Prompted by a few recent debates I feel some clarity on why banks actually exist would be interesting. The glib answer is “to make profits by borrowing and lending” – although many would put it in terms much more offensive than that.
Why are these profits available, though? What actual function does a bank perform? In short, what economic use is a bank?
Thinking about it I believe banks provide a partial solution to two major problems – the fact that wealth, once earned, needs to be re-allocated to more productive purposes and (this one is often missed) the temporal distribution of wealth.
The first one is fairly easy to spot, although that does not stop people from missing it. People with wealth they have no current use for – even though they may know they will need it later – want to put the wealth somewhere they know it will be reasonably safe and, if possible, receive a return on it. If they want to be nearly absolutely safe in capital terms they could put it into a safety deposit box until they need it – but this incurs fees and pays no interest. For a very little more risk, but with a return, they can deposit it in a bank. For hopefully higher returns they can invest it in bonds or buy shares. Thus banks provide a partial answer to this question.
The other side of this is the lending side. To pay interest on the funds deposited, banks lend the money out. They are lent to people that need the funds now and promise to pay them back in the future. Hopefully, this is done in such a way that the losses from people that fail to pay are more than made up for the gains from people who do – and this is where Clive and his friends come in – trying to make as sure as possible of this part.
In a Sharia compliant bank the problem is only a little different in that returns to none of the parties should be guaranteed in advance. While interest is not paid, equity-like returns are, so the problem, and the solution, is much the same.
More interesting, perhaps, is the temporal problem, hinted at in the above. It may even be two sides of the same coin (gold, naturally).
The problem is not so much the distribution of wealth between people but the distribution of wealth over time. People tend to earn more as they get older and a continuous, and increasing, income stream tends to mean a better ability to afford housing and other major capital expenditure.
For major capital equipment purchases (like housing) we therefore have a choice – wait until we have the spare cash around to buy it, go into debt to purchase it or to rent it.
If we go the waiting option then we still need somewhere to live while we are saving – so we can rent or live with our parents. During the period up until the 1970s – due to the less efficient debt markets – this happened a lot. Due to improved debt markets inter-temporal wealth distribution can be improved – using other people’s savings we can buy a house (or other capital equipment) now using our expected future income to repay the people we have borrowed off.
Banking profits come from facilitating this transaction – repackaging funds the banks are lent by depositors to term structures that are attractive to borrowers and then managing the resulting risks. Again, this is a problem of timing. Depositors like to have call access to their funds. Borrowers cannot deal with that uncertainty. On average, there are lots of funds deposited at any one time – but the actual borrowers and lenders change minute by minute. Much of banking profits come frm managing this risk – but also failure to manage this risk properly is the main cause of bank failure. Running out of money now, no matter how much you are owed in the future, means you close your doors now – just ask Northern Rock or Bear Stearns.
Unbanked societies tend to solve this inter-temporal problem by having the whole community turn up to assist each other with major capital works – on the unspoken but strongly enforced understanding that assisting with everyone else’s building is the cost for getting your own built that way. This is a good solution to this problem, but it breaks down as the societies grow to the point where people can lose track. The free-riders end up destroying it. Additionally, if a city has 1 million people in it it can be difficult to organise all of them to help on building a house.
One of the accusations often made against this system is that it increases inflation. This solution to this inter-temporal problem is not perfect, as we can only mobilise current savings against future income – but on inflation this is the point. We are only capable of using current savings for this purpose. Productive effort has to have happened for these savings to occur – they can then be lent out to others actually consume. Even then it is imperfect as prudent risk management and regulation both say that only a proportion of them can be lent.
All of the usual things we all say about individual banks (and I am just as capable of getting annoyed with them as anyone else) we should recognise that the banking systme as a whole does much that is useful – and is actually vital to the smooth(ish) functioning of a modern economy.
1 comment
28 May, 2008 at 11:58 pm
Clive
Not sure I can contribute anything, but re-casting your ideas:
The Bank’s advantage (and hence its value) is pooling large numbers of diverse individual lending/saving requirements. The statistical stability of a large diverse pool allows the bank the borrow short (normally cheaper) and lend long – their business model.
The short vs long balance is normally stable enough that banks can operate on small fractional reserves – leverage the business model.
Having a large pool (many diverse exposures) at each point in time neutralises the temporal issue far more effectively than small groups of individuals would be able to – hence the banks add value by being market makers and by providing a stable interest rate structure.
As long as the pool is large and diverse there should be negligible chance of a liquidity crisis for a bank, because all transactions in the economy have two parties and so constitute a net inflow and equivalent net outflow to the banking system as a whole.
But as you have extensively commented, liquidity crises can and do occur. A statistical slant is that the “independence” property of the diverse pool evaporates as each successive calling up of short term funds increases the chance that others will do likewise. In reality it can be more like the madness of crowds! But even such a run of fund outflows must be net inflows elsewhere.