As soon as markets are perfect, intermediaries are redundant: they lose their function as soon as savers and investors have the perfect information to find each other directly, immediately and without any impediments, so without costs.” therefore the imperfect of the market give rise to the existence of the banks.
3.3 Delegated monitoring
Banks play a role of delegated monitoring to solve the contracting problem between the borrowers and lenders. Because of the asymmetric information, moral hazard of borrowers will be caused after the contract, for the lenders will never know what’s the real incentive of the borrowers, who may change their behavior after a loan has been made. Monitoring is necessary to ensure the behavior of the borrowers and the repayment of the loans. Who will do it? A major theory of the banking is that banks have advantages in this area. Diamond (1984) points out that to some extent monitoring is a public goods that no one have the incentive to provide, banks can be the most efficient way to conduct this task for two reasons: (1) Banks has the economies of scale in monitoring. “Economies of scope are said to exist when two or more products can be jointly produced at a lower cost than if the same products are produced individually.”(Shelagh A Heffernan, 1996, p19), the economies of scale in monitoring means banks can pool all of the loans together and monitor them with a lower cost. (2) Ability to reduce the cost of monitoring by diversification.
3.4 Control
The same as delegated monitoring, control have the same effect in solving the problem of moral hazard, banks conduct this role by making incentive contract with the borrowers to identify the share of the benefits and losses with the borrowers and enforcing the contract if the borrowers have no ability to fulfill them, which is always involving high costs.
3.5 Insurance role of banks
Bank plays the role of insurance by pooling all the deposit together to meet the liquidity needs of different depositors. This insurance services cannot be provided by the insurance company because of the risk is too low to meet the minimum standard of them. “Bank thus transforms imperfectly marketable, long term assets into fully marketable, short-term liabilities, and in the process provides its debt-holders with insurance against the contingency that they will be caught short by an unexpected liquidity shock” Dowd (1996)
3.6 Commitment theories
Banks play the role of agency by accepting the deposits and making loans, they solve a lot of problems of direct dealing with individuals and provide a convenient way to satisfy most of the customers’ needs.
3.7 Regulatory subsidies
In addition to the intrinsic advantages obtained by the banks, which are discussed above, banks still have the advantages that were given by the subsidies. Such as the regulation and the deposit insurance. Regulation make the banking industry are less competitive. The entry barriers are so high that the other institutions cannot provide the banking services easily. Banks have the monopoly position and the comparative advantages in providing the traditional banking services.
3.8 The special role of banks in the payment system.
Banks take deposit from the lenders and make loans to the borrowers, and offer the depositors high liquidity of their deposits whenever they want. Most of the theories of banking highlight the payment facilities of banks, as banks are the integral part of the payments system.
Intermediary and payment services identified the reasons why bank exist, but how does this two functions link together? Shelagh A Heffernan (1996) points that because of the cost of maintaining a balance that just meet payments demand is too high, most of the customers will hold surplus money and put them into the bank, and only demand a necessary amount when they need. “For the bank, which pools these surplus funds, there is an opportunity for profit through fractional reserve lending, that is, lending out money at an interest rate which is higher than what the bank pays on the deposits, after allowing for the riskness of the loan and the cost of intermediation. Therefore, bank intermediation and payments services are inextricably linked”. (Shelagh A Heffernan 1996) that’s what we can see from the figure 1 at the start of this paper.
4. Why can’t borrowers and lenders come together without the banks?
The traditional rational of the existence of banks which is presented above are also the role of the banks in the financial system. Our understanding of those roles can be found in many models, such as partial models, which are the portfolio structure models, and complete models that include monopoly models, risk aversion models and real resource models that are known as the theory of banking firm (Baltensperger, 1980) and also the theory of intermediation. In the theory of intermediation, the question that why ultimate savers, lenders, creditors prefer the liabilities of financial intermediation to direct deal are examined by most economists. Most of them focus on the transaction cost and asymmetric information.
Gurley and Shaw (1960) and many subsequent authors have stressed the role of transaction costs. “Fixed costs of asset evaluation mean that intermediaries have an advantage over individuals because they allow such costs to be shared. Similarly, trading costs mean that intermediaries can more easily be diversified than individuals”. (Franklin& Anthony, 1996)
In terms of asymmetric information, Leland and Pyle (1977) first point out that financial intermediation can invest their asset in the area that they have special knowledge, and Diamond (1984) also state that financial intermediation can overcome the problem of asymmetric information by delegated monitoring which have been discussed before.
Tobin (19//) also highlights the advantages of using financial intermediation than individuals from four aspects: (1) convenience of denomination, (2) risk pooling, reduction and allocation. (3) Maturity shifting. (4) Transforming illiquid assets into liquid liabilities.
As one form of the financial intermediation, banks have the same characteristics with the other intermediations; therefore those are all the advantages of using banks rather then deal individuals. In order to examine the reasons why the society is ready to pay the intermediation cost of banks more precisely, the author will discuss the advantages and problems of direct deals in detail, and how banks can solve those problem.
