The Purpose of Banking
Transforming Banking for Stability and Economic Growth
ANJAN V. THAKOR
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Library of Congress Cataloging-in-Publication Data
Names: Thakor, Anjan V., author.
Title: The purpose of banking : transforming banking for stability and economic growth / Anjan V. Thakor.
Description: New York : Oxford University Press, [2019]
Identifiers: LCCN 2018031498 | ISBN 9780190919535 (hardcover) | ISBN 9780190919542 (updf) | ISBN 9780190919559 (epub)
Subjects: LCSH: Banks and banking. | Banking law. | Economic development. Classification: LCC HG1601 .T355 2018 | DDC 332.1—dc23 LC record available at https://lccn.loc.gov/2018031498
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Printed by Sheridan Books, Inc., United States of America
To the latest inspirations for my higher purpose: Aiden and Lily.
Introduction: The Columbo Approach: A Bird’s-Eye View of the Book 1
ACT I. The Purpose of Banks: What Banks Do and Why
1. Money, Guns, and Lawyers: The Business of Banking 7
2. The Origins of Banking and the Services Banks Provide: Customers, Investors, and Other Stakeholders 17
3. Out of Sight, Out of Mind? Off-Balance-Sheet Banking 33
ACT II. Bank Decision-Making and the Regulation of Banks: Capital, Regulation, Purpose, and Culture
4. When Your Chickens Come Home to Roost: Bank Capital Regulation and the Search for Financial Stability 51
5. Higher Purpose, Culture, and Capital: Is Banking on Culture a Capital Idea? 69
ACT III. Banks and Markets: Interactions That Affect Stability and Growth
6. Financial System Architecture: Where Do Banks Sit in the Financial System? 95
7. Changes in Banking over Time 105
8. Financial Crises and Banks: What Caused the Great Recession, and What Were Its Effects? 117
ACT V. Reforming Banking and Looking Ahead: Improving Banking and the Potential Interactions with Fintech
9. The Final Frontier: An Improved Banking System to Achieve Financial Stability and Economic Growth 159
10. Closing Curtain: Should Banking Be Fundamentally Redesigned? 179
11. Summing Up and Looking Ahead: Fintech and Banking 203
The Columbo Approach
A Bird’s- Eye View of the Book
IN THE TYPICAL mystery novel, say an Agatha Christie classic like Murder on the Orient Express, there is an intriguing mystery about whodunit, and you have to wait until the end of the novel to find out. Well, this is not a mystery novel. Rather, it is a synthesis of a large body of research in banking to answer one of the most important questions: How do we design a banking system to achieve the “right” balance between financial stability and economic growth? That is, how do we get banks to help the economy grow, but without recurring crises? You will not have to wait until the end of the book to find out the answer. Instead, you will have it in this chapter.
If there is an analogy to a murder mystery, a more fitting one is to the TV show Columbo. Invariably, the show tips the audience off to who the killer is right at the outset. The rest of the show is then devoted to a discovery of how Columbo found out who the killer was and how he went about proving it. So it is with this book. I will give you the answer to the question above, as well as the most important takeaways from the book in this chapter. The rest of the book is devoted to how these conclusions can be reached by accessing the vast body of research that has been done in the past three or four decades.
The Four Biggest Takeaways
Takeaway #1: A key to understanding how to develop a banking system for economic stability and growth is first understanding the core economic functions banks serve. There are three core functions:
1. Banks create funding liquidity and private money by gathering deposits and lending money to borrowers who they screen, monitor, and develop lending relationships with.
2. Banks provide safekeeping services for valuables, maintain the confidentiality of clients’ information, and develop trust.
3. Banks process different sorts of information that helps to reduce contracting costs and costs of verification of cash flows, asset ownership, and so on.
Takeaway #2: These core economic functions help to crystalize the higher purpose of banks and their corporate culture. The banks’ clearly articulated higher purpose should be built around the provision of these services, but not in a conventional way. The purpose should be defined not in terms of an economic transaction but in terms of a contribution. An authentic higher purpose expresses the true intent of the bank in serving these core functions, but it requires delivering these services in a way that exceeds the conventional expectations of the customer. It is thus a prosocial goal that transcends the usual business goals of the bank but intersects with these goals, and it encourages the development of a corporate culture that generates trust in the bank. When the higher purpose is the arbitrator of all decisions, the culture of the bank is continually reshaped to serve and exceed the changing needs of the customer.
