3) Self-fulfilling prophecy Diamond and Rajan (1998) argue further that the somewhat fragile capitalstructure of banks, which subjects them to runs, disciplines them to monitor corporations properly. Diamond Rajan (1998), “Liquidity risk, liquidity creation, and financial fragility: a theory of banking”.
4) Lack of transparency. Asymmetric information difficult for banks to secure loans from other banks. Even if the bank would be prepared to accept or offer a higher interest rate, this might be perceived a an indicator of higher risk rather than as a normal market reaction in case of a shortage.
Correspondingly, several types of risk in banking are listed in literature:
. (a) Credit risk - the risk that a bank's counterpart might not pay on due date.
(b) Liquidity risk - the risk that the bank might itself fail to meet its obligations when falling due.
(c) Yield (or interest rate) risk - the risk that the bank's asset may generate less income than the expense generated by its liabilities.
(d) . Market risk - the risk of loss resulting from movements in the market price of financial instruments in which a bank has a position.
(e) Operational risk - the risk of failure in the bank's procedures or controls, either from external causes or as a result of internal error or fraud. (f) Ownership/management risk - the risk that shareholders, directors
or senior management might be unfit for their roles or are actually dishonest. .
Nevertheless, there is a type of liquidity risk which is peculiar, and, crucially, its existence enhances most of the other risks as well, at least in a subjective sense as seen from the position of banks' depositors.
(6) The specific liquidity problem of banks, though, has to be understood properly. It doesn't result from maturity mismatch as such, as is often claimed. A saving institution, for instance, too faces maturity mismatch without being prone to the same liquidity risk.
The peculiar nature of banks' liquidity problem stems from the fact that they create assets (normally more or less long-term loans) by simultaneously creating specific liabilities, which it cannot meet by themselves and which can fall due at any moment in time, but may not fall due at all. In short, a liquidity risk for the bank exists, because its liabilities are accepted as "money" in transactions while not being the only type of money. There are other banks (competing commercial banks as well as the central bank) creating their own money. And any bank's money, in order to be accepted, must be convertible in any other bank's money. To quote from a prominent newer textbook: "[T]he bulk of the money supply used in modem economies is bank deposits, and these deposits are actually created by the commercial banking system. The money-creating function of banks is what distinguishes them from other financial intermediaries such as saving banks, brokers, and stock markets. All of those institutions collect, lend, and invest funds, but none of them has the right to create money, because none of them may legally lend more than they have received in deposits.
By lending money that they do not directly possess (?), commercial banks are in effect issuing money. ... [B]y issuing a loan to a customer, a bank increases the volume of its assets ... The increase is matched on the liability side by the amount of the loan credited to the customer's bank account. That is, in a nutshell, how new money is created by banks" (Burda/Wyplosz 2001, 201 f; italics are mine, WH).
In short, the modem payment system owes its high flexibility exactly to this type of arrangement, which, however, is also responsible for its extreme fragility.
(7) The fact just described as such cannot, however, really explain the high degree of public intervention (alias regulation) in banking. In my personal view, there are two additional aspects which lay at the ground:.
1. Money essentially must be perceived as a social device for avoiding moral hazard problems in large modem societies to undermine any form of intertemporal exchange of goods and services. The rules of the money game are a (liberal) substitute for the tight social control, by which small, narrow and basically static communities prevent systematic "exploitation" of some members by others. Since the rationale of money results exactly from the fact that most individual promises (to deliver suitable goods and services at a suitable date) of market participants would not be fulfilled, a "competitive" money supply (which would require freedom to enter and exit the industry) implies something
of a. contradictio in adjecto. Actually, money supply has characteristics of a. natural monopoly, given the public. good nature of money's acceptance which requires some form of general agreement. True, the public monopoly of providing the "ultimate" money (base money) has often been abused at all times in history, but this fact as such does not give sufficient reason to abolish the public monopoly altogether, no more than the experience of bending the law has ever led to an agreement on
purely private law. The simple reason is that the latter would almost certainly make things worse rather than better.
2. Acceptance of any modem money whatsoever depends on the confidence of the public that promises of banks (liabilities in the form of demand deposits) are not issued extensively. The systemic consequences of the latter would be an increase in the general price level and/or the creation of bad assets. The cost of extensive money creation will thus be externalised to a large degree while the benefits (higher profit) will be perfectly internalised to the bank. This classical public choice problem explains why it would be illusory and very risky to leave the money supply to free market competition.
The inevitable public nature of money has exactly been the reason, why
even the toughest liberal economists and philosophers, like Henry Simon, Irving Fisher, James Buchanan, Milton Friedman and many others, never advocated for a complete privatisation of the monetary system, although they heavily criticised existing arrangements. Friedrich A. von Hayek, who stimulated a revival of interest in free banking issues with his provoking proposal for "denationalising money" (1976), is the exception rather than the rule.
(8) Banking regulation (as other regulations), however, almost always developed in an ad hoc manner. Particularly, in the wake of financial disorders during the 1930s, government all over the world have imposed extensive prudential controls on their respective banking systems:
A. Preventive regulation aims at limiting the risks incurred by banks:
. by functioning as a surrogate of normal market forces, which only work
very imperfectly due to serious asymmetries in information;
. because the safety-net for banks may otherwise lead to extensive risk
taking (moral hazard), which should be offset by official actions;
. because social costs of bank failures (individually or systemic) may be
enormous.
1. Anti-competitive regulation
2. Capital adequacy requirements
3. Liquidity requirements
4. Measures to mitigate interest rate risks
5. Limitations to banking activities.
6. Limits on loans regarding clients as well as amounts
7. Bank supervision.
B. Protective regulation superficially aims at the protection of consumers
or other depositors, their primary aim, however, is to avoid a drawback from the market by frustrated clients of banks:
1. Deposit insurance in several variants 2. Lender of last resort.
(9) Those extensive regulation of banking has been rationalised especially by four arguments:
(i) Bank deposits are "money", the volume of which national authorities
seek to control (originally it was this intention, which led to reserve requirements and the like).
(ii) Bank play a pivotal role in the financial system as a whole; thus government often tried to control their lending activities (which sometimes, as in France, even led to nationalise the banking industry).
(iii) Banks' role as attracting public's saving rises the concern of consumer protection (which was implemented by way of deposit insurance and/or lender of last resort).
(iv) Banks are particularly considered to be prone of collapses, because their stability depends on depositors' confidence (which led to pru
dential regulation).
Note, however, that these arguments reflect the rationale given above to a certain degree only, and they go even further in some respects. A coherent framework of bank regulation has so far not been established. Although there seems to be little doubt with regard to the necessity of public regulation of banking as such, the degrees and forms are still matters very much open to debate.
