Financial Cryptography

What banking is. (Essential for predicting the end of finance as we know it.)

To understand what's happening today in the economy, we have to understand what banking is, and by that, I mean really understand how it works.

This time it's personal, right? Let's starts with what Niall Ferguson says about banking:

To understand why we have come so close to a rerun of the 1930s, we need to begin at the beginning, with banks and the money they make. From the Middle Ages until the mid-20th century, most banks made their money by maximizing the difference between the costs of their liabilities (payments to depositors) and the earnings on their assets (interest and commissions on loans). Some banks also made money by financing trade, discounting the commercial bills issued by merchants. Others issued and traded bonds and stocks, or dealt in commodities (especially precious metals). But the core business of banking was simple. It consisted, as the third Lord Rothschild pithily put it, "essentially of facilitating the movement of money from Point A, where it is, to Point B, where it is needed."

As much as the good Prof's comments are good and fruitful, we need more. Here's what banking really is:

Banking is borrowing from the public on demand, and lending those demand deposits to the public at term.

Sounds simple, right? No, it's not. Every one of those words is critically important, and change one or two of them and we've broken it. Let's walk it through:

Banking is borrowing from the public ..., and lending ... to the public.

Both from the public, and to the public. The public at both ends of banking is essential to ensure a diversification effect (A to B), a facilitation effect (bank as intermediary), and ultimately a public policy interest in regulation (the central bank). If one of those conditions aren't met, if one of those parties aren't "the public", then: it's not banking. For example,

• a building society or Savings & Loan is not doing banking, because .. it borrows from *members* who are by normal custom allowed to band together and do what they like with their money.
• a mutual fund is not banking because the lenders are sophisticated individuals, and the borrowers are generally sophisticated as well.
• Likewise, an investment bank does not deal with the public at all. So it's not banking. By this theory, it's really a financial investment house for savvy players (tell that to Deutschebank when it's chasing Goldman-Sachs for a missing billion...).

So now we can see that there is actually a reason why the Central Banks are concerned about banks, but less so about funds, S&Ls, etc. Back to the definition:

Banking is borrowing ... on demand, and lending those demand deposits ... at term.

On demand means you walk into the bank and get your money back. Sounds quite reasonable. At term means you don't. You have to wait until the term expires. Then you get your money back. Hopefully.

The bank has a demand obligation to the public lender, and a (long) term promise from the public borrower. This is quaintly called a maturity mismatch in the trade. What's with that?

The bank is stuck between a rock and a hard place. Let's put more meat on these bones: if the bank borrows today, on demand, and lends that out at term, then in the future, it is totally dependent on the economy being kind to the people owing the money. That's called risk, and for that, banks make money.

This might sound a bit dry, but Mervyn King, the Governor of the Bank of England, also recently took time to say it in even more dry terms (as spotted by Hasan):

3. The theory of banking

Why are banks so risky? The starting point is that banks make heavy use of short-term debt. Short-term debt holders can always run if they start to have doubts about an institution. Equity holders and long-term debt holders cannot cut and run so easily. Douglas Diamond and Philip Dybvig showed nearly thirty years ago that this can create fragile institutions even in the absence of risk associated with the assets that a bank holds. All that is required is a cost to the liquidation of long-term assets and that banks serve customers on a first-come, first-served basis (Diamond and Dybvig, 1983).

This is not ordinary risk. For various important reasons, banking risk is extraordinary risk, because no bank, no matter where we are talking, can deal with unexpected risks that shift the economy against it. Which risks manifest themselves with an increase in defaults, that is, when the long term money doesn't come back at all.

Another view on this same problem is when the lending public perceive a problem, and decide to get their money out. That's called a run; no bank can deal with unexpected shifts in public perception, and all the lending public know this, so they run to get the money out. Which isn't there, because it is all lent out.

(If this is today, and you're in Ireland, read quietly...)

A third view on this is the legal definition of fraud: making deceptive statements, by entering into contracts that you know you cannot meet, with an intent to make a profit. By this view, a bank enters into a fraudulent contract with the demand depositor, because the bank knows (as does everyone else) that the bank cannot meet the demand contract for everyone, only for around 1-2% of the depositors.

Historically, however, banking was very valuable. Recall Mr Rothschild's goal of "facilitating the movement of money from Point A, where it is, to Point B, where it is needed." It was necessary for society because we simply had no other efficient way of getting small savings from the left to large and small projects on the right. Banking was essential for the rise of modern civilisation, or so suggests Mervyn King, in an earlier speech:

Writing in 1826, under the pseudonym of Malachi Malagrowther, [Sir Walter Scott] observed that:

"Not only did the Banks dispersed throughout Scotland afford the means of bringing the country to an unexpected and almost marvellous degree of prosperity, but in no considerable instance, save one [the Ayr Bank], have their own over-speculating undertakings been the means of interrupting that prosperity".

Banking developed for a fairly long period, but as a matter of historical fact, it eventually settled on a structure known as central banking [1]. It's also worth mentioning that this historical development of central banking is the history of the Bank of England, and the Governor is therefore the custodian of that evolution.

Then, the Central Bank was the /lender of last resort/ who would stop the run.

Nevertheless, there are benefits to this maturity transformation - funds can be pooled allowing a greater proportion to be directed to long-term illiquid investments, and less held back to meet individual needs for liquidity. And from Diamond's and Dybvig's insights, flows an intellectual foundation for many of the policy structures that we have today - especially deposit insurance and Bagehot's time-honoured key principle of central banks acting as lender of last resort in a crisis.

Regulation and the structure we know today therefore rest on three columns:

1. the function of lender of last resort, which itself is exclusively required by the improbable contract of deposits being lent at term,
2. the public responsibility of public lending and public borrowing, and
3. the public interest in providing the prosperity for all,

That which we know today as banking is really central banking. Later on, we find refinements such as the BIS and their capital ratio, the concept of big strong banks, national champions, coinage and issuance, interest rate targets, non-banking banking, best practices and stress testing, etc etc. All these followed in due course, often accompanied with a view of bigger, stronger, more diversified.

Which sets half of the scene for how the global financial crisis is slowly pushing us closer to our future. The other half in a future post, but in the meantime, dwell on this: Why is Mervyn King, as the Guv of the Old Lady of Threadneedle Street (a.k.a. Bank of England), spending time teaching us all about banking?

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1. What banking is. (Essential for predicting the end of finance as we know it.)


2. What caused the financial crisis. (Laying bare the end of banking.)


3. A small amount of Evidence. (In which, the end of banking and the rise of markets is suggested.)


4. Mervyn King calls us to the Old Lady's deathbed?

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[1] Slight handwaving dance here as we sidestep past Scotland, and let's head back to England. I'm being slightly innocent with the truth here, and ignoring the pointed reference to Scotland.

Posted by iang at November 21, 2010 07:25 AM | TrackBack