Takeaway #3: In performing their core economic functions in accordance with the higher purpose, banks engage in activities like depository services, relationship lending, selling loan commitments and standby letters of credit, and securitization. These activities put banks on center stage within the overall financial system, and thus banking stability and health also affect the health of financial markets and the whole financial system. This has numerous implications:
1. Banks are crucial for economic growth.
2. Financial markets cannot be developed effectively without first developing banks.
3. The centrality of banks makes it very tempting for politicians to influence banking, and politics can contribute to financial crises.
4. The centrality of banks means that a sufficiently high number of bank failures can generate financial crises that have significant effects on the real sector (Main Street)—the 2007–2009 crisis cost the US economy $22 trillion.
5. The specter of such costs creates a powerful incentive for the government to intervene to prevent financial crises or minimize the damage they cause. Interventions include ex ante safety nets like deposit insurance for financial institutions and bailouts of failing institutions. These safety nets encourage these institutions to take excessive risks and be excessively leveraged (too little equity capital). Many of these behaviors are due to
deep-seated attributes of the corporate culture in some banks, a culture that is not shaped by an authentic higher purpose for the bank’s existence.
Takeaway #4: Although extensive regulations seek to limit such risk-taking behavior by banks, regulators tolerate undercapitalized and risky banks because they believe that there is a tradeoff between economic stability and growth. Asking banks to keep more capital will make them safer, but it is believed that it will be at the expense of economic growth because it will reduce lending and liquidity creation. However, this is a false tradeoff. Extensive research points to the fact that we can get long-run stability as well as economic growth if we:
• increase equity capital significantly in banks without burdening them with onerous liquidity requirements
• strengthen bank culture and encourage it to be linked to an explicitly articulated higher purpose that is prosocial, and
• develop a more integrated regulatory structure, keeping fintech developments on the radar and permitting banks to integrate these developments into their activities.
With these changes, banks will become more trusted by their counterparties and taxpayers; they will create more liquidity, lend more, contribute to higher long-term economic growth, and be less crisis-prone, leading to a much lower exposure for taxpayers.
Recent Proposals to Fundamentally Reform Banking
In the wake of the 2007–2009 financial crisis, some countries (e.g., Iceland and Switzerland) have recently contemplated a fundamental remaking of banking. The proposals they have considered rest on the premise that the crisis that led to the Great Recession was a liquidity crisis. So the proposals seek to end the specter of bank runs and panics by changing banks themselves. The proposed new system is one in which all bank branches would disappear. All deposit gathering would be done by the central bank, which would then distribute deposits to banks at a price determined by supply and demand forces, subject to banks posting sufficient equity capital. The central bank would be the counterparty for all depositors. Deposit insurance as presently designed, bank bailouts, and bank-level liquidity requirements would all be eliminated. Gone would be “liquidity crises” in which healthy (solvent) banks fail because liquidity unexpectedly dries up.
I explain that this proposal is a logical consequence of the research that argues that a central problem in financial crises—including the 2007–2009 crisis—is liquidity risk. In this view, liquidity risk arises from the likelihood of massive deposit withdrawals from banks that are due to the sudden liquidity needs of depositors and unrelated to the financial health of the bank’s assets; nonetheless, these withdrawals can cause the bank to collapse. Centralizing deposits at the central bank helps to address this risk of bank runs. I then evaluate the pros and cons of this proposal in light of the overall empirical evidence available and other considerations discussed throughout the book.
The Future
The book closes with some thoughts about the potential impact of fintech on banking. In particular, how will banks respond to blockchain technology, cryptocurrencies, P2P lending, and other developments? In a nutshell, I do not view these developments as threatening banking, but I do see them changing the core economic functions of banks. One important way in which this change will occur is that banks will become more integrated with the financial market, and the lines delineating banks from the market will become increasingly blurred. Another is that the provision of financial services will become increasingly “decentralized” and customized to the needs of customers. Their ability to engender trust with their customers and counterparties may remain the last distinctive asset of banks. And the ability of banks to engender trust will depend on their ability to articulate and implement an authentic higher purpose.
