Banking

Banking makes a major contribution to mature economies but banking crises can do them great damage. Bank regulation is a compromise between the avoidance of banking crises and the preservation of banking efficiency. Following the crash of 2008, proposals for regulatory reform are under consideration, and there are prospects of major changes to the structure of the world's banking industry.

(For definitions of the terms shown in italics in this article, see the glossary on the Related Articles subpage).

Banking essentials

Banks are financial intermediaries - acting as middlemen between lenders and borrowers. Most banks accept payments from depositors and lend money to borrowers. In addition to the money they get from depositors, they can get short-term loans from their central bank's "discount window"", or from the money market. They make profits by charging higher interest rates to their borrowers than they pay to their lenders - a difference that is known as their "spread". They normally make loans amounting to many times the total of their deposits - often as much as twenty times as much - but maintain reserves in the form of cash or assets that can be quickly sold for cash in order to pay for withdrawals by depositors. Reserves can usually be augmented, if necessary, by borrowing from other banks or, in an emergency, by borrowing from their central bank.

The banks that accept deposits from the public are called "commercial" or "retail" banks. "Wholesale" banks deal with other banks or financial companies, rather than the general public. "Investment banks", also known as "merchant banks", concentrate on raising money for companies by finding buyers for their equity and their corporate bonds. "universal banks" combine all of those activities, and often others such as insurance.

Banking theory

The Diamond-Dybvig model

Banks usually make loans that they cannot withdraw at short notice, and pay for them with deposits that can be withdawn without notice. This is referred to as a situation in which a bank's liabilities are more liquid than its assets. A bank is said to suffer a liquidity crisis if too many depositors attempt to withdraw their money at one time - a situation referred to as a bank run. The Diamond-Dybvig model explains why banks choose to issue deposits that are more liquid than their assets and why banks are subject to runs. It is a highly stylised three-period one-bank construction that makes use of the game theory concept of a Nash equilibrium to derive its conclusions. . The model has been widely used as theoretical framework for analyzing the economics of banking and banking policy

Incomplete contract theory

When it is not feasible to provide in a contract for all of the circumstances that may govern its fulfilment, the contract is said to be incomplete. There is often a tacit understanding that the terms of an incomplete contract may be renegotiated if there any unexpected developments. The concept of an incomplete is applicable to a bank loan because it is always possible that circumstances will arise under which the recipient may be unable to comply with its terms. Under those circumstances, renegotiation may be better than bankrutcy, both for the bank and for the borrower. It can be argued that it is the incomplete contract concept that has thus distinguished bank loans from other forms of borrowing. There is no established mechanism, for example, for the renegotiation of the terms of a bond. Incomplete contract theory is about the economic advantages that can arise from the flexibility provided for in an incomplete contract. The theory has also been used to explain the historical development of banking practice and to make suggestions concerning its future development .

The agency problem

A problem can arise when an agent, who is employed to look after the interests of a principal, uses for his own benefit the authority given to him for that purpose. The agency problem is to decide how much it is worth spending on precautions or incentives to discourage such behaviour. Principal-agent relations are a necessary feature of financial intermediaries and conflicts of interest are inevitable. Market forces may be expected to deter agent misbehaviour when the principals are as well-informed as their agents, but "information asymetry" gives at least temporary protection to misbehaving agents in the complex context of modern banking. A wide range of potential agency problems has been identified , and there was extensive study of the influence of pay incentives such as performance-related bonuses. However, the perception that performance-related bonuses could encourage investment managers to take unwarranted risks was not voiced until 2008.

Risk management theory

Mathematical risk management models have tended to replace the exercise of subjective judgments in assessing the riskiness of banking investments . Their common feature is the assumption that the risks are stochastic rather than deterministic - that is to say, the assumption that they arise from the existence or random fluctuations, not as a consequence of human behaviour. On that assumption, the probability of default, for example, can be calculated from an analysis of past records. There was widespread use of such models in the 1990s and thereafter, despite objections by Barry du Toit and Avinash Persaud that they used data that had been contaminated by previous rescues, and that their use generated herding behaviour that itself contributed to instability.

The supply of money and credit

The creation of money

With the development in the 20th century of "fiat money" the banking system has come to play an essential part in the supply of money. It can be shown that a fractional-reserve banking system can actually create money, and that, for example, a bank with a ten per cent reserve ratio can convert a £1000 deposit into an increase in money of up to £10,000. . The extent to which it does so in practice depends upon the exent to which money borrowed from the banking system is deposited in the system , and - crucially - upon the banks' reserve ratios (or leverage). In times of strong economic growth, the banks tend to increase their leverage with the result that there is an increase in the money supply , facilitating yet more investment and consumption. Conversely, there is a tendency to "deleverage" in times of recession, causing a reduction in the availability of money that worsens the recession.