4.1 Advantages of direct deals.
4.1.1 Borrowers and lenders make direct contract, which can give rise to the external advantages such as trade credit in terms of business. By using banks as an intermediation, you cannot get this credit but just the loans.
4.1.2 In theory, direct deals can cut out the intermediation cost by bypassing banks. Both of them don’t need to pay the high intermediation cost by dealing directly at a better interest rate. In fact, although the intermediation cost is saved, the other costs are raised. The most important parts are the information costs and also the other costs do exist. Now the author will explain each of them in turn and how can we use banks to solve those problems.
4.2 Problems of direct deals and how can banks solve them.
4.2.1 Search costs:
Two parties have to obtain information, select, meet and negotiate with each other whenever there is a contract. Without the banks, search costs will be incurred. Banks can save these costs by pooling all the surplus of the depositors and offering loans to the borrowers. When the borrowers need money, they can go to banks directly without searching the counter party.
4.2.2 Portfolio preference: barter
This is the problem we have known in barter. Different people have different preference; given direct deal, you have to find what you want and offer what the others want at the same time, therefore, finding a counter party and satisfying both of their needs are very difficult. By using banks, that problem will not exist at all for banks can offer many kinds of loans to fulfill all the borrowers’ needs.
4.2.3 Asymmetric information
Because of the asymmetric information, there are some verification costs: lenders must verify whether the borrower’s information is correct. “Asymmetry of information between borrower and lender will give rise to a problem of adverse selection, which will cause the inefficient allocation in markets.” (Shelagh A Heffernan, 1996) by managing customers’ accounts, banks have the access to the credibility of the borrowers, that’s will ensure the efficiency of granting the loans.
4.2.4 Monitoring costs
Lender have to observe the borrower’s activities, in order to make sure the loans will be returned in time. It will be costly if the individual lenders monitor the borrowers’ behavior by themselves. Banks have the advantages in delegating the monitoring role for the reasons that have been discussed in section 3.
4.2.5 Enforcement of contracts
Enforcement costs are higher for the individuals. “Once the loans cannot be repaid. The injured party has to take action to either enforce the contract or seek compensation in the event of breach the contract.” (Shelagh A Heffernan, 1996) It is very expensive to implement the contracts. Bank can do it more easily if the borrower default on their loans. Individual may not take any action for the high costs of prosecution. Meanwhile, individual borrowers will behave badly as they assume the lenders will not sue them in fear of the high costs, therefore moral hazard will be raised as a result. That will increase the default probability of the loans. Banks have more powerful ability to take any actions when the loans cannot be repaid in time.
4.2.6 Concentrated portfolio
Borrowers obtain money from the individual lenders; therefore the loans are not well diversified. When the borrowers go burst, the lenders will be wiped out. Compared with the individual lenders, banks have the lower probability to go burst. Therefore, banks loans are more diversified and have a lower risk than individuals.
4.2.7 Lender of last resort
The definition of lender of last resort is as the nation's central bank, the Federal Reserve has the authority and financial resources to act as 'lender of last resort' by extending credit to depository institutions or to other entities in unusual circumstances involving a national or regional emergency, where failure to obtain credit would have a severe adverse impact on the economy. In this regard, bank is safer than individuals, but there is no certainty that the central bank will take any action including the lender of last resort to save a bank when it is going bust, the fact is that investors believe there is the lender of last resort, which gives banks the advantages to attract more investors, although it may not exist.
4.2.8 Signal weak
Market signal will give a rating or reputation of the potential borrower, but this signal will not go far. For instance, if one borrower default on his loan in the market, only the lenders and a small fraction of people will know it compared with the default of loans to the banks, all the banking industry not only the lending bank but also the other banks will know it through the banking system and they will revalue the credibility of the borrowers. Therefore the signals in the banks are stronger than the market.
4.2.9 Liquidity
Lenders may have emergent need of money, but the loans to the individuals are illiquid. The most important characteristic of banks is the high liquidity of investors’ deposits. Banks transfer short-term liability to long-term asset and keep the high liquidity of the deposits at the same time. You can withdraw your money whenever you like without the notice to the banks.
4.2.10 Contract problem
Although individuals can overcome most of the problems which have been discussed before and come to the stage of making contract, it is difficult for them to construct contracts individually for making contract is a very professional work. But banks have more expertise in doing this job. Although individuals can employ professionals to do it, the cost is too high to implement.
To summarize, if transactions occur between individuals, most of the costs will come out, instead, banks can solve those problems by arising smaller costs then individuals for their comparative advantages in providing these banking services. Shelagh A Heffernan (1996) states that unlike an individual lender, bank may enjoy informational economies of scope in lending and lending decisions “they can pool a portfolio of assets which have a lower default risk but the same expected return than what would be possible if depositors had tried to lend funds directly, and banks have access to privileged information when making a lending decision.” Banks can also obtain information on potential borrowers because they hold accounts at the bank. Therefore, banks can provide the banking services with lower costs than individuals, and individuals are willing to pay the intermediation costs to banks for these costs are lower than the costs when they deal directly.
