Deep Thinking on Banking

Forbes has a fascinating article by Laurence J. Kotlikoff and Edward Leamer, with fundamental thinking about banks.

They trace the problems of banks to the fundamental contradictions of having a highly leveraged financial firm, with assured returns and full liquidity for depositors, and opaque + illiquid assets. I agree with this gloomy prognosis. A more fleshed out argument is in this pair of articles — link and link — which were opinion pieces in 1999.

I stopped chasing those lines of thought because it seemed dishearteningly hard, trying to sell a world without banks as we know ‘em. But if you are persuaded by these arguments, then you will like a world where we do more finance through securities markets, through `defined contribution and NAV-based’ financial firms (i.e. direct household participation in financial markets, mutual funds and DC pensions), and less through `assured returns’ financial firms such as banks, DB pensions and insurance companies.

In a perverse way, India’s prodigous mistakes of policy on banking have helped steer the country into a more market-dominated financial system, which has helped build a better financial system.

Since we’re unlikely to reconstruct the economy in radical ways, we have to confront the problems of banks. I feel the most important element of safe and sound banking is: a proper deposit insurance mechanism. Chapter 6 of Raghuram Rajan’s report is the best blueprint out there about setting up a deposit insurance corporation, and other dimensions of improving systemic risk (see `V. Preventing Crisis and Dealing with Failure’).

You might like to also see this picture on banking reforms.

1 comment to Deep Thinking on Banking

  • Raymond

    Hello Ajay,

    Here in the US, banks and the nations monetary system has always been vulnerable to depositor withdrawals on a large scale. The reason is of course the unstable nature of fractional reserve banking itself. The creation of the Federal Reserve System and later the FDIC were both attempts at fixing this baked-in-the-cake problem for bankers. Yet the system is still at the mercy of depositors.

    It always help to look a little further back in history to grasp what is happening in todays global monetary system.
    According to Rothbards book: A History of Money and Banking in the United States:

    “In contrast to government paper, private bank notes and deposits, redeemable in specie, had begun in western Europe in Venice in the fourteenth century. Firms granting credit to consumers and businesses had existed in the ancient world and medieval Europe, but these were “money lenders” who loaned out their own savings. “Banking” in the sense of lending out the savings of others only began in England with the “scriveners” of the early 17th century. The scriveners were clerks who wrote contracts and bonds and were therefore in a position to learn of mercantile transactions and engage in money lending and borrowing.

    There were, however, no banks of deposit in England until the civil war in the mid-seventeenth century. Merchants had been in the habit of storing their surplus gold in the king’s mint for safekeeping. That habit proved unfortunate, for when Charles 1 needed money in 1638, shortly before the outbreak of the civil war, he confiscated the huge sum of 200,000 of gold, calling it a “loan” from the owners. Although merchants finally got their gold back, they were understandably shaken by the experience, and forsook the mint, depositing their gold instead in the coffers of private goldsmiths, who, like the mint, were accustomed to storing the valuable metal. The warehouse receipts of the goldsmiths soon came to be used as a surrogate for the gold itself. By the end of the civil war, in the 1660s, the goldsmiths fell prey to the temptation to print pseudo-warehouse receipts not covered by gold and lend them out; in this way fractional reserve banking came to England.”

    From there it made its way to the shores of the New World and later adopted by other nations. The role of goldsmiths are now played by governments and their central bankers.

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