Are banks useful?

The key to a balanced economic market is the flow of information. In the event of information asymmetry between different players, the equilibrium price will be difficult to achieve. This is because economic agents then use the method of adverse selection: to minimize risk, consumers are not prepared to pay a high price for a product, even if it is of excellent quality. Akerlof, winner of the Nobel Prize in Economics in 2001, explained this mechanism very well in his « market for lemons ». In a situation of imperfect information, where the consumer is unable to recognize good cars from bad, he or she will refuse to pay more than the average trade-in price. Sellers of good used cars, deprived of customers, will then leave the market. Buyers, realizing that only wrecks remain for sale, will in turn leave the market, leading to its demise. Similar reasoning applies to the banking market, which suffers from a high degree of information asymmetry.

Firstly, the asymmetry is high when the loan is issued. Initially, the lender has very little information on the borrower (annual accounts or employment contract for an individual), while the borrower is less opaque about his future prospects. In this context, the selection of financing becomes difficult, with the risk of a sharp reduction or even rationing of loans. It will be difficult for a private individual to calibrate a model that perfectly meets the needs of his counterparty, a skill that the banking profession makes available to its customers.

Secondly, once a loan has been granted, regular monitoring must be put in place to prevent misappropriation of funds or simply to ensure repayment. This follow-up entails monitoring costs, which can be very high compared to the interest earned. According to the theory of Diamond and Dybvig (1983), the bank consolidates these control operations, thereby significantly reducing costs. In an environment where margins can be tight, economies of scale are not negligible. This point is all the more true when banks are able to establish long-term relationships with borrowers.

Thirdly, banks make it possible to pool risks. An individual would probably have to mobilize a large part of his resources to finance a counterparty, whereas the bank diversifies the risk of default. Along with asymmetric information, risk diversification is the second key point in the usefulness of banks.

Finally, banks help transform short-term deposits into long-term loans. Indeed, loans require the ability to mobilize money over a long period, without the possibility of renegotiation. This makes liquidity management a key skill, and one that banks have mastered to perfection.

However, the existence of banks does not completely solve the problem of asymmetric information. Rather, the bank transfers the problem of informational rent between lender and borrower to the relationship between savers and financial intermediaries. Indeed, the latter do not carry out an in-depth financial analysis of the health of the institutions where they deposit their money. In the event of an incident reported by the media, they may be tempted to withdraw their deposits hastily, in a rush to the counter. This is a terrible situation for banks in difficulty, which then see part of their resources withdrawn without being able to reduce their use of funds (in the extreme case of Northern Rock, for example). To counter this phenomenon, the regulator has introduced a number of mechanisms: bank regulation in line with Basel Committee rules, the obligation for banks to publish their financial statements on a regular basis, and above all a deposit guarantee mechanism. In concrete terms, banks pay a monthly contribution to an insurance fund that will reimburse savers in the event of bankruptcy. This well-thought-out mechanism is designed to dissuade depositors from panicking, while at the same time having a curative aspect, since it provides real compensation.

In conclusion, even if banks are criticized by a segment of public opinion that sees their intermediation role as futile, they nevertheless offer key advantages for the economy: selection of financing, control of borrowers, diversification of risks, transformation of deposits. Of course, disintermediated financing has its own advantages, but we can’t really criticize banks for their intermediation activity. Without them, financing of the economy would be atrophied, with all the attendant consequences for growth. However, their economic usefulness does not obviate the need to strengthen supervision of the banking system, and to reflect on the current model of integrating market and retail activities under the same umbrella. But this is a subject for another article.

References

Diamond DW, Dybvig PH. « Bank runs, deposit insurance, and liquidity ». Journal of Political Economy, 1983.
Akerlof. « The Market for Lemons: quality uncertainty and the market mechanism », 1970.