Financial Intermediation: The Future Will Test What the Past Has Taught
Pearls of Wisdom from Dr Frank Fabozzi
Read the trascript from the Mahattva session with Dr. Frank Fabozzi. See the full video on our YouTube channel here.
Vinod Kothari
Good day, everyone, and today our guest is Dr. Frank Fabozzi. If you are in finance, I don’t need to introduce who Dr. Fabozzi is, because anyone who has studied finance would have gone through some of his books. If you are in the financial world, you would probably go through some of the institutions where he started. If you are in one of the leading financial players, you would have probably heard or benefited from his lectures or writings. Author of over 150 books. Over the last 60 years of teaching and writing history, Dr. Fabozzi is a leading, pioneering name in the world of finance, and today it’s sheer good luck that we have him. He has taught in leading institutions in the world, including the MIT, including City University of New York, including Yale University, plenty of academic institutions all over the world he has taught Dr. Fabozzi, it’s our indeed a great pleasure that despite your extremely busy schedule, you could find time to address us and our participants today. Dr. Fabozzi.
Dr Frank Fabozzi
Thank you for that kind introduction, I appreciate it.
Vinod Kothari
Okay. Dr. Fabozzi, the first that I have for you is quite generic, and I’m trying to talk or get some sense from you about financial intermediation in general. Now, you are a veteran, and you’ve seen the financial intermediaries evolve over the last, roughly about 60 years, and you’re, I mean, interacted and written with a lot of scholars all over this time. Could you tell us what are the key trends that you were able to identify, and going forward, how do you see these trends emerging? Dr Fabozzi.
Dr Frank Fabozzi
Well. I’ve been around, as you mentioned, in this market for 50 or 60 years, and, you know, if we’re talking about how financial intermediation or financial markets have changed over that period, I mean. I’ll give you some general information about it, but it’s very interesting. It’s hard to appreciate how the market has changed until you actually were involved in that market and saw how those innovations were important. But if we were looking at, like, thinking about several long-term trends that stand out over the last 50 to 60 years, I can think of, like, 3 themes that would help me think about how capital markets have changed. The first one is what we call the transformation from what is called “originate and hold” to “originate and distribute”. We’ll talk about that. Second, the impact of technology and data, and that’s often overlooked. And the growing inter-connectedness of the financial system.
So let me just take them one at a time.
First is, if we’ve seen a shift from bank-centered finance toward market-centered finance. So we know historically what a bank would have done. They’ve gathered deposits, they made loans, they largely held those loans on their balance sheet until maturity. Today, capital markets perform many functions that were once dominated by banks. For example, developments such as securitization, which you and I know very well, given a book on that area, syndicated lending, private credit. even ETFs and derivatives. They’ve expanded the role of markets in allocating capital, and managing risk. So the broader significance is really not what a lot of people think: the creation of new products. But it is a change in how financial intermediation is organized. The financial system has moved from, as I mentioned before, the originate and hold model, towards originate and distribute model, where origination, funding, risk-bearing, servicing, and distributions, can be performed by different specialized participants.
The second trend, I believe, is that information technology has fundamentally changed the economics of financial intermediation. Traditionally, banks possessed significant informational advantages because they knew their customers, and they knew their local markets better than anyone else. Credit decisions then, often relied on personal relationships, local knowledge, and accumulated experience. Today, we know there is a vast amount of financial, operational, and behavioral data that can be collated, analyzed, and transmitted almost instantly. Information that was once difficult to obtain and largely confined to local institutions has become far more accessible. As a result, this competitive advantage increasingly comes from the data, analytics, and technology, rather than proximity alone, or factors like understanding local markets. This has, if we think of the implications, lowered the information barriers, increased the competition, and enabled new entrants.
Vinod Kothari
New entrants, such as?
Dr Frank Fabozzi
FinTech companies, and firms that lend to private entities, and private credit in general. These all compete in an area that was once dominated by traditional banks.
And the third trend I see is regulation has played an important role in shaping the evolution of financial intermediation. You know, historically, after every major financial crisis, regulators get wiser.. They make sure that their regulated entities tighten up on their credit. improved liquidity, and they develop risk management requirements. So these reforms generally made the banking system safer and more resilient; but what they’ve also done is they’ve altered the economics of certain activities that go on in the financial markets. So as a result, some lending and risk-taking activities migrated to other parts of the financial system as a result. And the risk that disappears, that’s the important thing, we always think about, you know, these innovations as better handling of risk. But it’s the handling of risk, not risk disappearing. What we see is risk is now redistributed among the key participants in the financial market.
