Is there a future in banking? Towards a new theory of the commercial bank

According to some, the commercial bank -an institution that conducts the twin activities of accepting deposits payable on demand and originating loans -is anachronistic and in a state of terminal decline. The evidence, however, is somewhat mixed. This paper takes a different approach to analyzing the future of banks: I examine whether there is an economic rationale for their existing in the past and whether this rationale continues to hold. I first outline why the two core banking activities, of taking in deposits payable on demand and of originating non-marketable loans, are performed by financial institutions. Both activities essentially require an institution to come up with cash at short notice, that is, provide liquidity. Scale economies in providing liquidity then explain why both activities are provided by the same entity -a commercial bank. Deregulation and innovation have increased competition, which has forced banks to concentrate on the essentials of liquidity provision. This is why the outward nature of their activities -though not the underlying economic rationale -has changed. However, in the course of performing their traditional activities, banks have acquired competencies that enable them to perform a variety of other financial and non-financial activities that deregulation and innovation have opened up to them. The paper concludes with a discussion of why banks may want to limit their entry into some new activities. For example, the Chairman of the Federal Reserve Board, Alan Greenspan, is quoted by the Wall Street Journal 1 (July 9th, 1993) as saying “Public policy should be concerned with the decline in the importance of banking. The issues are too important for the future growth of our economy and the welfare of our citizens." In the same article, William Isaac, a former chairman of the Federal Deposit Insurance Corporation and an industry consultant, is quoted as saying “The banking industry is becoming irrelevant economically, and it's almost irrelevant politically". For the view that banks are in decline, see G. Gorton and R. Rosen, ACorporate Control, Portfolio Choice, and the 2 Decline of Banking@, Journal of Finance 50 (1995), 1377-1420. 7 According to many observers, the commercial bank -the institution that accepts deposits payable on demand and originates loans -has outlived its usefulness and is in a state of terminal decline. Commercial bank assets as a fraction of assets in financial institutions in the United States have fallen dramatically, from over 70% around the turn of the century to just around 30% today. Bank share of corporate debt in the United States has declined from 19.6% in 1979 to 14.5% in 1994. But history 2 suggests caution in projecting trends too far. Bank loans to industrial firms fell dramatically in the 1920s in the United States as firms directly tapped the public markets. Proclamations of the demise of commercial banking were often heard at that time. Since projections based on trends have been proved wrong, I take a different approach in evaluating the future of commercial banking. What I propose to do here is to explore why the two core banking activities, of taking in deposits payable on demand and of originating non-marketable loans, are performed by the same organization. While we have good theories as to why either activity is performed by institutions (rather than anonymously in the market place), we understand less well why both activities have historically been united in the form of the commercial bank. I present two related explanations. First, both activities essentially require an institution to come up with cash at short notice, i.e., provide liquidity. Scale economies in providing liquidity then explain why both activities are provided by the same entity. Second, since both activities essentially offer customers guarantees, the safety and soundness of the institution offering guarantees is important. I will argue that the activities, at least historically, co-insured each other, and these scope economies again made it advantageous to combine the activities in one organization. In the second half of the paper, I argue that deregulation and innovation have increased competition in banking and financial services, which has forced banks to concentrate on the essentials of liquidity provision. Also, the co-insurance between lending and liquidity provision has become less important. In In a series of papers and in The Global Financial System: A Functional Perspective (Harvard Business School Press, 4 Boston, 1995) Robert Merton and his colleagues argue for a functional approach to analyzing and regulating financial institutions. ARather than taking existing institutions and organizational structures as givens, [this research] is anchored on the underlying functions of financial systems.@ (Page vii). The idea is to take the economic function as given and then ask what institutional structure best performs the function at a given time and place. So institutional form follows function. While this approach has the commendable virtue of abstracting from institutional nomenclature to focus on the economics, it may be taken too far. Implicit in a strict application of such an approach (for example, regulating functions rather than institutions) is the assumption that functions are separable. This seems a little premature unless we understand why multiple financial functions are performed by a particular type of institution. If the performance of a financial function develops critical competencies in an institution, it may well be placed to perform other financial functions. A purely functional approach may miss the interlinkages between functions, while an approach which considers an institution as a whole, in terms of the functions it performs, will capture these. 8 response, the outward nature of bank activities has changed -though much of the underlying economic rationale has not. Furthermore, in the course of performing their traditional activities, I will argue that banks have acquired competencies that enable them to perform a variety of other financial and non-financial activities that deregulation has opened up to them. As part of their evaluation of these non-traditional activities, bankers must carefully consider whether their organizational structures, controls and compensation policies are appropriate for the new environment.` 3 WHY FINANCIAL INTERMEDIARIES WIN OUT OVER MARKET TRANSACTIONS. Financial institutions bring to financial transactions exactly that which industrial firms bring to industrial production -namely, an ability to accomplish some economic task or objective at lower cost than arm’s length contracts. I now elaborate on the advantages institutions bring to the two traditional financial activities that define a commercial bank. Why institutional intermediaries offer demand deposits. To focus on why institutional intermediaries are better at offering customers the ability to deposit money and withdraw it on demand, I start with the simplest such intermediary -an open-ended money market mutual fund -and compare it with the simplest direct alternative, that of the individual customer holding financial assets such as T-bills directly and liquidating them when the need for funds arises. a. Institutions have greater market power than individuals. A money market mutual fund can save investors the transactions costs of brokerage fees they would incur if they invested directly. Even if the mutual fund buys and sells as often, and in the same quantities, as all of its individual investors taken together (which I note below is not the case), intermediation by the