A significant challenge inherent in direct bilateral lending is the matching problem. This issue arises because a potential lender must find a potential borrower who not only wants to borrow but also needs the exact amount the lender wishes to provide at the same time. This difficulty in finding a 'double coincidence of wants' makes direct transactions inefficient and uncertain.

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A key question that arises in the Marco-Julia model is whether the saver (Marco) and the borrower (Julia) would prefer to engage in a direct bilateral loan or to utilize a bank for their saving and borrowing needs. This question explores the potential advantages of financial intermediation over direct lending, even when the basic financial outcomes appear similar.

Choice Between Bilateral Loan and Bank Services in the Marco-Julia Model

To cite the ebook, use The CORE Econ Team 2023 The Economy 2.0: Macroeconomics Open access e-text https://core-econ.org/the-economy/.

To cite a unit, use The CORE Econ Team 2023 The Economy 2.0: Macroeconomics Open access e-text https://core-econ.org/the-economy/ Unit [unit number] (url).

CORE Econ - The Economy 2.0: Macroeconomics

A primary reason to prefer a direct bilateral loan over using a bank is the potential for cost savings. Banks profit from the spread between the interest rate they charge on loans (e.g., 10%) and the rate they pay on deposits (e.g., 6%). By dealing directly, a borrower and lender can 'cut out the middleman' and agree on a single, intermediate interest rate (e.g., 8%) that is more favorable to both parties than the respective rates offered by the bank.

Potential Cost Advantage of Bilateral Loans over Bank Intermediation

The Matching Problem in Bilateral Debt

A key advantage of a bank's diversified loan portfolio over a single bilateral loan is the significant reduction in risk, specifically in the variability of returns. While a bilateral lender faces a wide range of outcomes from full repayment to total loss, a bank's return on its overall portfolio is much more stable and predictable. Even though the bank's actual return may fluctuate slightly around its expected return, this variability is substantially less than the risk faced in a one-to-one lending contract.

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