So, one of the enduring lessons of financial history is that regulation often brings changes where risk resides, who bears that risk, rather than eliminating the risk itself. So, looking ahead, here’s what I expect. Financial intermediation is going to become increasingly interconnected. The traditional boundaries between banks, asset management firms, technology firms, even the exchanges and data providers, are already becoming less distinct, and that trend is going to continue.
And at the same time, some of the things are unlikely to change, and this is important to emphasize. Finance is ultimately built on trust. Institutions can adopt new technology, business models, delivery channels, but still, they must earn the confidence of customers, investors, and markets. Those are the tools that’ll continue to continually evolve, but the core functions of finance: allocating capital, providing liquidity, managing risk – they fundamentally remain the same.
Vinod Kothari
Sir, thank you very much for the perspective, and you talked about three key trends which you say have changed the shape of financial intermediation over the years. You talked about, number one, the originate- to-distribute the model having taken over the originate- to-hold the model. And then you talked about the role of data technology. And then you talked about the increasing interconnectedness in the financial system. Extremely important, sir.
My second question flows from what you just mentioned; It’s actually an offshoot of what you just elaborated, and therefore comes naturally. You talked about the role of financial intermediaries from changing from the aggregated model: originating to hold, to continue to fund it, and continue to keep it, and to manage the risk of the lending transaction. And you’re saying that this is now getting kind of broken into several subcomponents. Now, does it mean the so-called concept of universal banking, where one bank does it all, is gradually giving way to more itemized or atomized functions, with each intermediary focusing on core competencies? There are some who do underwriting, some who do processing, there are some who do data keeping, there are some who do recoveries or risk management, and there are some who do funding. Do you see, therefore, that universal banking is going to be a thing of the past?
Dr Frank Fabozzi
Well I don’t know if it’s going to be a thing of the past. I do think the traditional concept of universal banks is under increasing pressure, although I don’t believe that they’ll disappear, and let me just explain why. Historically, if we think about it, universal banks offered all of the functions that you mentioned, [and it’s a little difficult for me to hear you, if you could put it a little louder, but I think I got what you said.] But, you know, you know, all of those things you mentioned, there were clear advantages to do that in one structure, because what can a bank do? A bank could share information internally, develop customer relationships, which could spill over to multiple products. and large balance sheets provided stability and funding capability. Now, let’s look at what has changed. Okay, first, technology dramatically lowered the cost of specialization. All those little things the banks did, today, different firms can excel at, for example, acquiring customers, credit assessment, payments, custody, investment management, servicing, data analytics. And they can all be done now by specialized firms. As a result, many activities that were bundled together in a universal bank can now be performed more efficiently by specialized providers. However, I don’t think that the coordinating function has disappeared. Financial services ultimately, and I’m coming back to this concept of depends on trust, accountability, and relationship management. Someone still needs to understand the customer, aggregate information across multiple activities, manage risk holistically, and provide a seamless experience. Those responsibilities become even more important as the underlying financial system becomes more fragmented, more participants. For that reason, I see universal banks evolving. Rather than disappearing. Their role’s likely to shift from being vertically integrated manufacturers of every financial product to becoming platforms that coordinate a network of specialized providers, and by platform, just to be clear, I mean an organization that brings together and coordinates multiple providers and customers through a common interface, rather than producing every service itself. The customer may continue to interact with a single institution, but what goes behind the scenes is : There are multiple firms that may be contributing different components to the overall service. For example, a wealth management client may receive investment advice through a brand, we see this bank brand platform, while portfolio management is provided by an asset management that could be a subsidiary to the bank. Securities are held by custodians. Trades are executed through external market makers and exchange. Risk analytics are supplied by specialized technology firms, and the underlying infrastructure operates on a third-party cloud computing platform. And similarly, if we look at the mortgage customer, they may deal exclusively with a bank, even though who all are actually involved ? Credit scoring by another entity. Property valuation. Nowadays we have these drive-by inspections in the United States. But you have specialized people who do that. You have fraud detection, documentation verification, then you have loan services. All provided by separate specialized providers. So, in this environment, the competitive advantage of universal banks will increasingly rely on their ability to integrate and oversee the specialized services. Well, from the customer’s perspective, they don’t see this. They just see one entity.
So, this evolution creates both opportunities and challenges. Specialization can improve efficiency. innovation and customer choice. At the same time, it makes risks harder to identify, because exposures are distributed across a network of institutions rather than concentrated on the balance sheet of just one entity. So understanding how these connections interact will become increasingly important, not only for market participants, but, really regulators also.