Money, Guns, and Lawyers
The Business of Banking
Introduction
Few outlaws are more notorious than Jesse James in the history of the Wild West. In the annals of Minnesota banking is the story of how the JamesYounger gang, led by Jesse James, was nearly wiped out attempting a bold daytime robbery of the Northfield First National Bank in 1876. The robbery started in the classic manner depicted in countless movies—a gang rides into town firing pistols, scaring people away and creating a diversion, while some other gang members walk into the bank brandishing guns. On this fateful day—September 7, 1876—however, one of the bank employees managed to escape and sound the alarm, which led to the people in the town surrounding the bank with guns blazing. In the aftermath, most of the gang was wiped out, but the James brothers managed to escape.
The Minnesota Historical Society has a Northfield bank note from the time of this raid. Signed by the bank cashier, G. M. Phillips, and bank president, F. Goodsell, this note survived the raid.1 Such bank notes were a part of the money supply then.
Why were the good folks of Northfield so determined to confront a dangerous gang and risk their lives? Because banks matter for the lives of everyday people. They provide a host of economic services, create money, and lubricate economic growth. For bankers, this means that it matters not only what they do but how what they do is perceived. As John Maynard Keynes put it:
It is necessarily part of the business of a banker to maintain appearances and to profess a conventional responsibility, which is more than
human. Lifelong practices of this kind make them the most romantic and least realistic of men.
Perceptions shape the confidence people have in banks. And confidence shapes their willingness to do business with banks. Not only must banks be trusted by their customers and various other counterparties in terms of the actions, but those they deal with should also have confidence in their financial viability. Indeed, this is one of the fundamental conundrums of banking— bankers can serve you only if you believe they will. A lot that happens in banking depends on perceptions and confidence. But what do banks really do? How do they serve you?
While “Lawyers, Guns, and Money” is a song by Warren Zevon from his 1978 album Excitable Boy, these are three things that go hand in glove with banking. Not just today; they always have. Money is a much older creation than guns, and banks were involved in the original creation of money. But money has always attracted weapons of war, so the association of guns with money is no surprise. And the centrality of banks in money creation and the payment system typically invites banking regulations. Of course, regulations are laws, and where there are laws, there are lawyers. And in some cases, politics too.
These literal interpretations aside, the phrase “lawyers, guns, and money” is often used as an analog for resources in general. And this is where the crucial economic role of banks comes in. They not only play a central role in how resources are allocated in the economy but also help create resources. This has been true for millennia. And while modern banks look very different from their ancient ancestors, it is striking how much of the original DNA still exists in modern banks. As we will see, this historical perspective is useful for informing contemporary issues.
The Bright and Dark Sides of Banking
The people of Northfield bravely defended their bank because it provided valuable economic services to them. But this bright side of banking is only one side of the equation. Like the moon, banking has a dark side, too, and it is most visible during financial crises.
After the Civil War, US banking grew rapidly. But then came the crisis of 1873. It started with a stock market crash in Europe. European investors began selling their investments in US railroads, and many American railroads went bankrupt. As is typically the case, bankruptcies in the “real economy” spilled over to banks, and they began to experience an increase in their risk of
insolvency. A big New York bank, Jay Cooke & Company, went bankrupt due to its large investments in the now-troubled railroads. Shocked by the failure of such a large bank, investors and depositors in banks panicked and began withdrawing their money from other banks.2 Over one hundred banks failed as a result. The New York Stock Exchange was closed for ten days. Credit began to shrink dramatically. Factories were shuttered. Thousands lost their jobs. The resulting economic pall lasted until 1879 in the United States, and even longer in Europe.
Banking Is Old, But We Can’t Do Without It
Neither the value provided by banks nor the economic carnage that accompanies banking crises is a new phenomenon. Some economic historians tell us that banking predates even the invention of coinage. Grain loans to farmers and traders by grain warehouses that evolved into banks probably began around 2000 bc e in ancient Egypt, Assyria, and Babylon. Others claim that the Venetian goldsmiths in the fourteenth century ce were the immediate predecessors of modern banks, and the antecedents of these early banks can be found in the goldsmiths in Athens around 700 bc e , which is roughly the time coinage first came into existence. 3 The first credit crisis apparently occurred in the fourth century bc e when Dionysius of Syracuse ordered that all metal coins be collected under penalty of death, restamped one- drachma pieces as two drachmas, and used his newly inflated coins to pay off his IOUs.4 So banks and financial crises have a long and hoary tradition.
