The Economics of Banking
What is the role of bankers in the economy — what functions does a bank have in the daily business of people and corporates or public entities; is their service adding any value? As economists, we like to analyse starting from first principles.
Supply Chains and Trade
Suppose we live in a global exchange economy with production: some or all agents are firms that produce new goods and services or housholds that bring in labour as a resource into the production processes. And they can exchange products and resources among them. That exchange is based on a system of flexible prices and quantities of goods, services or materials and resources that seeks a competitive equilibrium with the efficient allocation of resources and goods and »market clearance« (supply meets exactly demand; nothing is wasted). The global economy is characterized by a separation of production and consumption and the same applies to services, in particular if services are digital the market is global. Hence, there is a division of labour and a rather complex network of supply chains and trade across the planet (supply chains in general and after the pandemic). Obviously, we have multiple currencies, levies, tariffs & taxes, as well as other transaction costs and sometimes even some bribe, might be involved. The latter is most likely not covered by the mutual financial contracts on the underlying economic or financial transactions. However, there is money involved at all levels, locations and points in time that spans the transaction.
Money
Money is the medium of exchange and the unit of account. Money also is the store of value and the standard of deferred payments (also for forward transactions, options and futures as well as insurance contracts). The quality of money changed over time: Recently, since US President Nixon’s decision to decouple the US dollar from gold in 1971, a system of national fiat currencies has been used globally. The exchange rates of the main currencies are mainly floating, some are pegged to USD or EUR. Fiat money only has value because the government maintains its value, or because parties engaging in exchange agree on its value. For the sake of being politically not compromised Governments usually delegate the task of managing the money to the independent central bank of their jurisdiction. Central banks have the objective to stabilise the value of money at a specified target (e.g. like near but below 2% inflation) according to the agreed monetary policy strategy. This is no easy task since money can be measured in different monetary aggregates which differ in terms of wide or narrow use of money for different purposes, like a medium of transaction or as a store of value. The creation of money is not entirely in the hand of the central bank except for the paper bills (and the coins).
Fiat money and other financial products serve different purposes and meet different customers’ demands and requirements, although in the end it always comes to generic financial contracts, like a »promise to pay« (IOU) or written on a piece of paper like a promissory note. It’s all about the promise to »pay back an amount of money with interest at a point in time and location«, as specified (see the above image for an example). The contracts have different quality in terms of being able to be traded in secondary markets at more or less easily discovered prices. These prices most likely will be different from the nominal value. Hence, IOUs are inherently risky. At the core of banking business is to originate and package them, if necessary to split and restructure them and to hold them or to distribute them, essentially managing the risks. Some financial products can be seen as high-quality liquid assets (HQLA) and some are less so.
Central banks’ monetary policy during and after the crises did have to implement some unconventional monetary policy tools like »forward guidance«, negative interest rate policy (i.e. going below the lower bound of the »zero interest rate«), and large scale asset purchase programmes. The latter tool effectively substituted HQLA with central bank money. The normal expectation in such a situation was to see a crowding-out effect in the capital markets. However, that did not happen and — if you as an economist may take the mutual IS/LM-model as a starter — we might be observing something like the Japan economy Liquidity Trap of the 1990–2000 years. Or are we here »Arguing with Zombies« (Krugman 2020) and we need some new, more sophisticated models for the analysis? We may suspiciously be looking
» … whether the new monetary policy tools are likely to be sufficiently powerful in the next downturn.«
— Governor Lael Brainard, Federal Reserve Board (21.02.2020)
Uncertainty, Noise and »Bounded Rationality«
We are not living in a perfect world. We all do the planning for consumption and production without perfect foresight and, no matter what, some things always go wrong. That’s due to several reasons: forces of nature, accidents or fraud etc, and we still have business cycles (Plosser 1989), and we have financial cycles (Borio 2012). Hence, there is risks in the system. It is not only failure of processes or people or accidents due to adverse states of nature. As humans we might also have not all of the relevant information during a decision-making process, i.e. in the planning process or at execution. Hence, we get either Noise (Black 1986) instead of information, or we have only bounded rationality (Simon 1957) in terms of information processing, and we might trade on that or bet on that. This is where the financial system kicks in, in particular the banking system, bringing valuable services to the table. But we know also from history about the fragility of banks and the financial system.
Banks’ added value
The banking system — central banks, state-owned banks, public and private sector banks as well as the savings- & loan associations, the cooperatives and their service providers — not only provide the payment infrastructure to the economy.
