Financial crises are inevitable when finance is intermediated

Since retail savers have a strong preference for risk-free assets, financial intermediation is required to finance the economy. Financial intermediaries (banks, institutional investors) collect savings by issuing risk-free assets (bank deposits, life insurance contracts) and use these savings to finance risky investment projects. They therefore have risk-free liabilities and risky assets, which is at the root of financial crises: if financial intermediaries make losses on their assets, they cannot transfer them to their liabilities and therefore go bankrupt. To prevent such crises among financial intermediaries, regulations require them to hold buffers to absorb shocks to their assets: sizeable regulatory capital, reserves of liquid, risk-free assets. The art of regulating financial intermediaries consists in defining regulations that are sufficiently restrictive to prevent crises while not overly increasing the cost of financial intermediation. The only way to prevent financial crises would be if retail savers were willing to hold risky assets, in which case there would be no need for financial intermediaries. We illustrate these points with data from the euro zone.