So I don’t think the concluding response here is whether universal banks will survive. The more important message is they adapt. My expectation is that the most successful institutions will be those that combine the trust, the balance sheet strength, and relationships of traditional banking with the flexibility of platform based business models. So in that sense, the universal banking of the future may look less like a financial conglomerate and more like an orchestrator of a financial ecosystem.
Vinod Kothari
Extremely wonderful comment, sir.
So, my next flows from the point that you mentioned some time back. Where you were talking about the evolution of the regulations focusing on risk management. And, given that, you also mentioned that, there is an increasing risk-based regulation by the financial regulators across the world. Now, we also see that there is a development which is very clearly visible, and for this, concerns have been expressed by the Financial Stability Board as well. The development of unregulated or less regulated financial intermediaries, which are not banks. For example, talk about private credit funds. Now, roughly about $1.5 to $2 trillion are sitting with private credit funds, which are non-banking financial intermediaries. They are not banks. They’re doing functions which are similar to banks. And at the same time, there is obviously no prudential regulation applicable to them. Do you see any concern in this development where non-banking financial bodies, such as private credit funds, accumulate a substantial extent of wealth. They do a function which is quite close to the traditional banks, and yet not be subjected to the banking regulations.
Dr Frank Fabozzi
We’re talking about the rise of non-financial intermediaries, NDFIs, and actually, I think it’s one of the most significant developments in modern finance. These entities include asset managers, private credit funds, hedge funds, money market funds, insurance companies, and other entities that perform important intermediation functions without operating as traditional banks, as you pointed out. But to me, their growth is just a natural evolution of the financial systems. They’ve expanded access to capital, they’ve created alternative funding channels. They’ve brought specialized expertise to different market segments, and they’ve increased competition. So, in many cases, they’ve helped make financial markets broader and more efficient. To me, the key is not whether they’re good or they’re bad. They’re now an essential part of the financial system. The more important, I think, is whether we fully understand the risks that they create, and how those risks interact with the broader financial system.
So, if I were to focus on three areas, the first would be leverage. It can be more difficult to identify and measure risk of leverage in parts of the non-banking system. In banks. Leverage is generally visible. We could look at the balance sheet, and report to regulators, and they’re subject to extensive regulatory oversight. Now, when we talk about non-bank institutions. Leverage may arise through taking it away. They can securitise. You have derivatives, you have repo financing, you have borrowing arrangements, or you have other structures, but they’re not as transparent as the risks that we see as we can identify in banks. So as a result, risk can build gradually and remain largely unnoticed on these non-bank institutions. Until market conditions deteriorate.
The second is liquidity risk, and that remains a significant concern. Some investment vehicles offer frequent liquidity while holding assets that may be difficult to sell and value, during periods of market distress. Under normal conditions, that mismatch may not be apparent. During periods of uncertainty, however, it can create pressure for asset sales, and I think, create market instability.
And third, the financial system has become interconnected, as I’ve emphasized, everything across the board. If I didn’t mention clearinghouses, we have that same thing. They’re all linked through funding arrangements, collateral relationships, all having shared risk exposure. As a result, risks that originated in one sector can rapidly spread to others. Financial shocks rarely remain confined to the institutions where they first appeared. And this is particularly concerning really in private markets.
We talk about private credit and private equity, and those are the two major areas in alternative investments that we’re concerned with. And they’re key, also, to the role of development of startup companies. I don’t view NBFIs as a source of weakness, nor do I view them as a substitute for traditional banking. They become permanent and important components of the financial ecosystem. The challenge for regulators, in my opinion, and not only regulators, but investors, is to focus less on where risks are located, and more on how leverage, liquidity pressures, and this interconnectedness can interact across the system. So, in the future, financial stability will depend not only on the resilience of individual institutions, but also on our ability to understand the networks that connect them.
Vinod Kothari
That’s an extremely important observation, and you mentioned, the three significant risks of private credit, or private equity for that matter, are leverage, liquidity, and interconnectedness. Would you also take opacity as one of the significant risks? Opacity because they are not governed by any specific reporting requirements, and they are not governed by any specific valuation requirements as well?
Dr Frank Fabozzi
Yes, I agree, yeah.
