The Wonderful Technology of Banking

My pet project in life is to get more people to understand the workings — and brilliancy — of banks. “Financial intermediation,” as jargon-y and unappealing as that sounds, is an amazing thing. Banks do many things at once, and almost all consumers and firms in a modern developed economy have access to — and benefit from — their services. Legal institutions and regulations impact the way banks operate and banking systems develop. We might say that regulation “shapes” the path of banking and accounts for the vastly different outcomes we observe both today and historically. For the last session of the Harwood Graduate Colloquium on monetary institutions, we focus on banking systems and the regulation of banks.

What do banks do?

Across almost any institutional setting, banks bundle several distinct services. First, they facilitate payments — both by keeping funds safe and by providing a wide variety of payment options such as debit cards or payment apps. In historical free banking, for instance, private banks issued their own distinct notes (redeemable liabilities for the bank) that circulated widely in the community and allowed consumers to make payments with each other using the banks’ liabilities. In this sense, banks were “in the business of reducing transaction costs.” 

Second, banks channel funds between savers and borrowers by connecting those parties to each other more efficiently than they could have done on their own. There is some historical dispute here regarding how efficient banks may have been, as most lending in 18th- and 19th-century France seems to have taken place through notaries, matched and administered through peer-to-peer (a mechanism that might be coming back through cryptocurrencies as well as P2P marketplaces). 

They also facilitate the processing and monitoring of outstanding loans, since a specialized loan officer at a bank can more effectively and efficiently monitor the performance than decentralized individuals can. In the process, banks also create “risk smoothing” features since they assume the investment risk and return from lending while offering consumers a set interest rate on their deposits — regardless of how the investment turns out. 

Third, an added benefit that bank lending has over decentralized peer-to-peer lending or broader financial-market funding is the non-public information about a borrower that a bank obtains by virtue of seeing transactions going through your account. Banks have “inside information” about you as a client and your financial status. This makes banks ideally situated to fulfill customers’ financial needs and process and supply financial services. 

While chapter 3 in Lawrence White’s book The Theory of Monetary Institutions focuses on the theory of note-issuing banks, it also gets to the core of monetary competition. In particular, it illustrates the adverse-clearing mechanism so crucial for a free banking system and how it works to check and limit aggressive bank expansion — a topic of relevance even today. The presence of note-issuing free banks, in theory and history, allows for a flexible money supply and effortless shifts between bank deposits and currency (“liability transformation”). 

In contrast to White’s chapter is George Selgin’s paper on the American experience of suppressing state bank notes by levying a 10 percent tax on them. It illustrates the impact that regulation may have on banking as well as many core issues that are crucial to monetary theory and monetary competition, including Gresham’s law, network effects, and asymmetric information. Additionally, there’s a brief comparison between American and Canadian banking history that well captures the value of studying different banking systems to figure out how regulations impact banks’ behavior.  

The two last papers (Josh Hendrickson’s “Contingent Liability” article and Todd Keister’s chapter on liquidity and monetary policy) are much more recent and deal with questions of bank liability, bank reserves, Basel III regulations, and their connection to monetary policy. Together, they ask a lot of questions about banking regulation and bring most readers up to speed on current in-depth debates in central banking (“macroprudential regulation,” in jargon).   

Hendrickson’s overview article in Cato Journal dives into the workings of contingent liability, the default legal structure for most banks in most countries up until the 20th century (partners in Goldman Sachs, for instance, were unlimitedly liable for the firm’s debts until the 1980s, and shareholders of American Express had unlimited liability until 1965). 

Since the financial crisis over a decade ago, governments and central banks around the world have attempted to implement a plethora of regulations aimed at making banks safer. Extended shareholder liability, as it operated in centuries past, would seem like an easier and superior way of achieving safer banks by aligning the incentives of shareholders with depositors — essentially a way of disciplining bank management to get them to behave prudently. 

Keister’s chapter explores the so-called liquidity coverage ratio (LCR) — a Basel regulation that has come into place in recent years — and how it might change the way banks structure their short-term liquidity. In a typical instance of “fighting the last war,” regulators have attempted to solve the problem of evaporating liquidity in short-term funding markets that banks faced in the lead-up to the financial crisis. LCRs now force banks to hold more liquid assets and reduce their reliance on short-term funding. Keister shows how the demand for such liquid assets has thereby changed, which has impacted interest rates — and, Keister argues, might obstruct how well central banks can perform monetary policy going forward. 

In sum, the virtue of using monetary and financial history in informing our views about the present lies in its ability to greatly widen the range of regimes that we are familiar with. The past, as L.P. Hartley famously said, is a foreign country, and doing things differently under diverse circumstances and institutions provides us with options for how we could structure our financial and monetary arrangements today. 

Modern banking is a wonderful technology. Understanding how regulation shapes it and contributes to the outcomes we observe is of great importance. 

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