Diversification and the function of banks December 29, 2011 at 5:33 pm

Steve Randy Waldman has an interesting post at interfluidity about the role of banks as credit intermediaries and how their existence facilitates risk bearing. It is pretty insightful in places:

Financial systems help us overcome a collective action problem. In a world of investment projects whose costs and risks are perfectly transparent, most individuals would be frightened. Real enterprise is very risky. Further, the probability of success of any one project depends upon the degree to which other projects are simultaneously underway… One purpose of a financial system is to ensure that we are, in general, in a high-investment dynamic rather than a low-investment stasis.

(That, by the way, is a purpose developed world banking is not fulfilling right now, but that is not the subject of this post.)

What interfluidity correctly identifies is the importance

  • of banks as diversified pools of risk;
  • of the tranching of bank fundings as a mechanism for ensuring investors can select an appropriate security [e.g. deposits, senior debt, sub debt, or bank equity]; and
  • of deposit insurance

I would also add maturity transformation, as this is a key function of banks. (Maturity transformation plus deposit insurance is kinda magical: maturity transformation without insured deposits is just scary.)

Banks capital structure and backstops mean that it is quite likely that banks will perform based on the realised value of their lending, not their market value: they will stick around long enough to see how things play out. That is important, as the realised value of a highly diversified pool of risk across an economic cycle is very likely to positive. Markets are very good at setting prices so that this is true. Sure, sometimes markets screw up, but not in all asset classes all of the time. Moreover, when markets screw up, they eventually over correct, so the banks that survive make out like bandits the next year.

Given all of this, and assuming that we regulate banks properly, set sensible capital requirements and so on (OK, perhaps a big ‘if’); well, then the risk of bank failure is small, and it is worth bearing in exchange for the increased growth that efficient credit extension provides.

Now I am not arguing that this model is a good (or a bad) thing. But it has worked pretty well in the past, and I think it could work reasonably well again. Therefore I don’t agree with Interfluidity’s conclusions:

Financial systems are sugar pills by which we collectively embolden ourselves to bear economic risk. As with any good placebo, we must never understand that it is just a bit of sugar.

Diversification, tranching, maturity transformation, and capital allocation are not sugar pills. They are legitimate and valuable economic functions which can and do earn a positive return. (Probably they shouldn’t earn as big a return as they have done over the last few years, but again, that isn’t the point.) Just because some part of the current financial system are not serving society well does not mean that we can do without entities which take deposits and make loans.

One Response to “Diversification and the function of banks”

  1. […] always excellent David Murphy objects to my characterization of finance as a placebo: Diversification, tranching, maturity […]