A SYNTHESIS OF THE TRANSACTION COSTS THEORY OF FINANCIAL INTERMEDIATION (SEARCH MODELS, EXTERNAL FUNDS)

In the last twenty-five years, modern financial theory has made many contributions to financial economists understanding of the pricing of financial claims and the functioning of securities markets. However, one of the questions not yet answered by modern financial theory is what are the economic functions of financial intermediaries and service firms. In an era of deregulation and instability in financial markets, such an issue is of crucial importance to our ability to regulate and manage these institutions. In this dissertation we propose to formally examine in the context of a sequential search model the frequently encountered conjecture that the demand for intermediary services arises from the existence of transactions costs in financial markets. Our approach is to derive stopping rules for the non-financial firm which searches in a financial market for a lender who offers it funds, the financial input to its production process, at an acceptable rate. In attempting to acquire funds, the firm incurs direct search or location costs, the costs of entering into financial contracts, and waiting costs which represent profits lost or deferred because of the time search consumes. The search model allows us to focus on the trade-offs between the additional costs of procuring funds and the prospect of locating a lender who offers funds at a lower interest rate. The conditions under which an equilibrium can occur in a financial market characterized by costly search and contracting are explored.;In this context we introduce an intermediary market in which location and procurement services are produced by a monopolistic intermediary and purchased by the firms described above. The demand for these services is derived from the demand for funds when there are acquisition costs. We hypothesize three possible types of intermediaries; they differ according to whether or not they take a position in the funds market and when they initiate the search for lenders. The conditions under which each might separately exist are found to depend on the structure of the costs the intermediary incurs and the values firms attach to services like immediacy.