to hold equities, okay. So in the modern financial system, price is doing a lot more work, okay, then it used to in 196 Prices doing a lot more work. That's why we're, everyone is focusing on what happens to the stock market, whenever, whenever, some little blip happens. I'm giving you this so you're now ready to think about banks as intermediaries and the evolution from traditional banking to shadow banking as being just like this evolution from inter-mediation to, to this kind of direct finance here. The same thing that happened in capital market, okay, has happened in banking and in, and money market. And shadow banking is, is, is really, is really the, the natural evolution, the natural next step. In that, in that, instutional evolution.
