17.6 – The Role of Banks

Erik Dean; Justin Elardo; Mitch Green; Benjamin Wilson; Sebastian Berger; Richard Dadzie; Adapted from OpenStax Principles of Economics

17.6 – The Role of Banks

Learning Objectives

By the end of this section, you will be able to:

Explain how banks act as intermediaries between savers and borrowers in the orthodox approach
Explain how banks create liquidity through loans in the heterodox approach
Evaluate the relationship between banks, savings and loans, and credit unions
Analyze the causes of bankruptcy and recessions

Somebody once asked the bank robber Willie Sutton why he robbed banks. He answered: “That’s where the money is.” While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and consequently, with the broader economy.

Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if everybody had to make all payments in cash. When shopping for a large purchase or going on vacation you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card.

Banks are a critical intermediary in what we call the payment system, which helps an economy exchange goods and services for money or other financial assets. However, the role these institutions play in the broader economy is a subject of disagreement among economists. Whereas orthodox economists typically look at banks mainly in terms of facilitating the movement of money from savers to borrowers, many heterodox economists see their function as almost the complete opposite. In this section, we will look at these two perspectives on the role of banks.

Banks as Financial Intermediaries: The Orthodox Perspective

Banks allow people with extra money that they would like to save to store their money in a bank rather than look for an individual who is willing to borrow it from them and then repay them at a later date. Likewise, those who want to borrow money can go directly to a bank rather than trying to find someone to lend them cash. Transaction costs are the costs associated with finding a lender or a borrower for this money. Thus, from the orthodox economics perspective, banks lower transactions costs and act as financial intermediaries—they bring savers and borrowers together.

An “intermediary” is one who stands between two other parties. Banks are a financial intermediary—that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. Financial intermediaries include other institutions in the financial market such as insurance companies and pension funds, but we will not include them in this discussion because they are not depository institutions, which are institutions that accept money deposits and then use these to make loans. All the deposited funds mingle in one big pool, which the financial institution then lends. Figure 1 illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the banks will try to funnel financial capital to healthy businesses that have good prospects for repaying the loans, not to firms that are suffering losses and may be unable to repay.

The illustration shows the circular transactions between savers, banks, and borrowers. Savers give deposits to banks, and the bank provides them with withdrawals and interest payments. Borrowers give repayment of loans and interest payments to banks and the banks provide them with loans.

How are banks, savings and loans, and credit unions related?

Banks have a couple of close cousins: savings institutions and credit unions. Banks, as we explained, receive deposits from individuals and businesses and make loans with the money.

Savings institutions are also sometimes called “savings and loans” or “thrifts.” They also take loans and make deposits. However, from the 1930s until the 1980s, federal law limited how much interest savings institutions were allowed to pay to depositors. They were also required to make most of their loans in the form of housing-related loans, either to homebuyers or to real-estate developers and builders.

A credit union is a nonprofit financial institution that its members own and run. Members of each credit union decide who is eligible to be a member. Usually, potential members would be everyone in a certain community, or groups of employees, or members of a certain organization. The credit union accepts deposits from members and focuses on making loans back to its members. While there are more credit unions than banks and more banks than savings and loans, the total assets of credit unions are growing.

In 2008, there were 7,085 banks. Due to the bank failures of 2007–2009 and bank mergers, there were 5,571 banks in the United States at the end of the fourth quarter in 2014. According to the Credit Union National Association, as of December 2014 there were 6,535 credit unions with assets totaling $1.1 billion. A day of “Transfer Your Money” took place in 2009 out of general public disgust with big bank bailouts. People were encouraged to transfer their deposits to credit unions. This has grown into the ongoing Move Your Money Project. Consequently, some now hold deposits as large as $50 billion. However, as of 2013, the 12 largest banks (0.2%) controlled 69 percent of all banking assets, according to the Dallas Federal Reserve.

Banks as Liquidity Makers: The Heterodox Perspective

The orthodox perspective above stems from a conceptualization of money as a discrete ‘thing’. Maybe that thing is a seashell, or maybe it’s an electronic ‘reserve’ that only exists on a hard drive at the Federal Reserve; but, in any case, money exists as an essentially scarce quantity. Many heterodox economists, in contrast, see money as a relationship between people–specifically, an IOU or credit-debt relationship that is widely excepted as payment. In this alternative viewpoint, money isn’t a given quantity; instead, it’s actively created and destroyed by people making and fulfilling those agreements. It can be difficult to wrap your mind around this notion of money, not as a dollar in your wallet but as a relationship, but in fact we’ve already seen how this works earlier in the chapter. Specifically, we saw that, from the heterodox perspective, banks create money ‘from thin air’, by making loans.