But what about the state of banking today? While no one denies that banks are still important in modern times, the spectacular development of financial markets—especially in the United States—has led many to believe that the importance of banks is fading. Indeed, many research papers were written in the 1980s about the demise of banks, as mutual funds emerged and drained deposits out of banks.5 Today people talk of Bitcoin and digital currencies replacing the bank-dependent, fiat-currency-based payment systems we have and P2P platforms taking loan market share away from banks. Nonetheless, we underestimate the importance of banks at our own peril. This lesson was brought home to me forcefully in 2001–2002 when I was at the University of Michigan. My colleague Anna Meyendorff and I worked on a project (requested by the Central Bank of Romania) under the auspices of the Davidson Institute to study the Romanian financial system and make recommendations for reform.6
The prevailing wisdom at the time was that economies like Romania’s that had recently made the transition from a Soviet-style, centrally planned economic system to a free-market system ought to focus on developing their stock and bond markets by establishing exchanges on which the formerly state-owned companies could be traded. In other words, following the example of the United States, which has deep and liquid securities markets, the path to economic development lies in focus on developing such markets.
Romania had taken this advice and focused on the development of their stock exchange in Bucharest, called RASDAQ, patterned after NASDAQ in the United States. However, when we studied the Romanian financial system, we found that it faced a number of challenges. It had weak corporate governance in (formerly state-owned) firms. It had weak banks that relied on fee income but loaned little. This was in part because the banks felt they lacked the skills to make risky loans that might have to be restructured later. The other reason was that there was no securitization then, so some forms of lending— like home mortgages—were just considered too illiquid and risky. Moreover, even though the former state-owned enterprises were privatized and listed on RASDAQ, most of them were not involved in raising capital. So corporate investment was low. Companies were not getting enough credit, and they were not making up for that by capital market financing. Economic growth was hindered because the financial system was not lubricating this growth. Why was this transition to a free-market economy not flourishing?
The answer, we discovered, was simple—the banking system had not been developed. It is wrong to focus on securities markets before developing a robust banking system. Markets do not work well without a strong banking system. This is reminiscent of Adam Smith, who wrote in The Wealth of Nations (1776):
That the trade and industry of Scotland, however, have increased very considerably during this period, and that the banks have contributed a good deal to this increase, cannot be doubted.
There is now extensive academic research that explains why financial markets cannot function well without robust banks; I will discuss some of it later. But what matters for now is that we concluded that banks had to become the central focus of development, and we came up with a specific set of recommendations to achieve this. This was Romania in 2002, and it is a story we saw repeated in other former Soviet-bloc countries. Let us now turn to the banks of today.
From the Old to the New: What
Do the Banks of Today Do and Affect?
Highgrove Partners is a family-owned landscaping business in Atlanta. It provides commercial landscape, development, and water management to property managers and owners. Its CEO, Jim McCutcheon, decided to do his banking with Atlantic Capital. McCutcheon describes his relationship with the bank as follows:
By now I’ve worked with Atlantic Capital on many things—real estate loans, lines of credit, and equipment lines of credit. . . . I even went through the challenging situation of buying out two partners, and ACB worked through that with me.7
Like the experience of Hargrove Partners, today’s banks touch our lives in many ways. They safeguard our money, allow us to write checks, give us loans to buy houses and finance our businesses, enable us to use credit cards, participate in securitizing loans of all kinds, buy the bonds that finance our state and federal governments, and act as market makers in various securities. Today’s banks are as essential to our daily lives as the roads we drive on and the electronic devices we are addicted to.