Control of the money supply

In order to limit the destabilising consequences of the cyclical variations of banking leverage, the country's monetary authorities usually attempt to regulate the money supply. By reducing its discount rate (the interest rate that the it charges for loans to banks), a central bank can increase the banks' motive to increase their reserves by borrowing, and thus raise their ability to issue loans and create money. Correspondingly, an increase in the central bank's discount rate is a means of reducing the money supply. The money supply can also be raised by an open market operation in which the central bank offers to buy government securities from them, paying for them by a nominal increase in the reserves that the banks deposit with it (sometimes referred to as "printing money"). The resulting increase in the banks' reserves enable them to increase borrowing and create money. Alternatively, the money supply can be increased more directly by reducing their required reserve ratios, or their required capital adequacy ratios. However, the degree of control that can be achieved is limited by the fluctuations that occur in the demand for money.

Banking innovations - a brief history

Medieval banking

A variety of enterprises whose activities can be broadly described as banking were in existence before and during the middle ages. Some, that have been categorised as "deposit banks", accepted deposits and made loans; some, termed "exchange banks" were restricted to providing the means of making transactions between traders using different currencies; and others combined both functions. Deposit banking is believed by historians to have evolved from money changing. Coins were displacing barter as a means of trading but since they were of variable quality, it is thought to have been convenient to use the services of a money-changer. A trader could open an account with a money-changer into which he could deposit and withdraw coinage. Payments to other traders with accounts with the same trader could then be made by having the money-changer debit his account and credit theirs. The money-changer had to keep some coins in reserve for withdrawals and payments to other money-changers but since, with random inflows and outflows, a net outflow amounting to a major proportion of the money deposited was unlikely, the otherwise idle cash was made available for loans. Those loans usually took the form of overdrafts to depositors because they were considered less risky than loans to strangers. The main causes of bank failures were fraud, and defaults on loans made to kings to pay their armies .

Renaissance banking

Few European banks achieved a reputation for probity and stability before the 17th century, mainly because of the absence of established property rights or of the effective discouragement of fraud. There were a few local attempts to create stable and reliable banks. For example, the municipal authorities in Barcelona set up a public bank in the late fourteenth century, which accepted deposits but was not authorised to make loans to the public , but elsewhere banking fraud and financial failure were commonplace. The best-known among the few exception was the Medici bank, which flourished in Florence in the first half of the fifteenth century, surviving long enough to develop some significant innovations. In particular, it brought about the general commercial use of "bills, of exchange" (which are the banking counterpart of promissary notes or IOUs), which enabled traders to defer payment for a purchase . Its practices are thought to have served as the model for modern European banking.

Banking in the 17th and 18th centuries

In the early years of the 17th century, the municipal authorities of Amsterdam, being aware that commercial activity there was being hampered by the uncertainties created by the circulaton of coins of various currencies and differing quality, decided to take action. As a corrective they founded the "Wisselbank" in 1609, , and required it to maintain a high level of stability by maintaining its reserves of coins and precious metals at a level close to 100 per centof its deposits. It operated mainly as a service to merchants who were trading in different currencies and it did not make loans to the public. Its main contribution to banking innovation was a system of transfers by cheques and direct debits that was similar to the system in use in the 21st century. The Wisselbank had some of the characterestics of a modern central bank and it inaugurated a five-hundred-year period of participation in, and regulation of banks by public authorities. However, the claim to have been the world's first central bank is made by the Swedish Riksbank which was inaugurated 1668 as the successor to John Palmstruch's "Stockholm Banco". It was nominally a private bank, but the King of Sweden appointed its management, and regulated its operations. Unlike the Wisselbank, it issued loans and maintained reserves at only a fraction of its deposits. Its main contribution to banking innovation was the issue the first modern banknotes, which were interest-free bills of exchange, denominated in specific amounts and - in principal - corresponding in total value to money deposited in the bank. It was later to be formally recognised as a public bank with a statutory monopoly of the issue of banknotes . The Bank of England was created as a private bank in 1694 , mainly in order to raise money for the government of the day (by converting some of its debt to shares in the bank and in 1709 it was granted a partial monopoly in the issue of banknotes. . . The bank maintained sufficient reserves of gold to redeem its notes on demand (except during the Napoleonic War, when that facility had to be suspended). An attempt was made to set up a French central bank in 1710, but after a successful start, it collapsed in 1720, causing a major economic crisis. . United States banking commenced in the 1780s with the chartering of the Bank of North America, and the creation of the First Bank of the United States with a limited role as a central bank. .