Banks ‘creating money’ by making loans in the heterodox approach might appear to be the same thing as banks expanding the money supply in the orthodox approach, but there is an important difference. In the orthodox approach, banks are merely expanding on a given amount of initial deposits. Deposits become loans, in that view, which is why banks are seen as intermediaries between savers and the borrowers of those savings (see above). In the heterodox approach, however, no deposits are necessary to make loans. In fact, no deposits could be made were it not for loans creating the money to subsequently be deposited. Hence, from a heterodox approach, banks don’t act as intermediaries so much as they act as the fuel injectors of the capitalist economy–where the fuel is the money that comes ultimately from making the loans.

But to be sure, when banks create money there are strings attached, specifically in the basic accounting principle that assets and liabilities must match. When a bank makes a loan, it creates money in the borrower’s checking account, an asset to the borrower; but that asset is (ignoring interest) exactly offset by the loan itself, a liability to the borrower. Hence, when we say the bank creates money by making loans, we don’t mean that the the bank is creating net wealth–that is, greater assets than liabilities. Instead, the bank is creating a set of IOUs, the loan itself and the checking account, which (again, ignoring interest) exactly offset each other.

So, what’s the point of making these offsetting IOUs, then, if it doesn’t result in more net wealth?

This is the key. The difference between the loan agreement and the checking account is that the loan is illiquid–it won’t be repaid for a while–whereas the checking account is liquid–it can be used to make payments right now. What the banks create when they make loans isn’t net wealth; they create liquidity, or spending power, so that firms can buy machines, families can buy houses and cars, and so on today.

How Mortgages Facilitate Housing

Imagine a community in which there is no housing to speak of, and also no money. The people in this community are willing and able to work, many of them in the construction trades, but they all agree that they won’t work for free–that is, they want money before they lift a finger. How are they to house themselves?Now, in the standard (orthodox) economics approach, the solution would be to save up, either individually or to allow a bank to expand an initial deposit of money into loans–that is, mortgages for houses. The problem here: there’s no money. And since no one will work for free, there’s not going to be any work at all, which means no income, which of course means no savings. Perhaps, they could set out to create money–maybe by prospecting for gold–but what if they don’t find any? Should a lack of a precious metals, seashells, or other suitable money things keep them from building the housing that they are fully capable of building?

From a heterodox perspective this community has everything it needs to put people in housing, but for one thing: liquidity. To solve this, they simply need someone to act as the banker. That person will keep track of accounts, assets and liabilities, and, by making loans, will create the liquidity necessary to pay the people to build the housing.

You can imagine these initial mortgages setting the whole economy in motion. People borrow to pay contractors to build their homes, the contractors then pay those people to provide goods and services, and the money circulates throughout the community, putting people to work producing all sorts of things. Eventually, the money created by the loans gets destroyed as the loans are repaid.

Notice, that seeing banks as liquidity makers rather than financial intermediaries puts saving in a very different place than we saw in the orthodox approach. In that approach, people saving money provides the seed for borrowing–say, for a business to upgrade its servers. In this alternative, heterodox approach, saving isn’t necessary at all for the business to take out a loan. Instead, the bank simply has to agree to make the loan and the money (the liquidity, or purchasing power) gets made. Saving, then, only happens afterwards, once the business has employed people, allowing them to earn an income, which they can then deposit into their savings accounts.

How Banks Go Bankrupt

Say that a family takes out a 30-year mortgage loan from Safe and Secure Bank to purchase a house, which means that the borrower will repay the loan over the next 30 years. This loan is clearly an asset from the bank’s perspective, because the borrower has a legal obligation to make payments to the bank over time. However, in practical terms, how can we measure the value of the mortgage loan that the borrower is paying over 30 years in the present? One way of measuring the value of something—whether a loan or anything else—is by estimating what another party in the market is willing to pay for it. Many banks issue home loans, and charge various handling and processing fees for doing so, but then sell the loans to other banks or financial institutions who collect the loan payments. We call the market where financial institutions make loans to borrowers the primary loan market, while the market in which financial institutions buy and sell these loans is the secondary loan market.

One key factor that affects what financial institutions are willing to pay for a loan, when they buy it in the secondary loan market, is the perceived riskiness of the loan: that is, given the borrower’s characteristics, such as income level and whether the local economy is performing strongly, what proportion of loans of this type will the borrower repay? The greater the risk that a borrower will not repay loan, the less that any financial institution will pay to acquire the loan.

Another key factor is to compare the interest rate the financial institution charged on the original loan with the current interest rate in the economy. If the original loan requires the borrower to pay a low interest rate, but current interest rates are relatively high, then a financial institution will pay less to acquire the loan. In contrast, if the original loan requires the borrower to pay a high interest rate, while current interest rates are relatively low, then a financial institution will pay more to acquire the loan.