This centrality of banking in our lives is time honored. In a report submitted to the lord commissioners of trade for the foreign plantations on January 9, 1740, Governor Richard Ward of Rhode Island wrote: “If this colony be in any respect happy and flourishing, it is paper money and a right application of it that hath rendered as so.”8
As the principal conduit for the creation and flow of paper money, banks were an important part of economic growth in the eighteenth century. That role is an important part of banking even today. But it is augmented by a plethora of other economic functions that include off-balance-sheet activities like loan commitments and letters of credit, securitization, and others. The core economic functions banks perform are threefold: (1) they create funding liquidity (and money) by gathering deposits and developing lending relationships; (2) they provide safekeeping services, protect the confidentiality of their clients’ information, and engage in activities that require the trust of their counterparties; and (3) they reduce transactions costs of contracting by more efficiently processing various sorts of information and reducing verification costs of all kinds (e.g., verification of asset ownership, borrower cash flows, etc.). As a result of these core functions, it is difficult to talk about
banking in isolation from the rest of the financial system, and we will talk later about the architecture of the financial system and how banks fit into that.
It is because of their central role in economic activity that the real sector experiences serious indigestion when the banking system has a hiccup. This was brought home to us forcefully during the 2007–2009 financial crisis. What began as defaults on US subprime mortgages grew into a fire that ravaged the global financial system. Employment dropped, consumption dropped, and companies cut back on investments. Research estimates put the damage done to the US economy alone at between $6 trillion and $14 trillion.9 These were the direct costs. When the estimated indirect costs—like productivity losses and the costs of mortgage foreclosures—are taken into account, the General Accounting Office puts the losses at around $22 trillion.10 When banks bleed, we all do.
Of course, crises are not new. They are as old as banking itself. The first banking crisis in the United States occurred in 1792. The first emerging market crisis occurred in Latin America in 1825. Not only are banks are disrupted by crises and thus more likely to fail during those times; crises are the fire in which the shape of banking is itself forged.
Preventing Banking Crises
An enormous amount of research, both theoretical and empirical, has been done on what causes financial crises.11 Less has been done on how to design banking systems that are less crisis-prone. In fact, some believe that avoiding financial crises may be impossible.
The problem then is not that we lack theories of what causes banking crises. Rather, we probably have too many. Many of these are elegant and complex, but the challenge is to find a parsimonious set of theories that explain a large set of facts about crises and are also possible to test empirically. That is, we would not only like them to explain what we have documented about crises, but we would like these theories to predict things we do not know so we can test them. Accurate predictions would give us greater confidence in these theories, so we could take their policy implications more seriously.
Whether it is the lack of a dominant theory of financial crises that is widely endorsed and fits the facts or it is our unwillingness to learn from the vast amount of research about crises, our response to any financial crisis is predictable. Politicians point fingers at greedy bankers, typically representing newer parts of the financial system,12 then they pass new regulations—often too many—to “solve” the problems that they think led to the crisis, and then
they complain about how banks behave by being innovative in getting around the new regulations. “Never waste a good crisis” is a statement often used to indicate that a crisis provides increased opportunities for politicians to enact new rules and regulations. As we will see later, the ever-present potential for the intrusion of politics into banking can severely limit the attractiveness of many reform proposals.
Do these regulations work? Some do. Some don’t. Can we tell which will work well and which will do more harm than good? How do we avoid this reactive regulatory dynamic? How much does research help us here?
These are important questions. As we work on answering them, we will begin to see a picture that emerges about what a healthy, relatively crisis-free banking system would look like.
As a society, we value stability. It facilitates planning and encourages individuals and corporations to invest. But achieving stability at the expense of economic growth is not always desirable. If it were, it would be easy to simply restrict all our banks with insured deposits to be “narrow banks” that can invest only in very safe assets like US Treasury securities. This is akin to an individual planning for retirement. If all you care about is stability, then you invest all your wealth in federally insured deposit accounts and US Treasury bonds. But if you are also interested in the growth of your wealth, then you have a blended portfolio that also includes riskier securities like common stock and claims on real estate. So any theory of financial stability must confront the stability- growth tradeoff. Moreover, the theory should focus on the common elements that are found in most crises and avoid the trap of being tailored to deal with those that were particular to the last crisis.
