Discuss the reasons for the existence of banks and whether their future existence is assured
... Why do we need intermediaries? As the process of lending and borrowing in order to achieve investment and growth is an important part of economy, intermediaries (i.e. banks) are sought to undertake the process on behalf of both parties. Financial institutions that borrow from ultimate lenders and lend to ultimate borrowers are found in all developed economies, as they have the means to overcome the problems discussed/described above. It must be remembered however, that by introducing an intermediary, a further set of costs are being introduced, therefore any suggestion that using an intermediary is an improvement over direct lending and borrowing must take these costs into consideration. The literature suggests that banks alleviate the problems of direct lending and borrowing in the following two ways. Banks as ‘transformers’ By acting as ‘transformers’, banks can facilitate borrowing and lending on terms which are desirable to both the borrower and lender. Gurley and Shaw (1960) described this as transforming “the primary securities issued by firms into the indirect securities desired by ultimate lenders”. They do this in three ways: Maturity transformation Individual lenders can deposit money with financial institutions, earn a small interest payment on their deposit and retrieve their money on demand. The financial institutions can then use these deposits to fund long-term loans to borrowers. This is commonly called “borrowing short and lending long”. This ‘mismatching’ of assets and liabilities exposes the bank to liquidity risk, which is the risk that it may not have enough liquid assets to meet its obligations. This can be overcome by estimating its liquid requirements, and holding the necessary capital. However, if a ‘run’ develops, the banks solvency will be threatened. Risk transformation Banks can transform the relatively high-risk loans it makes to borrowers into the almost zero-risk deposits made by lenders in a number of ways. They can minimise the individual risks taken on by not lending to bad risks, and can diversify by lending to different types of borrower, so as to create greater independence of each loan risk. Risks are also minimised by pooling, (i.e. making a large number of loans so that the law of large numbers reduces individual risk), and by ensuring they have adequate capital supplies should a certain number of loans default. Size transformation Banks can combine the number of small deposits made by lenders in order to fund larger loans to borrowers. As shown in Buckle and Thompson (1992), there are also economies of scale to be gained from an intermediary undertaking all of the above, rather than each process being undertaken by a number of individual lenders, therefore transactions costs are reduced. Gurley and Shaw (1960) also support this theory by stating: on the lending side the intermediary can invest and manage investments in primary securities at unit costs far below the experience of most individual lenders. Solving the problem of asymmetric information This is currently the main reason for the existence of banks. The first problem it poses, that of adverse selection, can be solved by producing information about potential borrowers so that the information asymmetry between both parties isn’t as unbalanced. This information can then be used to assess whether or not the borrower is a good risk, and hence whether or not the bank should make the loan. In the US, this information can be bought from companies such as Moody’s and Standard & Poor’s, who produce the information by investigating companies’ past and present activities and analysing their financial statements. However, the value of this information is limited due to the free-rider problem. This refers to investors watching which companies investors (who have paid for information) are investing in/lending money to, and copying them. This leads to individuals not getting the sole benefit from doing or paying for this research, and will result in less research being undertaken. Banks however, are experts at information production, especially if the borrower banks with them as they have access to their transactions accounts. A private loan such as this also alleviates the free-rider problem, as outside investors cannot see that the bank is making the loan and try and bid for it. Banks overcome the second problem posed, the moral hazard, by the use of restrictive covenants. This is a clause written into the debt contract restricting the borrowers activities, e.g. specifying which items can be purchased with the borrowed funds. These clauses must be monitored and enforced, and the cost of this again gives rise to the free-rider problem (with traded securities), as each bond holder is likely to assume other bond holders are doing enough monitoring and hence not enough monitoring will be done. Banks again avoid this problem by mainly making non-traded loans. (A further reason for their existence suggested by Diamond is described in appendix 1.) It can therefore be seen that financial intermediaries increase lending and borrowing in the economy to finance investment by overcoming the problems of direct lending (see appendix 2 for Hirschleifer’s model). What would happen, however, if these problems disappeared? Would there still be a need for banks? Benson and Smith (1976) suggest that “in a market without any frictions such as transactions costs, information costs, or indivisibilities, financial intermediaries would not exist”. The decline of traditional banking Evidence suggests that traditional banking (defined as long-term loans funded by issuing short-term securities) is in decline. Chart 1 (appendix 3) shows that in the US, there has been a large decline in commercial banks’ share of loans to non-financial borrowers. We can also see from Table 1 (appendix 3) that the relative size of banks’ balance sheet assets is decreasing, as they lose their share to other intermediaries. It must be remembered however, that this only indicates a decline in traditional