A bank that is bankrupt will have a negative net worth, meaning its assets will be worth less than its liabilities. How can this happen? A well-run bank will assume that a small percentage of borrowers will not repay their loans on time, or at all, and factor these missing payments into its planning. Remember, the calculations of the banks’ expenses every year include a factor for loans that borrowers do not repay, and the value of a bank’s loans on its balance sheet assumes a certain level of riskiness because some customers will not repay loans. Even if a bank expects a certain number of loan defaults, it will suffer if the number of loan defaults is much greater than expected, as can happen during a recession. For example, if the Safe and Secure Bank in Table 1 experienced a wave of unexpected defaults, so that its loans declined in value from $5 million to $3 million, then the assets of the Safe and Secure Bank would decline so that the bank had negative net worth.

**Table 1. A Balance Sheet for the Safe and Secure Bank**
Assets	Liabilities + Net Worth
Loans: $5 million	Deposits: $10 million
US Government Securities (USGS): $4 million
Reserve: $2 million	Net Worth: $1 million

What led to the 2008–2009 financial crisis?

Many banks make mortgage loans so that people can buy a home, but then do not keep the loans on their books as an asset. Instead, the bank sells the loan. These loans are “securitized,” which means that they are bundled together into a financial security that a financial institution sells to investors. Investors in these mortgage-backed securities receive a rate of return based on the level of payments that people make on all the mortgages that stand behind the security.

Securitization offers certain advantages. If a bank makes most of its loans in a local area, then the bank may be financially vulnerable if the local economy declines, so that many people are unable to make their payments. However, if a bank sells its local loans, and then buys a mortgage-backed security based on home loans in many parts of the country, it can avoid exposure to local financial risks. (In the simple example in the text, banks just own “bonds.” In reality, banks can own a number of financial instruments, as long as these financial investments are safe enough to satisfy the government bank regulators.) From the standpoint of a local homebuyer, securitization offers the benefit that a local bank does not need to have significant extra funds to make a loan, because the bank is only planning to hold that loan for a short time, before selling the loan so that it can pool it into a financial security.

However, securitization also offers one potentially large disadvantage. If a bank plans to hold a mortgage loan as an asset, the bank has an incentive to scrutinize the borrower carefully to ensure that the customer is likely to repay the loan. However, a bank that plans to sell the loan may be less careful in making the loan in the first place. The bank will be more willing to make what we call “subprime loans,” which are loans that have characteristics like low or zero down-payment, little scrutiny of whether the borrower has a reliable income, and sometimes low payments for the first year or two that will be followed by much higher payments. Economists dubbed some financial institutions that made subprime loans in the mid-2000s NINJA loans: loans that financial institutions made even though the borrower had demonstrated No Income, No Job, or Assets.

Financial institutions typically sold these subprime loans and turned them into financial securities—but with a twist. The idea was that if losses occurred on these mortgage-backed securities, certain investors would agree to take the first, say, 5% of such losses. Other investors would agree to take, say, the next 5% of losses. By this approach, still other investors would not need to take any losses unless these mortgage-backed financial securities lost 25% or 30% or more of their total value. These complex securities, along with other economic factors, encouraged a large expansion of subprime loans in the mid-2000s.

The economic stage was now set for a banking crisis. Banks thought they were buying only ultra-safe securities, because even though the securities were ultimately backed by risky subprime mortgages, the banks only invested in the part of those securities where they were protected from small or moderate levels of losses. However, as housing prices fell after 2007, and the deepening recession made it harder for many people to make their mortgage payments, many banks found that their mortgage-backed financial assets could be worth much less than they had expected—and so the banks were faced with staring bankruptcy. In the 2008–2011 period, 318 banks failed in the United States.

The risk of an unexpectedly high level of loan defaults can be especially difficult for banks because a bank’s liabilities, namely it customers’ deposits. Customers can withdraw funds quickly but many of the bank’s assets like loans and bonds will only be repaid over years or even decades. This asset-liability time mismatch—the ability for customers to withdraw bank’s liabilities in the short term while customers repay its assets in the long term—can cause severe problems for a bank. The root of the problem: banks make their money by making loans, which are by definition less liquid than deposits.

For example, imagine a bank that has loaned a substantial amount of money at a certain interest rate, but then sees interest rates rise substantially. The bank can find itself in a precarious situation. If it does not raise the interest rate it pays to depositors, then deposits will flow to other institutions that offer the higher interest rates that are now prevailing. However, if the bank raises the interest rates that it pays to depositors, it may end up in a situation where it is paying a higher interest rate to depositors than it is collecting from those past loans that it made at lower interest rates. Clearly, the bank cannot survive in the long term if it is paying out more in interest to depositors than it is receiving from borrowers.

