April 5, 2011 Reading Time: 4 minutes

There’s plenty of frustration, irritation, and anger at banks during times of financial crisis and recession. Complaints run the gamut: bank over-exuberance (“predatory lending”) fueled the boom, and their under-exuberance (tight credit) contributes to the bust. They’re charging outrageous overdraft fees and being too harsh on loan defaulters. And oh yes, the taxpayer-funded bailouts! Why should we be forced to cover their bad bets, and what incentive structure does this put in place for the future (moral hazard!)? Throw into the mix a vast array of “reform” proposals that only add to the confusion and chaos, and the anger and frustration become understandable.

On top of all this anti-bank rage comes a serious argument from a dedicated camp of anti-bank writers: banking is an inherently immoral and economically destabilizing activity.

In light of these critiques, it would be helpful to address some banking basics. What the heck are banks good for, anyway?

1. The basic economic function of banks

Anyone who wants to trash banks should first consider their ubiquity: there are over 7,000 banks in the US, with a total of $9.4 Trillion in deposits, serving over 90% of American households. Observing something so utterly commonplace—a centuries-old business that the vast majority of people are involved in—this economist’s initial reaction is that the benefits of banking probably exceed its costs.

So what are the benefits? Let’s start with the depositors. For one, bank deposits are a great place to park money. They are liquid and give access to the “payments system,” allowing depositors to easily pay people all over the world via checks, debit cards and wire transfer, to access funds at ATMs, etc. Sometimes depositors can earn interest to boot, such as with large “time” deposits like CDs. And bank statements are quite useful in helping households and businesses track their expenses.

For the banks, deposits are a cheap source of funds, especially very short-term deposits like checking and savings accounts which pay little if any interest. And banks of course pool many individuals’ deposits, allowing them to use their specialized knowledge and expertise to fund various investment projects.

So yes, banks provide pretty darn useful services to their deposit customers, and these deposits are a great, cheap source of investment funds for the banks! It’s a win-win, unless and until, of course, the bank screws up and loses your funds. So let’s explore what could possibly prevent this and make banking generally reliable and stable in a free market economy.

2. Basic Bank Regulation

As I discussed in my last post, competition is the main economic force that “regulates” banks. But how, exactly, does competition prevent systematic investment errors by bankers? There are two big problems any bank wants to avoid in order to keep its customers happy and stay in business. The worst is INSOLVENCY: a bank makes too many bad investments,[1] loses funds, is unable to repay depositors and goes broke. The next-worst is ILLIQUIDITY: a bank runs out of cash and again can’t repay depositors, even though its loans might be OK.

The key incentive mechanism that helps banks avoid these problems is the “principle of adverse clearings.” This is a somewhat involved economic process, so here’s a very brief thumbnail sketch: When the Bank of Watts (BoW) invests in a loan, it issues claims on itself payable in money.[2] Most of these claims will be used in payments by the borrower, and then deposited by sellers in other banks. Other banks don’t want claims on BoW, however. They want the underlying money.[3] The other banks present the claims at BoW: “Give us the money!” If BoW loans are not doing so well—i.e. too many loans are in default—BoW is not getting a flow of cash repayments sufficient to repay incoming claims. It must do something, and fast, lest it be found insolvent. Similarly with an illiquidity situation—say BoW loans are doing great, but it sees a sudden rush of depositors seeking to withdraw cash, say for tickets for a just-announced Grateful Dead tribute concert. Banks have many options at this point: illiquid, but otherwise sound, banks will usually be able to borrow short term cash from other banks. Even insolvent banks can try to attract deposits by paying higher interest. They can also try to raise equity capital in the stock market, or “call in” certain loans. Of course at some point, a bank may not recover; unable to raise enough funds nor turn around the fortunes of its loan portfolio, it goes into bankruptcy. In a market economy, bankruptcy may indeed mean a loss of funds for the junior creditors—i.e. depositors—giving bankers a keen incentive to screen loan applicants and monitor investments closely.

Whatever the result, “adverse clearings” will ensure that poorly-run banks will be swiftly revealed as such, and not long survive in the competitive marketplace. Bankers naturally have a constant eye on their clearing balances, which give pretty much instant feedback on their financial health.

3. Banks and crisis

While I haven’t done justice to the intricacies of a fully competitive banking system, at least we have established the possibilities that a market-based banking industry is capable of: a) providing great mutual benefits for bank owners and customers, and b) imposing tight, swift constraints on the ability of banks, and the banking system, to overindulge in bad investments. So that leaves the matter of financial crises and business cycles—the most relevant point of attack for those trenchant critics of the business of banking. In my next post, I’ll explore the question of whether banking is inherently unstable. As you might suspect, as long as the mechanism of “the principle of adverse clearings” is fully at play, it will be extremely difficult, if not impossible, for banks to engineer a financial crisis sua sponte.

[1] Note I say “too many” and not “any,” because investing is inherently risky and the only way to avoid loss is to not invest at all!

[2] Nowadays such claims are strictly checks, but historically banks could issue their own banknotes—essentially checks “payable to bearer.”

[3] Again, nowadays this means Federal Reserve brand fiat “dollars,” but in the past it meant a specified quantity of gold or silver.

Tyler Watts is an assistant professor of economics at Ball State University.

Image by Idea go / FreeDigitalPhotos.net.

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