banking, for as Boyd and Gertler (1994) and Kaufman and Mote (1994) point out, we also need to consider their off-balance sheet business. Evidence from the Cruickshank Report, a report into competition in the UK banking industry, shows that overall profits in the industry are not in decline, and actually stated that “The accounting methodology suggests that total returns to date for the firms in the sample (from 1989 to the end of 1999) have been neutral to excessive over the period.” See appendix 5 for more information on shareholder returns and bank profits. Therefore, if traditional banking is in fact in decline, but banks are still making considerable (or “super-normal” according to the Cruickshank) profits, where is this extra profit coming from? Why is traditional banking in decline? Economic forces and financial innovations in recent years have resulted in a large number of changes in the banking industry. Declining entry barriers, such as developments in technology (ATMs, Internet, telephone, and digital TV banking) have meant that the high capital cost of acquiring a large network of branches is no longer required, and have led to increased competition from new-comers into the industry, such as insurance companies and other non-financial companies such as supermarkets and other retailers. This increased competition has led to the decline in traditional banking activities in two ways: a diminished advantage in banks acquiring funds and diminished loan advantages. Diminished advantage in banks acquiring funds This is more of an issue in the US as up until 1980 legislation prevented banks from paying interest on their current accounts and only paying specified amounts on savings and time deposits, which meant that customers went elsewhere. When the regulation was abolished, the cost to banks of acquiring funds in this way increased. This isn’t as much of an issue in the UK, although competition for deposits from other entrants into the market has meant that banks have needed to offer more incentives to attract and retain customers, at an increased cost to the bank. Diminished loan advantages Developments in technology and the increased sophistication of consumers means that increasingly firms are borrowing directly from ultimate lenders through commercial paper. The growth of the junk bond market has also enabled lower quality borrowers to issue bonds. In the US, sales of junk bonds have rose from $2.9 billion in 1992 to $60 billion in only three years. The increased securitisation of assets is described by Edwards and Mishkin (1995): “Advances in information and data processing technology have enabled non-bank competitors to originate loans, transform these into marketable securities, and sell them to obtain more funding with which to make more loans.” These technological advancements enabled other institutions to reduce the transactions costs in lending, and have therefore challenged banks’ competitive advantage. In today’s global economy firms also have easier access to international securities markets, as well as offshore capital markets such as the Eurobond market. A further explaination by Diamond for the decline in the need for banks can be found in appendix 6. How have banks responded to these changes? Banks have responded to these changes in four key ways: Increased number of mergers and failures In the US, from 1946 – 1980, approximately six banks failed per year. During the 1980s, this number had risen to approximately 104 per year (Gorton and Rosen, 1995). In the last 7 years, most large banks in both the UK and the US have also merged, resulting in there being fewer banks. Expansion into new, riskier areas of lending Banks have begun expanding into new riskier areas of lending such as commercial and private real-estate lending. However, Japanese banks suffered huge losses when property values collapsed in the early 1990s, and French and UK banks lost a lot of money from certain risky commercial real-estate ventures. Evidence also shows that banks have increased lending to less credit-worthy customers, as in recent years their loan loss provisions relative to their assets have increased considerably. Pursuing off-balance sheet business Financial innovations have led to tremendous growth in banks’ involvements in derivatives markets; in the past few years we have seen off-balance sheet derivatives reach $95 trillion in notational value (ft report). However, although the returns are potentially high, regulators are concerned about the risks involved. Expanding into other consumer financial services In the 1980s, banks began providing mortgages, after controls on bank lending were abolished in 1980. Now, banks are beginning to provide more and more consumer-related financial services, such as insurance and pensions products. In the 1990s, banks such as Lloyds TSB in the UK and Credit Suisse bought life assurance companies to help drive revenue growth by selling pension products to existing customers. Is their future existence assured? Despite concern about banks involvement in off-balance sheet business, the report by Edwards and Mishkin (1995) (see references) demonstrates that banks can continue to participate in this area without risking the stability of the financial system, as long as they manage their risk exposure (credit and market) effectively. Such activities already provide a large source of banks profits, and look as though they will continue to do so in the future. Another key area of expansion for banks is into other financial products by becoming ‘financial supermarkets’. Forrester Research indicates that 61% of consumers prefer to consolidate financial services with their bank, and industry experience shows that the more products customers buy from one supplier, the less likely they are to change. This is called the retail customer profitability/retention phenomenon, and demonstrates that there is incredible power in selling multiple products to customers (Thomson, 1991). Allianz bought Dresdner Bank last year to help increase its presence in bancassurance. It planned to use Dresdner's retail network and fund m...