Should Banks Exist?

Official agreement that the flames of economic crisis were fanned by banking dysfunction has prompted calls for all sorts of changes: for systemic restructuring, for heightened scrutiny and regulation, for curtailment of bank activity, even for the establishment of deposit-funded “narrow” banks forbidden from assuming credit risk. Embedded in any criticism of the sector are assumptions about what banks are supposed to do; yet these remain hidden, unexplored and perhaps unknown. Few critics have gone to the trouble of questioning what banks are for, indeed of asking whether banks should even exist. Below I highlight some functions commonly attributed to banking, and challenge the efficacy of the arrangement.

A) Offer savers risk-free assets

Savers are defined by a desire to consume in the future and a demand for instruments that permit them to do so. Banks are entrusted with satisfying most of this demand by issuing risk-free deposits. An exponent of banking would argue that the risk-free character of deposits is down to insurance obtained by pooling myriad credit exposures together. According to the laws of probability, such diversity reduces portfolio loss severity, allowing a relatively small first loss piece in the form of bank equity to cushion depositors from loan losses that inevitably arise. Although banks do obtain the benefits of insurance, it is not a good that they produce: insurance is a by-product of statistical tendencies exhibited by natural populations. Accordingly, credit insurance can be extracted by any entity with the scale to aggregate together a number and range of loans sufficient for the sample to resemble the population, within a certain confidence interval.

Banks are by no means the only type of entity that could harness this resource. In fact, banks have not even been particularly proficient at risk management, as the scale of the fiscal subsidy to the sector attests. To some extent, banks are brokering a level of implicit public reinsurance; even assuming this was an appropriate service for the state to provide, surely it would be better provided directly. In my last post, I identified a dormant source of risk-free assets with which -under a rehabilitated social contract- everyone would be endowed. This would allow investors to offer their assets to savers in return for liquidity, and thus dispense with bank intermediation.

B) Lift borrowing constraints

Individuals’ ability to borrow is constrained by a number of factors. Such borrowing constraints deter savers from lending money to them. However, savers are willing to make deposits with banks, which, in turn, are prepared to lend on to otherwise constrained borrowers. According to this, the existence of banks extends the availability of credit, and this stimulates economic growth. There is truth to this, and indeed this probably explains the origins of banking. However, banks are not the only creditworthy institution capable of financial intermediation: any conglomerate could benefit from insurance and thus increase its risk appetite above what an individual saver could tolerate. Moreover, as noted above, banks’ creditworthiness has relied greatly on a public guarantee, which is an unfair, and costly, advantage.

As noted above, endowing individuals with their natural entitlement of risk-free assets would immediately remove borrowing constraints, and dispense with any reliance on banking.

C) Promote liquidity

It is sometimes said that banks export liquidity, making themselves less liquid in the process. This characterisation is not entirely accurate, but what is helpful is the sense in which liquidity is scarce i.e. that if someone is to have more of it, then someone else is left with less. Measured across society, liquidity charts the degree to which a given level of output is consumed voluntarily. Liquidity ranges from zero, which describes a state of social collapse plagued by hyperinflation, hoarding and squalor; through to one (unity), which would accord with absolute social trust, with savers holding liquid instruments, allowing goods to circulate to meet the demand to consume. Liquidity can be enhanced along this scale through refinements in the social contract and through insurance. The latter is a service offered by banks, yet nothing banks can do can raise liquidity above unity. All that any monetary operation can achieve, including quantitative easing performed by the central bank, is to help redistribute liquidity from where it is not needed to where it is in demand, in return for the appropriate liquidity premium.

Rather than harvesting liquidity from its natural supplier -savers- banks issue new deposits, whose risk-free status qualifies them as money. Expanding the money supply as the method of redistributing liquidity makes banks more leveraged and fragile and means that bank lending casts a long shadow over public finances. However, this is not allowed to make banks any the less liquid, as is sometimes claimed, because, as should be clear, no illiquid entity can function as a bank. Put differently, money issued by a given bank cannot suffer a nominal write-down without impairing the entire currency. When they make loans it is not banks that lose liquidity, it is money, whose oversupply -being delivered to spenders and savers alike- creates a redundancy, and places it at the mercy of shifts in the demand to save or consume. For some time, behind the illusion of ever-growing liquidity, real surpluses are being gradually replaced by “forced savings”. This is a recipe for price volatility, since demand is able to switch suddenly between saving and consumption. In the worst case this may trigger a collapse in liquidity and hyperinflation as savers fly from financial instruments into real goods.

As noted in previous posts, under the existing social contract, an asset’s liquidity is its only means of being risk-free, which is a costly conflation since banks are all but obliged to offer interest and liquidity in order to compete for business. Yet by failing to charge a premium for liquidity, either the premium is charged from the public or else liquidity is a mirage. Liquidity is scarce and banking an inefficient method of rationing it. After all, savers have no wish to consume right away and should be natural sellers of liquidity to capital investors. Provided an alternative to public insurance is established as the source of risk-free assets -a topic addressed in an earlier post- a simple clearing house can be shown as being far superior to banking as a conduit for liquidity.

D) Handle payments

Since bank claims function as “inside” money, they are used to settle transactions. This creates a role for banks in the payment system. Payment instructions often cross banking divides: if Dave, who banks with National Bank, writes a wage cheque to George, who banks with Credit Bank, then National Bank must redeem Dave’s deposit and pay this to Credit Bank, which must go on to issue a deposit in George’s name. Note that the interbank transaction made on behalf of Dave (that evidences the payment of wages to George) is settled not with “inside” money but with “outside” base money. The quantity of base money is subject to the sole discretion of the central bank, which exposes individual banks to possible shortages in such reserves, even while fulfilling the mundane task of handling payments. While there can never be a systemic shortage of base money provided banks are willing to lend to each other, a nasty feature of banking crises is that banks refuse one another credit, thus freezing the payment system and disrupting all manner of economic activity. Administering payments within a single non-bank clearing system would avoid this risk.

Conclusion

None of the functions above are dependent for their performance on a banking system. Maintaining a banking system at all cost, as we do now, is a hugely expensive luxury, and one offering few benefits. Moreover, it has encouraged a number of harmful practices such as speculation, and suppressed useful forces such as balanced investment, both leading to bubbles. Yet despite the palpable costs imposed on society by banking, not even its sternest critics dare question its existence. Indeed, the all-out political and media assault that banks have sustained does not expose weakness, it underscores the strength of political support for the sector – so much so, in fact, that our sovereign credibility has been pledged in order to preserve the banking system. Is a decrepit and dysfunctional banking system really worth sacrificing our fiscal flexibility and economic health for? The small group of strange companies known as banks owes its existence to the grace of the general public, whose tacit consent for its monopoly privileges should be urgently reconsidered to safeguard our economic wellbeing.

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