Banking in the 19th century

In the United States, there followed a protracted series of politically controversial and mainly unsuccessful attempts to regulate its rapidly expanding banking sector . At the state level, banks had to be registered with state legislatures, who set reserve requirements that were, at best, loosely enforced. Few of them survived for more than five years. At the national level, the First Bank of the United States was closed, to be succeeded by the Second Bank of the United States until it too was closed in 1836 without achieving a significant improvement in banking stability. In 1864, the United States Congress passed the National Banking Act with the intention of creating a network of federally-chartered "national banks" with improved regulatory standards, but without setting up another central bank .

In England, the need for intervention became evident in 1866 when the collapse of the Gurney-Overend bank caused a panic in which large numbers of people tried to withdraw deposits from their banks; leading to the collapse of over 200 companies . On that occasion the Bank of England had refused to help, but the influential commentator Walter Bagehot urged that in a future panic it should "advance freely and vigorously to the public out of its reserves" in order to avoid another "run on the banks", a recommendation that is credited with the esablishment of the concept of the central bank as lender of last resort . The 1890 failure of the Barings bank (then the world's largest investment bank) further established the role of the Bank as a guardian of the English banking sector when it organised a rescue by guaranteeing loans to it by other banks, thereby establishing the concept of "too big to fail". The Bank Charter Act of 1844 had already established it as the only institution in England with note-issuing powers , and the Bank of England was gradually assuming in full, the role of a modern central bank.

Regulation, deregulation and securitisation in the 20th century

In the United States there had been similar initial inaction in face of the panic of 1893 but following the further panic of 1907 the Congress created the Federal Reserve System and granted it powers to assist banks that faced demands that they would otherwise be unable to meet . The subsequent practice of central banks in the United States and elsewhere has been to assume the role of lender of last resort and provide short-term loans to solvent banks to tide them over temporary liquidity difficulties , and also to provide or arrange longer-term loans to avert failures that would be large enough to threaten the stability of the banking system. The next important innovation was prompted by the sequence of bank runs and failures that occurred in the period from 1929 t0 1933. The Banking Act of 1933, established the Federal Deposit Insurance Corporation, with authority to regulate and supervise state banks outside the Federal Reserve System and provide them with deposit insurance. The Act also prohibited combinations of commercial and investment banking. and other restrictions were also imposed upon banking activity (see the Addendum subpage). Restrictions upon banking activities - intended to reduce the danger of a recurrence of the financial instability experienced in the early 1930s - were imposed by most other industrialised countries. Until the 1980s, investment banks were not normally permitted to undertake non-financial activities, nor other financial activities such as branch banking, insurance or mortgage lending.

In the 1980s, however, there was extensive deregulation of the banks with the intention of increasing competition and improving efficiency . , which made possible a series of innovations, the most significant of which was the practice of securitisation, meaning the conversion of their loans into graded packages of bonds; and the development of the strategy known as "originate and distribute", under which such bonds were sold to pension funds, insurance companies and other banks.

The benefits of banking

There is a presumption that - by providing an improved conduit between savers and investors - banking makes a significant contribution to the functioning of an economy. The improvement that it provides is generally attributed to the banks' screening of applicants for investment funds, to their mobilisation of savings, to their monitoring of investment projects, and to their allocation of risks in response to the needs of different categories of investors. Despite measurement difficulties, the consensus view among economist is that belief in the economic benefits of banking is well supported by empirical evidence - even to the extent of suggesting that a well-functioning banking sector may be a necessary precondition for economic growth. Studies of the Dutch Republic, England, the U.S., France, Germany and Japan suggest that the establishment of a financial system has always preceded the onset of economic growth, and a correlation between financial developments and economic growth over the period 1850-1997 has been established by a cross-section study of 17 countries. It has also been shown that countries with more sophisticated financial systems tend to engage in more trade, and appear to be better integrated with other economies. . Other empirical investigations have shown that the ratio of banking liabilities to GDP is strongly correlated with economic growth .

The riskiness of banking

Inherent risks

Like any other enterprise, a bank can increase its profitability - but also its risk of insolvency - by increasing its leverage (as explained on the tutorials subpage) . A bank creates leverage when it lends more money than it holds as reserves (the money provided by its shareholders plus retained profits). With leverage ratios commonly as high as 20, losses of over 5 per cent can be sufficient to create insolvency. For a bank, the principal risks of loss are credit risk, which is the risk that the value of a bank's loans will fall as a result of defaults on the part of borrowers, and interest rate risk, which is the risk that the value of a fixed-rate loan will fall as a result of a rise in interest rates.