5. Banking in the new ages
Banking business experienced a substantial growth in 1980th with the development of off-balance sheet income and provision of a wider range of financial services. (Llewellyn, 1992) banks have monopoly power and comparative advantages in providing the banking services. In 1990, the situation changed a lot. The traditional services of banks are declining. A tendency towards a relative reduction of the traditional banking services is shown in the US, from the figure, it is easy to find out that the relative size of depository institutions mainly the banks in the financial system diminishes from 50% in 1950 to 25% in 1995. Bert Scholtens & Dick van Wensveen (2000) “Banks have lost market share of some financial intermediation business to the capital market, non-bank financial institutions, and non-finance companies.” (Bisignano, 1990)
“The combined pressures of competition, deregulation, financial innovation, and technology have eroded some of the comparative advantages of the banks in their traditional financial intermediation business.” (Llewellyn, 1991) The theoretical rational for the existence of banks is facing challenge for all the reasons give rise to the comparative advantages of banks become less powerful.
- Information advantage: (1) Financial innovation and technology are reducing transactions costs and information costs and market imperfections, which are the basis of banks’ efficiencies over direct credit markets. (Llewellyn, 1992) (2) New disclosure laws applicable to companies make the information more public to the investors. Lower the problem of asymmetric information for direct deals between individuals.
- Imperfect markets: Market pressures are eroding the market imperfections, which give rise to the banks comparative advantages over intermediation in capital markets and the reason for the emergence of the financial intermediations. (Eisenbeis, 1990) Financial innovation widening the range of capital market options. All have the effect of increasing the relative efficiency of capital markets over banks.
- Delegated monitoring and control theory: The emergence of rating agencies enables individual investors more easier to get the information about the credibility of the potential borrowers, not only the banks have the privileged information by managing the customers’ accounts. And the delegated monitoring role is still challenged by the rating agencies. Mater (1994) pointed out that, monitoring cannot only be provided by banks, but also can be provided by the other parties as a fee-based services
- Insurance role: the development of Unit trusts and mutual founds as a result of the financial innovation make the banks traditional advantage as a supplier of liquidity insurance declined. Therefore the insurance theory became vulnerable.
- Regulatory subsidy: Deregulation make the banking industry more competitive, banks will cease to benefit from the previous regulation. More other institutions are able to come into this market for the deregulation lower the entry barriers.
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Payment advantages: “technology facilitates the verification of the standing of transactors.” (Llewellyn, 1992) the emergence of electronic money can offer the payment facilities without banks.
From the above analysis, the traditional theoretical rational for the existence of banks is becoming vulnerable in nowadays subject to the combined pressures of competition, de-regulation, financial innovation, and technology, therefore, a new perspective relating to the existence of banks should be given.
6 what’s the value added by banks?
The role of banks cannot be simplified measured by the volume of assets on the balance sheet, and in fact, banks also compensate for the loss of some business by diversifying into other areas.
Figure 2 shows the ratio of banks assets to GDP, from it, we can conclude that the banking industry is not fading away. “Only an institutional perspective might conclude (on the basis of Fig. 1) to disintermediation of the banking industry. The functional view, however, reveals that banking are of increasing importance to the modern economy.”(Bert Scholtens & Dick van Wensveen, 2000)
The value added by banks (the ultimate measure of their role in the financial system) is wider than the measure of banks assets. Llewellyn, T David, (1996). “Financial institutions do not act as ‘agents’ who intermediate between savers and investors and thus alleviate ‘market imperfections’ like asymmetric information and participation costs, but are independent market parties that create financial products and whose value added to their clients is the transformation of financial risk, term, scale, location, and liquidity.” (Bert Scholtens & Dick van Wensveen, 2000), they also give a table to show the main theory of financial intermediation including the banks should be amended. The process of financial innovation and market differentiation should be included.
When the value added by banks is examined, banks are not a financial intermediation, which not only conduct the traditional services but also provide more diversified services. Although the traditional theoretical rational for the existence of banks are becoming vulnerable, Banks themselves are continuously evolving. They provide new financial services to the markets; exploit new comparative advantages in the new areas.
- Conclusion
The traditional view of a bank is a financial intermediary, which accepts deposits with one set of characteristics and makes loans or acquires assets with a different set. The traditional rational for the existence of banks can be examined by looking at the roles of the banks in the economy. Banks can provide the banking services with lower costs than individuals for their monopoly positions and the comparative advantages in providing the banking services, therefore individuals are willing to pay the intermediation costs to banks for these costs are lower than the costs when they deal directly.
In recently, the related pressures of competition, de-regulation, financial innovation, and technology have eliminated some of the comparative advantages of the banks in their traditional banking business. The traditional theoretical rational for the existence of banks are facing challenges. When the value added by the banks is examined, only an institutional perspective might conclude to disintermediation of the banking industry. The functional view, however, reveals that banking are of increasing importance to the modern economy. The traditional rational for the existence of banks are becoming less powerful in nowadays, but it doesn’t mean that the banks will disappear in a near future. In facing the pressures, banks will adapt and the nature of banking business will continue to evolve. They will exploit new comparative advantages in the other areas; therefore, the definition and nature of banks should be changed continuously.
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