In discussing these issues, I will attach special importance to three things: bank capital, bank culture, and bank higher purpose. Capital is a heavily researched topic, so my task is relatively easy—I can borrow from that vast body of knowledge. Bank culture is a newer topic, and much work remains to be done. But increasingly, bank regulators are realizing the limits of their regulatory effectiveness and the need for a greater focus on culture to ensure that banks maintain their role as trusted intermediaries. That is, there is growing recognition that the trust of counterparties is an essential asset of banks, and bank culture has to ensure that this trust is maintained. Nonetheless, issues of bank culture have been alluded to over many past decades. Consider the example of Jacob Franklin Butcher, known to most as Jack Butcher, who built a financial empire in Tennessee and was the Democratic Party nominee for governor of Tennessee in 1978. He was convicted of banking fraud after
pleading guilty in 1985; he got a twenty-year prison term. The New York Times (September 6, 1984) reported:
Eighteen months after the collapse of the Butcher brothers’ Tennessee banking empire, the Federal Deposit Insurance Corporation fears that its losses on the episode may total several hundred million dollars more than it initially expected. . . .
The agency also said it found that the Butchers had been shifting bad loans from bank to bank to keep regulators from noticing them. On Valentine’s Day 1983, Tennessee had the F.D.I.C. arrange the sale of Jack Butcher’s flagship, the United American Bank of Knoxville, and the unraveling began.
The following month, C. H. Butcher’s Southern Industrial Banking Corporation, a consumer finance company that attracted uninsured deposits by paying high interest rates, filed for protection from creditors under Chapter 11. . . . In May 1983, the F.D.I.C. sold five more Tennessee banks that were owned or formerly controlled by the Butchers.
. . . Since then, nine more Tennessee banks have failed at least in part because of problems related to the Butchers.
These kinds of bank failures are not just due to bad luck. Rather, they reflect systematic failures of culture that jeopardize the trust taxpayers place in the banking system.
Finally, there is the issue of higher purpose, a reason for the bank to exist—typically a prosocial goal—that transcends typical business goals but intersects with these goals. This is an issue of great import, but one that has received little attention from banks, and even less in research.13 When an organization has higher purpose, decisions are made that are in line with both prosocial goals and the business goals. A higher purpose expresses the deepest authentic intent of the organization. Steve Jobs described it thus:
Great companies must have a noble cause. Then it is the leader’s job to transform that noble cause into such an inspiring vision that it will attract the most talented people in the world to want to join it.
Higher purpose is not charity or corporate social responsibility. These terms mean different things to different people, but to me they are distinct from an authentic (not PR), organizational higher purpose.
What should a bank’s higher purpose be? Since we are interested in how the bank makes decisions at the intersection of its business goals and its higher purpose, this question is difficult to answer until we understand what banks do and why they do it. That is, we first need a deeper understanding of the business of banking. After these ideas have been established, I will return to a discussion of how higher purpose interacts with bank culture and the role it can play in financial stability.
Notes
1. See Nicholson 2000–2001.
2. Banks runs are typically triggered by worries about economic fundamentals. That is, they are not completely random phenomena, but are caused by observed economic stresses caused by things like asset price declines, loan defaults, layoffs, and so on. In 1873, this shock to fundamentals came from bankruptcies in the real sector. More generally, bank runs are typically triggered by a decline in the values of assets banks hold on their balance sheets due to stresses in the real sector. In the 2007–2009 crisis, this decline was in the values of home mortgages and mortgage-backed securities due to falling house prices.
3. See Donaldson, Piacentino, and Thakor 2018.
4. See Reinhart and Rogoff 2009.
5. See, for example, Gorton and Rosen 1995.
6. See Meyendorff and Thakor 2002.
7. See the website of Atlantic Capital: http://www.atlanticcapitalmanagement. com/.
8. See chapter 2 in Mayer 1975.
9. See Atkinson, Luttrell, and Rosenblum 2013 and Thakor 2015.
10. See General Accounting Office 2013. The Bank for International Settlements estimates that a typical crisis costs 158% of the nation’s GDP.
11. See Thakor 2015.
12. See “Financial Crises” 2014.
13. See Quinn and Thakor 2018.
References
Atkinson, Tyler, David Luttrell, and Harvey Rosenblum. 2013. “How Bad Was It? The Costs and Consequences of the 2007‒09 Financial Crisis.” Staff Papers 20, Federal Reserve Bank of Dallas, July.
Donaldson, Jason, Giorgia Piacentino, and Anjan V. Thakor. 2018. “Warehouse Banking.” Journal of Financial Economics 129:250–267
