The future of traditional banking
The role of banking in the economy
Bitcoin, Blockchain, Peer-to-Peer, Fintech are some of the buzz words that we all have heard in recent years. New technologies and a world that is increasingly interconnected have challenged the status quo of traditional banks. However, are ‘normal’ banks’ days really numbered?
In this article I will go through a couple of aspects of banking (specifically commercial banking) that are often overlooked.
What do traditional banks do?
Traditional banks take deposits, provide immediate access to those deposits with a checking or other payment facility, and use the deposits to fund loans to borrowers. They provide loans to firms to fund the firms’ projects and they also make loans to households for real estate (in the form of mortgages) or consumption (credit cards and personal loans).
What does it mean that banks stand between central banks and the real economy?
In a liquidity crisis all financial market participants find it difficult to acquire liquidity. A general fear that liquidity will be hard to acquire is self fulfilling. Fearing a shortage of liquidity, firms and households will refuse to make payments to others and draw down on lines of credit.
Some examples of liquidity crises are:
· the Asian banking crisis in 1997
· the Russian debt crisis in 1998
· the Dotcom buble in 2000
· the 9/11 attack on New York
· the last Global Financial Crisis
Central banks always promise to supply more than adequate liquidity to prevent fears of a crisis becoming self fulfilling as liquidity dries up. When the central banks release liquidity into the economy, that liquidity flows directly into the banks and is then distributed to households and firms as they draw down on lines of credit supplied by banks.
Convert liquidity into credit
Banks have a key role in the economy as they are able to convert liquidity into credit. No other financial intermediary does this on a stable, permanent, large scale basis.
How is this accomplished?
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One way in which central banks stimulate the economy is through their monetary policies.
Let’s go through an example.
Let’s assume that the Fed funds rate in the US is 3.00% and inflation is at 1.5% per annum. However, the growth rate of the economy is too low and unemployment is too high, so the Fed want to speed up the economy.
Banks reserves (money that banks need to keep with the central bank) now exceed their reserve requirements and they have an incentive to lend that money out.
This low interest rate environment induces a household to borrow $1 million from Well Fargo to build a house and that full payment is made to the builder of the house, directly from the bank, at the time of the handover of the house. At that time the following things will happen:
· Wells Fargo will make a loan of $1 million to the household which will increase its assets by $1 million
· Wells Fargo will pay $1 million to the builder in the form of a bank cheque
· The builder will then deposit the bank cheque with Bank of America (BoA) and the cheque will clear
At this point, the following happens:
· The reserves of BoA at the Fed go up by $1 million and the reserves of Wells Fargo go down by $1 million. Therefore, total reserves are unchanged
· The deposits of BoA go up $1 million and the reserves of BoA go up $1 million
The net effect of these transaction is:
· The balance sheet of Wells Fargo is unchanged in size but it has turned $1 million of its reserves into a $1 million loan asset (creation of credit) and the reserves are now with BoA
· The balance sheet of BoA has expanded by $1 million. It has an extra $1 million of assets (the reserves) and an extra $1 million of liabilities (the deposit). It has to hold extra reserves against the increased deposits, so now the excess reserves at the Fed are slightly reduced
To avoid overwhelming the reader I won’t go through the details on how banks manage long term loans and short term liabilities and what banks do if depositors want their money back however it’s important to know that the role of turning liquidity into credit makes banks inherently unstable.
The money multiplier
Banks make loans, the proceeds of which go into the real economy to support consumption and about 80% reappear as deposits in the banking system.
Banks lend the new deposits out again, creating more credit. The credit cycles through the real economy and 80% of it reappears in the banking system as deposits, only to be lent out again.
Every $1 of new base money leads to a money multiplier of c. 5 dollars of new credit. As the Fed’s balance sheet expands by 1 dollar, the balance sheets of the banking system expands by 5 dollars. The money multiplier varies as it depends on several factors such as the amount of reserves that banks are comfortable keeping with the Fed (above minimum requirements).
