1. Financial intermediaries
Financial intermediation serves to match supply of and demand for financial funds in a wide range of economic relations especially between private households and commercial entities. Financial intermediaries in the narrow sense are predominantly banks (European banking market). Additionally, the term encompasses insurance companies (internal market (insurance)), capital investment companies, other comprehensive financial service providers as well as stock exchanges. In the broader sense, all institutions supporting the congruence of supply and demand in financial markets may be called financial intermediaries.
2. Purpose and concept of financial intermediation
Financial intermediaries in the narrow sense essentially serve three purposes. First, they serve a transformation function in that they transform assets or liabilities into different assets or liabilities. Private households taken together generate a surplus of capital and, therefore, supply most of the deposits while businesses usually demand capital through credit facilities. Banks channel financial funds between a large number of suppliers and consumers. This enables them to compensate for differences in capacity (batch size), time periods (maturity), availability of capital (liquidity) and security needs (risks).
The second purpose of financial intermediaries is transaction handling. This is the technical juxtaposition of supply and demand as it is practised by stock exchanges and, to an increasing extent, by alternative trading systems. Beyond that, banks provide services regarding the initiation, closing and execution of transactions. They apply standardized and therefore cost-efficient procedures.
The third purpose relates to information intermediation, ie the routing of information between issuers and investors. Such services are partly offered by information intermediaries in the narrow sense. To a larger extent they are covered by specialized information intermediaries. Generally, the purpose of information intermediation is to facilitate transactions. To that end the services of information intermediaries augment the information efficiency of the financial market. Information intermediaries verify available information, evaluate it in line with macroeconomic developments and supply missing information. The most important specialized information intermediaries of financial markets are auditors, financial analysts and rating agencies.
The existence of financial intermediaries can be explained by transaction costs economics and the principal-agent theory (economic analysis of European private law). These explanations have originally been applied to banks but are applicable to other financial intermediaries as well. Transaction cost economics is based on the realistic assumption that the conclusion of a contract itself generates costs (transaction costs). Financial intermediaries help to lower these costs by combining the interests of a great number of capital suppliers or investors and, therefore, in turn lowering the number of necessary contracts. Product quality is of great importance to consumers (consumers and consumer protection law). Financial products exhibit strong characteristics of credence goods. Unlike experience goods their relative ability to fulfil individual needs cannot be evaluated by one’s own experience (consumption). This is true, for example, for private pensions (pension funds). Through their specialized knowledge, financial intermediaries are able to overcome these information inabilities of capital takers at a reasonable cost.
The basis of the principal-agent theory is the assumption that the capital provider (principal) ceases to supervise the capital taker (agent) after conclusion of the contract. This leads to an information asymmetry, which may be exploited by the agent to keep possible profits for himself, sometimes in breach of contract. One example of such a relationship can be found between creditors and debtors. It will be unreasonably costly for a single, non-commercial creditor to implement viable supervision mechanisms. Additionally, his measures would benefit other creditors without reimbursement (free rider problem). Finally, the association with other creditors is ill-advised as it will give rise to substantial coordination costs. Therefore, a rational disinterest of investors (rational control apathy) facilitates their exploitation by opportunistic issuers.
Financial intermediaries provide a viable supervising mechanism. Banks, for example, undertake internal examination of the creditworthiness or earnings expectations of a potential debtor. Stock exchanges may trigger issuer competitions on product quality through market segmentation and specific admission requirements. Information intermediaries like auditors, financial analysts and rating agencies strengthen the information of investors and of the market as a whole. Altogether, financial intermediation promotes an efficient allocation of financial liquidity among worthy capital takers and hence supports the attainment of welfare gains.
The antonym to financial intermediation is disintermediation. This term describes the detachment of the aforementioned tasks traditionally conducted by financial intermediaries and the shift to market transactions. Direct transactions between capital providers and takers are economically advisable if the service by an intermediary does not generate a surplus. Investments in publicly traded stocks or bonds are prime examples of this. However, the described characteristics of financial products make information intermediaries necessary here as well. The ratio between intermediation and disintermediation is subject to path-dependent factors of the economic environment. Especially with regard to private pensions for consumers in continental Europe or Japan, investing in capital markets continues to be less developed in comparison with the United Kingdom or the United States.
3. State of European legal harmonization
Harmonization of laws in Europe is highly advanced concerning the regulation of financial intermediaries. The concept of mutual recognition represents the paradigm of the process. The European passport for regulated financial services allows intermediaries authorized in one Member State to practise in any other Member State without an additional admission procedure. This form of mutual recognition leads to an extensive opening of national markets, and it is only possible because of a far-reaching coherence of legal provisions hardly found elsewhere in European business law.
