What else do banks do besides lending my money and making money?

The 2022 Nobel Prize in Economics was awarded to Ben S. Bernanke, Douglas Diamond and Philip H. Dybvig for their research on banks and financial crises.

Banks are closely connected with our daily lives. Savings, loans, and payments are all related to banks. But sometimes, a wave of bank failures may trigger a financial crisis, resulting in a large number of depositors' savings disappearing, a large number of bad debts, a sharp drop in asset prices, a sharp increase in borrowing costs, and a series of avalanche-like consequences. In fact, several of the largest economic collapses in history were also financial crises caused by a large number of bank failures.

Given that banking crises are so destructive, would the economy function as usual without “banks”?

“Borrow short-term debt and lend long-term” is difficult to do without banks

Diamond and Debvig developed a theoretical model that explains why banks exist: they can simultaneously meet the needs of savers for savings flexibility and borrowers for loan stability.

For the economy to function properly, savings must be directed to investment. If ordinary people's savings are just left there and not moved at all, the liquidity of market funds will be greatly reduced, and money will not be directed to where it is needed, such as self-employed individuals who need capital to open a store, or business owners who need financing to expand production.

But ordinary people have a high demand for flexibility in savings. The future is unpredictable, and they may need money urgently at any time, so they need to be able to withdraw the money immediately.

Borrowers cannot offer this kind of "flexibility" because it would mean early repayment, which would completely disrupt their investment plans.

If there were no banks, ordinary people would lend their savings directly, and this contradiction would be unsolvable. This problem can be solved by having banks act as credit intermediaries:

The money in the depositor's account is the bank's liability, which is equivalent to the money that the depositor "borrows" from the bank, while the bank's assets are the loans. The former is an uncertain short-term liability, because depositors can withdraw their money at any time, while the latter is a long-term asset. The bank has a commitment to the borrower, and the borrower does not have to repay the loan in advance.

Banks absorb a large amount of highly liquid and unstable short-term deposits and convert them into illiquid and stable long-term loans, which plays the role of maturity transformation.

This can certainly optimize the allocation of social funds, but it will also put banks at risk, and the dark cloud of "bank runs" will always hover over the banking industry.

The cost of banks’ role

The bank does not have all the cash on hand because part of it is used for lending. If a large number of depositors request to withdraw their money from the bank, the bank will not be able to meet their demands at the same time. The depositors are the bank's debtors, and the bank cannot repay its debts, so it can only declare bankruptcy.

The reason why banks have not collapsed is based on the general trust of ordinary people in the credit of banks. Once rumors spread in the market that the bank's reserves are insufficient, people who go late will not be able to withdraw money, making everyone rush to the bank to withdraw money, then it will be more difficult to withdraw money, which will further strengthen the authenticity of the rumors and make more people come to the bank to queue up to withdraw money.

This is a positive feedback mechanism that makes a bank run a self-fulfilling prophecy: if everyone believes that the bank will be unable to withdraw money, then it will actually be out of money.

Before Bernanke's research, people generally believed that banking crises were the result rather than the cause of economic recessions, but Bernanke's research confirmed that bank runs and the resulting bank failures played a decisive role in long-term depressions.

A bank run can spread from one bank to another. When people lack confidence, they withdraw their money from banks.

If bank deposits decline, they will not dare to issue new loans, companies will find it difficult to obtain convenient financial support and will be prone to bankruptcy, which will in turn affect the jobs of ordinary people.

Moreover, these panic runs may spread within the banking system through interbank lending, emotional contagion, and other channels, triggering a widespread banking and economic crisis, just as occurred in the United States in the 1930s.

Bernanke's research shows that it was not until the country finally implemented strong measures to prevent more panic runs, such as emergency liquidity support, deposit insurance, and even bank holidays, that the spread of panic was stopped and economic activity was restored.

Banks supervise loans and also need to accept financial supervision

Although government aid can help reduce the possibility of bank runs and the harm caused when they occur, on the other hand, because of the government's credit guarantee, the banking industry may be more inclined to ignore financial risks, especially to pursue tail risks, making crises more likely to occur.

In fact, the imprudent behavior of banks with government credit guarantees is a manifestation of moral hazard. Therefore, banks must be subject to appropriate supervision to avoid solving the problem of bank runs while bringing about moral hazard problems for bank practitioners.

This year's winners also delved into the issue of bank regulation, another important function of banks: monitoring borrowers to ensure they deliver on their promises.

Lending involves the risk that the other party will not repay the money. Assessing risk is a professional job. Banks have a credit assessment system to track investment progress.

Without banks, ordinary people acting as lenders would have a hard time assessing the likelihood of repayment. Private lending disputes are notoriously complex and time-consuming, so handing the risk of lending to banks and trusting them to manage funds well is also a very cost-effective arrangement.

Who, then, supervises the supervisors? Diamond concluded that the way banks are organized means they require no supervision from depositors.

Because if a bank cuts corners, it will suffer huge losses on its loans, and its regulator is the interests. As long as the bank manages its lending activities in a responsible manner, the risk of a large bank failing as a result is small.

A bank lends to a large number of borrowers. Even if a few borrowers default, the loss of all loans is still small. The existence of banks reduces the cost of transferring savings to productive investment, that is, the cost of credit intermediation. In turn, the reduction in costs means that more socially valuable investment projects can be financed.

The premise of cost reduction is that banks have a lot of knowledge capital to manage loans, and banks fully understand borrowers and know how they will use money. But during the crisis, a large number of banks collapsed, relevant information disappeared, and credit intermediation costs rose sharply, which hindered the economic recovery.

It takes a long time to rebuild and repair the banking system. During this period, the banking system will be even more powerless to regulate loans, further prolonging the duration of the depression. The outbreak of the subprime mortgage crisis in 2008 further highlighted the importance of financial regulation. Financial regulation not only helps to repair the banking system after the fact, but also regulates the behavior of banks before the fact, such as improving loss absorption capacity, etc., thereby reducing the vulnerability of the banking system in the face of a crisis.

As early as the 1980s, these three scholars paid attention to and even predicted to a certain extent the key role of banks in the financial crisis. It can be said that they deserved the Nobel Prize.

Banks are important but also inherently fragile. The subprime mortgage crisis also tells us that profit alone is not enough to guide banks to become strong regulators.

Therefore, appropriate financial supervision is very necessary, which is one of the reasons why the United States strengthened financial supervision after the 2008 crisis.

The work of these three scholars laid the theoretical foundation for modern banking supervision, deepened our understanding of financial crises, and enabled us to enjoy its convenience while minimizing the risks it brings.

References
[1]https://www.nobelprize.org/prizes/economic-sciences/2022/summary/

Author: Su Qi Nian, Window Knocking Rain

Editor: Emeria, Mai Mai

Reviewer: Ben

Guokr (ID: Guokr42)

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