This essay tries to highlight the contributions made to the theory of financial intermediation by Benston and Smith in 1976. Regarding the theory, there is one fundamental question among others, what is the main reason why financial intermediaries exist? In 1976 there was no clear consensus about the specific role of financial intermediaries and many different approaches existed on the issue how to analyze them in an appropriate way. The primary goal of the authors is to develop a proper framework for the analysis by setting the main focus on transaction costs. Therefore, they take a look at four different aspects: the demand for financial commodities, the production, their pricing altogether with the pricing of additional services and the influence of governmental regulation on financial intermediaries.
They start their survey from a contrary point as the other authors did in recent history by defining financial intermediaries as firms which create specialized financial commodities. On the supposition that the individuals’ earnings over time do not enable the achievement of the desired inter-temporal consumption pattern, demand for financial commodities arises. In this case assets held by the consumers serve as a possibility to rearrange their intra- and intertemporal consumption pattern for maximizing their utility. This leads to two key facts. First, utility is based on consumption at different points in time and second, transaction costs occur by acquiring financial commodities. Accordingly, financial intermediaries are able to facilitate intra- and inter-temporal consumption decisions due to a reduction of transaction costs. In this context reduction of transaction costs is seen as their central task. Concerning the inter- and intra-temporal demand for consumption it is necessary to take a look at the capital asset pricing model (CAPM), which gives a description of how to build a portfolio of risky and riskless assets that allows a consumer to maximize his utility. The CAPM meets most of the requirements needed for an appropriate analytical framework. According to the authors the CAPM can be expanded by transaction costs. The intra-temporal demand for financial commodities is mainly driven by the consumers’ wish to hold assets which can be traded for consumption goods with the lowest possible transaction costs. The mentioned facts allow the conclusion that there are two major characteristics concerning the connection between transaction costs and the demand for financial commodities. On the one hand financial intermediaries provide full investment opportunities to consumers. On the other hand they try to fulfill the consumers’ demand for temporally coordinated consumption by offering financial commodities which can be used to purchase goods or services at any amount, at any time and at minimal transaction costs.
Within the second aspect the authors focus mainly on three points – the price, the costs and specialization and diversification. The price is seen as a function of the total amount of accumulated production costs. Thereby, the price can be divided into three parts consisting of a part depending on the riskless rate, a risk premium and a part which compensates the producer’s costs for administration, monitoring and processing. The precise consideration of the production costs makes a large contribution to the answer of the question raised in the first part. The authors identify three sources of comparative advantages. These are namely economies of scale due to an increasing specialization, they gather information at lower costs and they are able to reduce search-related transaction costs. Through specialization and diversification there are further advantages. Economies of scale may arise on both sides.
Additionally on the side of diversification a decreasing probability of bankruptcy may be observable. But it is important to weigh up whether the benefits from diversification are larger than the cost of less specialization.

1

The last two aspects pricing and governmental regulation are closely connected. In this context the authors state that given an efficient market without governmental regulations financial intermediaries would unbundle their charges. But since governmental regulations exist an overview is given considering only the effect on the action of the financial intermediaries. They are divided into four groups: licensing, price control, credit allocation and supervision. In general governmental regulations are not beneficial but there are two exceptions examination and deposit insurance seem to reduce transaction costs.
As a conclusion Benston and Smith pave the way for further analysis within the theory of financial intermediation with their contribution made to the theory. Furthermore, a connection between their research and the current discussion about the failure of supervising financial intermediaries could be easily established. This reinforces the significance of their paper.

References:
George J. Benston and Clifford W. Smith, Jr. (1976): A transaction cost approach to the theory of financial intermediation, in: The Journal of Finance, Vol. 31, No. 2, pp. 215-231.