The Financial Services Action Plan 1999 guided this process until 2005. It revolved around banks, other investment service providers and insurance companies. Its objective was the establishment of a European set of rules being able to react swiftly to new challenges through tight coordination of different supervisory bodies and to overcome the fragmentation of the financial markets in Europe. The Financial Services Action Plan envisaged protection of the integrity of financial intermediaries and it consolidated and expanded applicable provisions. The core of the ensuing policy has been shaped by two directives which relate to the taking up and pursuit of the business of credit institutions (Dirs 2006/48 and 2006/49). Together with the directives on deposit-guarantee schemes (Dir 94/19) and on investor-compensation schemes (Dir 97/9), which aim at countering losses caused by insolvency of financial intermediaries, they provide a comprehensive protection scheme covering weaknesses of capitalization of financial intermediaries.
A further regulatory focus is the conduct of financial intermediaries in the market. The first of two legal instruments of special importance is Dir 2003/6 on market abuse. It supersedes Dir 89/592 on insider trading and introduces a unitary approach for all forms of market abuse. In this sense market abuse covers taking advantage of information which has not been made public for one’s own advantage or the advantage of a third person (insider dealing). Market abuse may also result from influencing the supply of, demand for or price of financial instruments or disseminating false or misleading information. The approach of the directive on market abuse is comprehensive through the combination of the prohibition of certain activities with criminal and administrative law penalties. This applies both to regulated and unregulated markets for financial instruments.
The second legal instrument is the Markets in Financial Instruments Directive (MiFID) of 2004 (Dir 2004/39). The MiFID resembles a constitution for capital markets. It replaces the Directive on Investment Services in the Securities Field (Dir 93/22) and introduces the European passport in general. Furthermore, it provides rules for the execution of investor transactions in stock markets, other trading systems and investment firms. In particular, financial intermediaries have to choose the execution venue delivering the best outcome regarding cost, probability and speed of the transaction (best execution). The adherence to these and other MiFID rules has to be documented and proved to the supervision authority. The client must be informed about benefits the financial intermediary receives from the issuer for his services (inducement fees or kick-backs). Further, it is a true innovation that the MiFID differentiates between consumer contracts and transactions executed with ‘eligible counterparties’ where the parties do not have to adhere to individual obligations. The MiFID also includes financial intermediaries in the broader sense. It specifically addresses financial analysts and obliges them to adhere to a strict set of rules with regard to conflicts of interest.
4. Regulatory structure and issues
The all-embracing principle of the regulation of financial markets is the inseparable connection between the protection of market operation as a whole and that of individual investors. Financial markets depend to a considerable extent on the amount of trust of the investing community (investor protection). Both in theory and practice the definition of duties and responsibilities of financial intermediaries is of the utmost importance. Financial intermediaries in a narrow sense heavily influence the market entrance of capital providers and takers through their screening of the debtors, marketing of selected financial instruments or the handling of the issuing of financial products. The analysis and statements of information intermediaries are de facto decisive for public opinion on issuers of financial instruments. In case of a negative evaluation of reliability, the cost of capital will rise or using the market for raising capital might even be rendered impossible.
This influence has been described as a ‘gatekeeper responsibility’ by US scholars as early as in the 1980s. Financial intermediaries may, by granting or denying their professional services, open or close the gate to the market for individual issuers of financial instruments. Congruent to that observation, they might be assigned obligations functionally equivalent to the tasks of supervisory authorities. In most continental European Member States, including Germany, the gatekeeper theory has not yet been paid much visible attention by scholars. In principle, however, the basic insights can be found in the widely harmonized European rules on auditors. The annual financial statements of issuers are subject to an auditing obligation. The statutory auditor is a private third party but acts in the public interest. The audit statement can be qualified, ie it can also include comments on weaknesses of the companies’ financial reporting. Through including or not including such qualifications the auditor can influence the public opinion and credit credentials of the issuer. Rating agencies and financial analysts play similar roles. Therefore one might ask whether their position should be regulated accordingly by the legislature.
A deeper understanding of the role of financial intermediaries is additionally advisable with regards to the corporate governance of listed companies. In continental Europe banks traditionally have greater influence on directors’ and officers’ decisions than in the United States or the United Kingdom. In Germany, in particular, bank representatives frequently served as members of the supervisory boards of companies. The inherent conflicts of interests and accountability issues resulting from these conflicts have led to a reversion of that trend. This was accompanied by a reduction of equity contributions by banks. The return of the banks to their core business caused a paradigm change regarding corporate governance. Indirectly this has led to a rise in importance of financial intermediaries in the broader sense, as their information services can hardly be overestimated with regards to the ever more important market-side supervision of issuers of financial products.