In common with other enterprises that make profits by financing long-term investments by short-term borrowing, banks are also vulnerable to liquidity risks. Deposits in banks that can be withdrawn on demand are, in principle, the same as short-term borrowings, although in normal circumstances it is unlikely that any substantial proportion of them would be withdrawn simultaneously. Should that happen, however, the bank may find itself unable to raise the money needed to pay its depositors. A run on a bank can happen if depositors lose confidence in its ability to repay all deposits in full, and try to withdraw their funds immediately. Liquidity crises and bank runs are not the same as insolvency, but they can drive a bank into insolvency as a result of losses on the resulting forced-sales of its assets . A loss of confidence in one bank can spread to other banks by a process termed contagion. It may affect only those banks that are considered to face similar problems, but it may becomme a panic and affect banks that would otherwise be considered trouble- free - and, under extreme circumstances, it can lead infect non-banking organisations and lead to a systemic failure of a country's financial system, or even of the world's entire financial system.

The effects of recent innovations

The banking innovations that were introduced in the 1980s allowed risks to be shared more widely, enabling investments to be undertaken that woould not otherwise have been possible, and thus contributing to economic growth. It was not recognised at the time that they also increased the risk of systemic failure, but there were some expressions of concern in the early years of the 21st century. One cause for concern was a growing tendency to finance lending by short-term borrowing on the money market. In normal times, money market loans were automatically renewed (rolled over) as soon as they matured, but any hint of trouble could prompt the withawal of that facility. Another was the realisation that the process of securitisation had transferred decision-making from managers on fixed salaries to investment managers who were being awarded profit-related bonuses that had the effect of rewarding risk-taking, and a suspicion that the market was being further distorted by herding behaviour by managers who feared being outperformed by their rivals . It also seemed possible that investors and regulators might not be getting an accurate picture of where risks were falling because of the opacity of a system in which "off-balance-sheet" investments enabled banks to conceal their true risk-exposures.

Risk management

A further innovation was the widespread development of risk-management models based upon the "Capital Asset Pricing Model" . However, such models assume that risks can be represented by the symmetrical bell-shaped normal distribution, and can give inaccurate results if the true distribution has a "fat tail", as a result of which there is a significant additional tail risk, and there is evidence that suggests that securitised assets may be expected to involve significant tail risks. . The risks represented in those models are based upon analyses of past experience and since the events involving such risks are by definition rare, they cannot be expected to be picked up by models based upon a five or six years' run of data.

Systemic crises

From an economic standpoint, individual bank failures need not be a cause for concern because they may be no more than a reflection of the fact that risk-taking is an unavoidable feature of banking; and because the market positions vacated by those banks that do fail because of bad management may be taken up by better-managed rivals. But the simultaneous failure of a group of banks is a different matter because it may constitute a "systemic" threat, arising from the damage caused to other financial and non-financial enterprises. Failures that result in a major reduction of a country's banking capital almost inevitably result in a systemic crisis as the remainder of the system falls victim to "positive feedback" because the economic damage done by initial failures results in the failure of banks that would otherwise have prospered. Positive feedback from an economic recession may similarly lead to systemic banking failures that further exacerbate the originating recession .

The article on bank failures and rescues lists the major bank failures and banking crises from the end of the first world war and the crash of 2008

Banking regulation

Central bank supervision

Governments have long been aware of the danger that a loss of confidence following the failure of one bank could lead to the failure of others, and eventually to "systemic failure" of the entire financial system. To limit that danger, they have traditionally required banks to limit the extent to which their loans exceed the funds provided by their shareholders by the imposition of minimum "reserve ratios" and have placed various other restrictions upon their activities. In the 1980s, however, it was widely considered that those regulations were imposing excessive economic penalties, and there was a general move toward "deregulation" . Restrictions that had prevented investment banks from broadening their activities to include branch banking, insurance or mortgage lending were dropped, and reserve requirements were relaxed.

The Glass-Steagall Act -- which was repealed by the Gramm-Leach-Bliley Act in 1999 -- was designed as a method by which to protect depositors from risks associated with securities transactions. It did this by prohibiting commercial banks from participating in investment banking activities and from collaborating with full-service brokerage firms

International recommendations

In 1974 the governors of the central banks of the Group of Ten leading industrial countries had set up The Basel Committee for Banking Supervision to coordinate precautionary banking regulations , and in 1988, concern about the increased danger of systemic failure led that committee to publish a set of regulatory recommendations that related a bank's required reserve ratio to the riskiness of its loans . In 1999 further concern about the danger of instability led to the creation of the Financial Stability Forum to promote information exchange and international co-operation in financial supervision and surveillance. In 2004, the Basel Committee published revised recommendations known as Basel II intended to require banks to take more detailed account of the riskiness of their loans. Responsibility for assessing risk was placed upon the banks and the credit agencies.

The crash of 2008

During the eighteen-month period between the middle of 2007 and the end of 2008 there occurred the failure or enforced rescue of fifteen major banks, three of the world's largest mortgage-lenders and one of the world's largest insurance companies , a disaster that has been attributed to risk-management errors on the part of the banks and the principal credit-rating agencies and to inaction on the part of the regulatory authorities.

Proposals for reform

The G20 summit proposals