Vinod Kothari
So, that brings me to the fifth question relating to artificial intelligence, and the entire world today is talking about artificial intelligence. So far as financial intermediaries are concerned, it’s quite obvious that most of them are currently relying on AI, and I’m sure you would agree that going forward, they rely more on use of AI, either for decision making, and obviously for managing their business. Now, one of the risks which is quite commonly pointed out when you rely on artificial intelligence is that human thinking could be different. Every human mind can think differently, but artificial intelligence, ultimately, the way it’s structured, it might probably lead to or give the same answer in given situations. So hundreds of thousands of people thinking alike, or thinking exactly the same because all of them are relying on the AI tool, might result in a homogenized action. And therefore, there might probably be more volatility in the system because of reliance on AI. Is that a risk that you perceive, or do you see any other risk in the increasing dependence of the financial world on financial technology, including artificial intelligence? Sir.
Dr Frank Fabozzi
Well, it’s the first time someone asked me about AI, mostly when people say, well, I lost my job due to AI? But, that’s a different answer, and for this one, and I’ll have a different answer. I think the concern that you mentioned is very real, although perhaps not for the reasons that some people often assume. Most discussions about AI and finance focus on whether AI can make better predictions, improve efficiency, reduce costs. or process information faster than humans can. And those are important, but let’s look at it from a financial stability perspective. I think the more important issue is whether AI changes what you just mentioned, the diversity of decision-making within the financial system. Financial markets function best when the market when participants hold different views.
Every time someone says, oh, great minds think alike, I would say, no, great minds should think differently. Every transaction , think about this, every transaction that we see going on in the marketplace reflects some disagreement about value, risk, or future outcomes. Historically, that diversity emerged because of different investors, institutions, investment committees brought different experiences, incentives, and judgments to the decision-making. So, the concern to me is that widespread adoption of AI can unintentionally reduce that diversity. If a large number of institutions rely on similar models, data sources and training methods, and they may begin to reach conclusions at roughly the same time, the same conclusions, at the same time. In normal markets. That may improve efficiency. During periods of stress, however, it can amplify market movements, because many participants are reaching, or they’re reacting in the same direction simultaneously, based on what AI provides. So, in many ways, this is not an entirely new phenomenon. If we look at financial history, it contains numerous examples of institutions relying on similar risk models, credit ratings, or forecasting frameworks. So, one lesson from a past crisis is that a system can become fragile when too many participants make decisions based on the same assumptions. Even if each individual institution appears to be prudent when viewed in isolation.
If we go back and we tear apart the global financial crisis, we could see the assumptions that were made. Just a simple example. You know, people generating their models assuming, their risk models assuming, a normal distribution.
We’ve now learned a lot more about probability distributions of outcomes, particularly extreme events, but people did that only after the crisis.
So at the same time, I don’t believe that the solution is to reject AI. Not that you could really reject it; that’s an impossibility. But the real challenge to me is governance. I didn’t spend a lot of time talking about governance. Now with AI and a few other events, I see that as becoming increasingly important. Because as AI becomes more deeply embedded in financial institutions, it’s essential that the responsibility for a decision remains with human professionals. Models can provide insights, recommendations, but accountability cannot be delegated to a computer programmer. You can’t get it from algorithms. So, decisions that affect clients. portfolios and institutions, they require human oversight, something I think we’re not seeing. Not only human oversights, judgment, and the ability to consider factors that may not be captured by the data. The goal should be Judgment enhanced by AI rather than judgment by AI.
By the way, look at the World Cup, since I imagine you have a global audience here. There’s a human that’s coaching that team. They have all the data and all the statistics. If you ever looked at the accumulation of information, statistics, on every moment. On a court, you know, whether it’s a basketball court, a soccer field, or a base they have all the statistics they want. We still have a human coach managing those teams, or coaching those teams.
So, in fact, I think the greatest risk is not that AI makes mistakes, because we all make mistakes. The greater risk is that large institutions begin making the same mistake at the same time, because they’re relying on similar models and similar recommendations. A single bad decision: no problem. That’s manageable. But thousands of institutions making the same bad decision simultaneously has systemic consequences.
So I think, to wrap it up, I think about AI in terms of financial stability. The key is not simply whether a model is accurate. The more important question is whether widespread adoption of that model makes the financial system, to use the term you said earlier, more homogeneous. Efficiency is valuable, but resilience often comes from diversity.
Vinod Kothari
Fantastic comments. I think it’s extremely wonderful to hear your thoughts on this, that ultimately it’s human decision, human governance, which can mitigate the risk of the homogenized behavior that might result from reliance on artificial intelligence. Extremely valid comment.