How can banks protect themselves against an unexpectedly high rate of loan defaults and against the risk of an asset-liability time mismatch? One strategy is for a bank to diversify its loans, which means lending to a variety of customers. For example, suppose a bank specialized in lending to a niche market—say, making a high proportion of its loans to construction companies that build offices in one downtown area. If that one area suffers an unexpected economic downturn, the bank will suffer large losses. However, if a bank loans both to consumers who are buying homes and cars and also to a wide range of firms in many industries and geographic areas, the bank is less exposed to risk. When a bank diversifies its loans, those categories of borrowers who have an unexpectedly large number of defaults will tend to be balanced out, according to random chance, by other borrowers who have an unexpectedly low number of defaults. Thus, diversification of loans can help banks to keep a positive net worth. However, if a widespread recession occurs that touches many industries and geographic areas, diversification will not help.

Along with diversifying their loans, banks have several other strategies to reduce the risk of an unexpectedly large number of loan defaults. For example, banks can sell some of the loans they make in the secondary loan market, as we described earlier, and instead hold a greater share of assets in the form of government bonds or reserves. Nevertheless, in a lengthy recession, most banks will see their net worth decline because customers will not repay a higher share of loans in tough economic times.

Summary

Banks facilitate using money for transactions in the economy because people and firms can use bank accounts when selling or buying goods and services, when paying a worker or receiving payment, and when saving money or receiving a loan. In the orthodox economics approach, banks are financial intermediaries in the financial capital market; that is, they operate between savers who supply financial capital and borrowers who demand loans. In contrast, in the heterodox approach, banks create the liquidity necessary to get the whole economy running. Banks run a risk of negative net worth if the value of their assets declines. The value of assets can decline because of an unexpectedly high number of defaults on loans, or if interest rates rise and the bank suffers an asset-liability time mismatch in which the bank is receiving a low interest rate on its long-term loans but must pay the currently higher market interest rate to attract depositors. Banks can protect themselves against these risks by choosing to diversify their loans or to hold a greater proportion of their assets in bonds and reserves. If banks hold only a fraction of their deposits as reserves, then the process of banks’ lending money, re-depositing those loans in banks, and the banks making additional loans will create money in the economy.

References

Credit Union National Association. 2014. “Monthly Credit Union Estimates.” Last accessed March 4, 2015. http://www.cuna.org/Research-And-Strategy/Credit-Union-Data-And-Statistics/.

Dallas Federal Reserve. 2013. “Ending `Too Big To Fail’: A Proposal for Reform Before It’s Too Late”. Accessed March 4, 2015. http://www.dallasfed.org/news/speeches/fisher/2013/fs130116.cfm.

Richard W. Fisher. “Ending ‘Too Big to Fail’: A Proposal for Reform Before It’s Too Late (With Reference to Patrick Henry, Complexity and Reality) Remarks before the Committee for the Republic, Washington, D.C. Dallas Federal Reserve. January 16, 2013.

“Commercial Banks in the U.S.” Federal Reserve Bank of St. Louis. Accessed November 2013. http://research.stlouisfed.org/fred2/series/USNUM.

Glossary

asset: item of value that a firm or an individual owns

asset–liability time mismatch: customers can withdraw a bank’s liabilities in the short term while customers repay its assets in the long term

balance sheet: an accounting tool that lists assets and liabilities

bank capital: a bank’s net worth

depository institution: institution that accepts money deposits and then uses these to make loans

diversify: making loans or investments with a variety of firms, to reduce the risk of being adversely affected by events at one or a few firms

financial intermediary: an institution that operates between a saver with financial assets to invest and an entity who will borrow those assets and pay a rate of return

liability: any amount or debt that a firm or an individual owes

net worth: the excess of the asset value over and above the amount of the liability; total assets minus total liabilities

payment system: helps an economy exchange goods and services for money or other financial assets

reserves: funds that a bank keeps on hand and that it does not loan out or invest in bonds

T-account: a balance sheet with a two-column format, with the T-shape formed by the vertical line down the middle and the horizontal line under the column headings for “Assets” and “Liabilities”

transaction costs: the costs associated with finding a lender or a borrower for money

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Principles of Economics: Scarcity and Social Provisioning (3rd Ed.) Copyright © by Erik Dean; Justin Elardo; Mitch Green; Benjamin Wilson; Sebastian Berger; Richard Dadzie; and Adapted from OpenStax Principles of Economics is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.