Banks also take deposits and grant loans. They channel the supply of capital and they provide liquidity from the market participants that have an excess of savings (deposits) to the entities in demand of financing for investments (loans). This service »makes the market« and sometimes it is match-making, and definitely saves customers’ time and money compared to their do-it-yourself searching the market. This is not for charity reasons but for profit: the match-maker / market-maker will earn a fee or interest income. Eminent important to the business partners is the role of »Banks as Secret Keepers« which is protecting intellectual property or saving business opportunities when having all the due diligences regarding the investment proposals on behalf of the customers that seek financing for those ventures. Banks also provide several valuable services like transforming different saving amounts into specific financing amounts or transforming the specific time structure of savings into time structure of financing demands in terms of interest rate or liquidity requirements. Regarding »trade financing« banks do factoring and reverse factoring as well as forfaiting, all for the better cash flow management of merchants, hence to enhance liquidity. Sometimes just a »letter of credit« is opening business opportunities because the bank is underwriting and the business trusts. Risk management in banks is monitoring and diversifying in the relevant dimensions like regions, industry, type of customer and last not least in different financial products and services.
Intermediation
Essentially these banking services reduce the customers costs of searching the adequate opportunities and are mitigating the risk of the customers due to asymmetric information like on a »market for lemons« (Akerlof 1970). Banks effectively take on the task of »delegated monitoring« (Diamond 1984) and to make sure that the saving customers will get their money back eventually. However, rogue behaviour of banks can potentially destroying trust and confidence of their customers who, of course in turn, must monitor trustworthiness of their bank themselves (Diamond/Dybvig 1983). That is the merit and the weakness of »Intermediation«, its curse and the blessing. To help out the customers having this Sisyphean task of bank monitoring private-run or public deposit insurance has been introduced in several jurisdictions after the Great Depression of the 20th century. Financial stability is now recognised to be a global public good (Garcia 2000). There are more things involved besides asymmetric information in most calamities: (A) the more people or entities involved in the business the more diffusion of information and increased noise in the process at several steps there will be. (B) there will be diffusion of responsibilities up to the point of conflicting interests (principal vs agent). In particular, any behaviour following an incentive to increase risks is called »moral hazard«, e.g. in the presence of unconditional guarantees or insurance that has no deductibles or unlimited coverage. The incident that participants might participate selectively in trades which benefit them the most, at the expense of the other party is called »adverse selection«, e.g. selling credit protection at higher than market prices. Watch out for those incidents and characteristics in any risk-taking business. This is not easy since banks are regulated by more and comprehensive requirements, in particular to enforce standards for adequate bank capitalisation and liquidity management to avoid insolvencies, maintain other regulatory standards to assure good governance, limit excessive risk-taking, and enforce firm entry and exit rules to keep the system sound (Garcia 2000), provide consumer protection and enhancing public confidence.
Credit Underwriting
Sometimes people bet on the outcome of future events, taking on risks. Take Mark Twain’s short story of »The Million Pound Bank Note« as an example (the story takes place in normal inflation context, not in hyperinflation context, that would be another story).
It is a very nice parable story to explain the principle of credit, of building confidence and reputation for doing business and taking opportunities as they come along (full text here or for listening here). Luckily for the reader, there is a happy ending to this story. Not every venture is taking the turn to the bright side of life.
The history of banking is full of ups and downs or booms and busts and troubled banks. Sometimes it is liquidity issues, sometimes it is solvency issues and sometimes it is rogue conduct in the markets (see Wells Fargo or the LIBOR Scandal).
Entertaining and thrilling in the movies is the fictional story titled »Margin Call« that takes place over a 24-hour period at a large Wall Street investment bank during the initial stages of the financial crisis of 2007–08. But tragic in real life is the story of the victims of this crisis.
No surprise about the need to regulate the banking business to avoid externalities and protect the consumer, the markets, the economy, and the whole society against the loss of welfare due to banking crises.
» Measured by decrease in per capita United States GDP compared to the pre-crisis trend, by 2016 the crisis had cost the country 15% of GDP, or $4.6 trillion.«
— Gautam Mukunda (hbr 25.09.2018)
Recently, in 2016/17, the Banco Popular Español S.A. had difficulties to meet capital requirement standards due to a write off of real estate loan portfolio sold (Banco Popular booked a net loss of EUR 3.5 bn in 2016 at balance sheet size of EUR 147.9 bn total). And on top of that the bank suffered a sudden deterioration of the liquidity which in turn forced the supervisor to determine the bank was failing or likely to fail. This was due to a considered bank run. The Financial Times titled “Banco Popular burnt through EUR 3.6 bn in two days ahead of rescue” and “Banco Popular faced eurozone’s first large-scale bank run, ECB says”. Banco Popular was then — as a »banking resolution case« according to the predetermined procedure of the bank resolution framework of the EU banking union — handed over to the competitor Banco Santander S.A., i.e. all shares were transferred at symbolic value of 1 EUR (and approx. 12.000 employees switched to Santander). This tested the after-crisis resolution policies and procedures (institutions) that were established in the EU to prevent more of the bail-out and too-big-to-fail incidents and prevent the loss of more taxpayer’s money. The story developed (see FT and see documentation of the EU Parliament).
The story developing:
Banks’ Reportings, Business Models, Risk Management & Regulatory Requirements. Bank Management according to the normative and the economic perspective, KPIs & KRIs. Stay tuned.