5. Prospects of harmonization
Harmonization in respect of financial intermediaries has become an increasingly vital target since the breakdown of the US investment bank Lehman Brothers in 2008 which is commonly understood to have been the trigger of the recent financial crisis. Whilst the general regulatory policy continues to track the key objectives of the Financial Services Action Plan 1999, the financial market crisis has alerted regulators to focus on specific dangers for operative financial intermediation. In its communication of June 2010 (COM 301 final) the European Commission announced that it will move ahead on the basis of the findings by the High-Level Group on Financial Supervision of 2009 (de Larosière Report). Legislation is envisaged especially in regard to the regulatory capital of financial institutions, the treatment of systemic risks (too big to fail problem), liquidity interventions by the state (lender of last resort problem) and, more generally, cross-border issues regarding the insolvency of internationally operating financial institutions.
The global presence of the European internal market points especially to a strengthening of the transatlantic dialogue. Events on international capital markets are widely dominated or influenced by the financial market of the United States. Additionally, the swift economic growth in Asia, especially China, suggests a further development of Europe-Asia relations which should complement solid relations with Japan. Asserting a resonant European voice in a globally influenced field therefore remains a paramount concern.
Last but not least, against this background one of the core questions of the European integration of financial markets revolves around a unitary supervisory authority for financial services. A clear answer is hardly possible due to the differences in the national financial markets. One basic difference relates to the functioning and effectiveness of self-regulation. Within the confined City of London codes of conduct (private rule-making and codes of conduct) have led to great successes especially in the field of takeover law. In other Member States like Germany, such successes could not be replicated—at least not in the same way. According to a 2005 White Paper of the European Commission this requires prioritizing on the improvement of information exchange between supervising authorities and the coordination of their measures.
The International Organization of Securities Commissions (IOSCO) is a main initiator of legal harmonization and practical advances. It was formed in 1983 out of an internationally active organization founded nine years earlier. Numerous national supervisory authorities are represented in the IOSCO today. It is the constant focus of the IOSCO to monitor and enhance internationally established trading practices (best practice) and to convert them into tangible measures ensuring lawful behaviour of financial intermediaries (compliance). A current example concerns the code of conduct for rating agencies which has recently been transformed into a regulation (Reg 2009/1060).
The law of financial intermediaries is heavily influenced by international practice. A current example concerns the handling of conflicts of interest in public security offerings. Financial intermediaries have to balance out the interest of the issuer in obtaining capital against the interest of the potential buyer in being subject to fair pricing. In addition, financial intermediaries are involved in the allotment of new securities and they have their own business interests in marketing the securities. Hence, a universal banking system as it is practised in Germany requires effective organizational measures for prevention and resolution of conflicts of interests. The separate banking system’s ability to avoid conflicts of interests by rendering creditor and debtor trading incompatible lost its most important representative with the abolishment of the US Glass-Steagall Act in 1999. The institutional separation of credit and investment banking, however, has become a discussion focus again in the aftermath of the ongoing financial crisis.
Since 2007, the IOSCO has recommended to refrain from handling public security offerings if the intermediary is creditor of the issuer and the loan may not be paid back without a successful outcome of the offering. In some legal systems—Germany is one of them—such a far-reaching obligation to refrain from business has not yet been laid down in law. Thus, attempts to harmonize the law of financial intermediaries at the international level can serve to intensify the integration of general European private law.
Douglas W Diamond, ‘Financial Intermediation and Delegated Monitoring’ (1984) 51 Review of Economic Studies 393; Reinier R Kraakman, ‘Gatekeepers’ (1986) 2 J L Econ & Org 53; Reinhard H Schmidt and Marcel Tyrell, ‘Information Theory and the Role of Intermediaries’ in Klaus J Hopt and others (eds), Corporate Governance in Context—Corporations, States and Markets in Europe, Japan, and the US (2005) 481; John C Coffee, Gatekeepers (2006); Guido Ferrarini and Eddy Wymeersch (eds), Investor Protection in Europe (2006); Niamh Moloney, EC Securities Regulation (2nd edn, 2008); Jochen Bigus and Patrick C Leyens, Einlagensicherung und Anlegerentschädigung (2008); Christoph Kumpan and Patrick C Leyens, ‘Conflicts of Interest of Financial Intermediaries’  ECFR 72; Jacques de Larosière, Report of the High-Level Group on Financial Supervision in the EU (2009); Martin Hellwig, ‘Systemic Risk in the Financial Sector: An Analysis of the Subprime-Mortgage Financial Crisis’ (2010) 157 De Economist 129.