Sir, I cannot resist the temptation but to ask you about this book that we wrote immediately after the global financial crisis. [Shows Introduction to Securitization, by Dr Fabozzi and Vinod Kothari] It’s your book Introduction to Securitization. So, where do we stand today? What do you think about securitization and credit derivatives? Are these the products which were designed for good times? But now that we have volatile markets, are these products still going to be relevant? What’s your futuristic thinking on these instruments?
Dr Frank Fabozzi
It’s very funny. You know as well as I, at that time, securitization was considered a gimmick and all that. As soon as the global financial crisis hit, though, the major agencies in the U.S. kept writing to emphasize the importance of securitization. If we think of it, there’s certainly periods when investors become more willing to take risks in search of higher returns. During those periods, you know, financial innovation often accelerates. Products become more complex, market participants sometimes focus more on yield than on the risk required to achieve the return. So financial history contains many of these examples, and, you know, we talk about securitization and credit derivatives. They’re such examples.
You know, it’s very difficult to see how the scenario changed. I’m 79. I’ll give you an example: When I tell you about securitization, how important it is, it is so difficult for most of the people listening to understand that. Let me put it in perspective. And this is no exaggeration at all. In 1972 or 73, prior to securitization I went to get a mortgage loan for a house. I went to my local savings and loan association, I walked in there, and I said, I’d like to get a house. I need money to buy this particular house, and I gave them the address. They said to me, first thing is, oh, do you have an account here? And I would say, yes, I did. Because I knew they were going to ask that.
Then they said to me, okay, you want to buy the old Phillips property? I know him, he’s a great guy, I used to golf with him on weekends, and we’d have dinners together, I know his kids, and all that. He knew all about the house. He said, oh, a couple of months ago, they just added an enhancement to their basement and all that. So he [banker] knew everything about the house. He knew everything about the seller. He didn’t know that much about me, because I just moved into the area. Now, what happened then? He said, I can evaluate your credit. He did. He said, we approve you for the loan. I said, great, when can I close? He said to me, you can close when other people who we’ve made loans to pay off their loans! Now, I couldn’t believe that I couldn’t get a loan until other people paid off their loans or defaulted.
So what happened? There were parts of the country where banks had a lot of money. There were other parts of the country, and I was in the other one. Parts of a country where money was very tight.
In comes securitization. And then, at the same time, there was the savings and loan crisis. Banks had 30-year mortgages on their books. During a period of rising interest rates, these banks were technically underwater, but the government kept them alive. And I mean, these institutions were savings and loan institutions.
So what then happened? Someone came up with a bright idea and said, Why keep the mortgage loans on the books? A bank doesn’t want to hold a loan for 30 years, because they’re worried about interest rates fluctuating up and down. When rates fluctuate up and down, a bank’s margin, will either decrease, or increase, and become negative, as it did during the savings and loan crisis1. So they developed securitization. What they did, they said, is take these illiquid loans. And pull them together, And then create securities based on these loans, that are backed by these loans.
And all of a sudden, you now created a capital market for these instruments alone, these mortgage-backed securities. And that helped resolve the savings and loan crisis, and make mortgages readily available. Nowadays, you want a mortgage? And you don’t have that much time. You have gone to fill up your gas tank. May not be the gas tank of a small car, but if you have a big truck, by the time you fill up that truck with gas, they will give you a mortgage.
So, to me, even though securitization sounds like a horrible thing, you could see in the context that I described why it was very important.
Credit derivatives did the same thing. Credit derivatives, and by the way, securitization, have gone beyond mortgages. We have student loans. You can even get municipalities doing securitization, their traffic tickets, everything, nowadays. And in fact, you may be an athlete in a certain sport. You can securitize your future royalties. Almost all the major entertainers, particularly musicians and other artists, securitized their future earnings.
So both credit derivatives and securitization, they were both developed to address legitimate economic needs. And they make economic sense. What they’re doing is separating the origination of risk from the ownership of risk. And that improves efficiency, expands access to capital, and enhances, certainly, risk management. When corporations do it, this securitization is a risk management tool for them. So, the difficulty arises when market participants begin to confuse risk transfer with risk elimination. Moving risk from one institution to another doesn’t make the risk disappear. It simply changes who bears it. So, that’s my view on the two. I don’t see them as being gimmickry at all.
Vinod Kothari
Thank you very much, sir. It’s an extremely pertinent comment. Your thoughts are extremely important for the market participants. And your time today, I know, is extremely precious, so thank you very much for giving your time today, and wish you health and happiness, sir. Thank you very much.
Dr Frank Fabozzi
Thank you, thank you for the opportunity.
- Readers may note US mortgages are typically fixed rate mortgages. ↩︎
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