The Business of Banking. When asked why he had robbed a bank, Willie Sutton, a 19th-century

When asked why he had robbed a bank, Willie Sutton, a 19th-century

American outlaw, replied: ‘Because that’s where the money is’. His rea-

soning is hard to fault: since modern banking emerged in 12th-century

Genoa, banks and money have gone hand in hand.

Banks are still pre-eminent in the financial system, although other

financial intermediaries are growing in importance. First, they are vi-

tal to economic activity, because they reallocate money, or credit, from

savers, who have a temporary surplus of it, to borrowers, who can make

better use of it.

Second, banks are at the heart of the clearing system. By collaborat-

ing to clear payments, they help individuals and firms fulfil transactions.

Payments can take the form of money orders, cheques or regular trans-

fers, such as standing orders and direct-debit mandates.

Banks take in money as deposits, on which they sometimes pay inter-

est, and then lend it to borrowers, who use it to finance investment or

consumption. They also borrow money in other ways, generally from

other banks in what is called the interbank market. They make profits

on the difference, called the margin or the spread, between interest paid

and received. As this spread has been driven down by better information

and the increasing sophistication of capital markets, banks have tried to

boost their profits with fee businesses, such as selling mutual funds. Such

income now accounts for 40 % of bank profits in America.

Deposits are banks’ liabilities. They come in two forms: current ac-

counts (in America, checking accounts), on which cheques can be drawn

and on which funds are payable immediately on demand; and deposit

or savings accounts. Some deposit accounts have notice periods before

money can be withdrawn: these are known as time deposits or notice

accounts. The interest rate paid on such accounts is generally higher

than on demand deposits, from which money can be immediately with-


Banks’ assets also range between short-term credit, such as overdrafts

or credit lines, which can be called in by the bank at little notice, and

longer-term loans, for example to buy a house, or capital equipment,

which may be repaid over tens of years. Most of a bank’s liabilities have

a shorter maturity than its assets.

There is, therefore, a mismatch between the two. This leads to prob-

lems if depositors become so worried about the quality of a bank’s lend-

ing book that they demand their savings back. Although some overdrafts

or credit lines can easily be called in, longer-term loans are much less

liquid. This ‘maturity transformation’ can cause a bank to fail.

A more common danger is credit risk: the possibility that borrowers

will be unable to repay their loans. This risk tends to mount in periods

of prosperity, when banks relax their lending criteria, only to become

apparent when recession strikes. In the late 1980s, for example, Japa-

nese banks, seduced by the country’s apparent economic invincibility,

lent masses of money to high-risk firms, many of which later went bust.

Some banks followed them into bankruptcy; the rest are still hobbled.

A third threat to banks is interest-rate risk. This is the possibility that a

bank will pay more interest on deposits than it is able to charge for loans.

It exists because interest on loans is often set at a fixed rate, whereas

rates on deposits are generally variable. This disparity destroyed much of

America’s savings-and-loan (thrifts) industry. When interest rates rose

sharply in 1979 the S&LS found themselves paying depositors more than

they were earning on their loans. The government eventually had to bail

out or close much of the industry.

One way around this is to lend at variable or floating rates, so as to

match floating-rate deposits. However, borrowers often prefer fixed-rate

debt, as it makes their own interest payments predictable. More recently,

banks and borrowers have been able to ‘swap’ fixed-rate assets for floa-

ting ones in the interest-rate swap market.

Another way in which regulators have tried to keep banks’ heads

above water is to force them to match a proportion of their risky assets

(i. e., loans) with capital, in the form of equity or retained earnings. In

1988 bank regulators from the richest countries agreed that the capital of

internationally active banks should, with a few variations, amount to at

least 8 % of the value of their risky assets. This agreement, called the Basle

Accord, is being revised, largely because the original makes only crude

distinctions between loans’ different levels of risk.

It is not just the failure of individual banks that gives regulators sleep-

less nights. The collapse of one bank can spread trouble throughout the

financial system as depositors from other, healthy, banks suddenly fear

for their money. Regulators step in because they want to prevent a col-

lapse of the entire system. Governments try to minimise the risk of such

failure in several ways. One is to impose harsher regulation on banks than

on other sorts of companies; often, the regulator is the central bank. An-

other tack is to try to prevent runs on banks in the first place. Following

the collapse of a third of all American banks in 1930-33, the government

set up an insurance scheme under which it guaranteed to repay deposi-

tors, up to a certain limit, in the event of bank failure.

Following America’s lead, other countries have also introduced de-

posit-guarantee schemes. Even where they have not, depositors often

assume that there is an implicit guarantee, because the government will

step in rather than risk a collapse of the whole system. In this decade,

the Japanese government went to the extreme of guaranteeing all lenders

(not just depositors) to the country’s biggest banks until the end of the


Some argue that these guarantees make bank failures more likely,

because they encourage depositors to be indifferent to the riskness of

banks’ lending. Moreover, as banks get bigger, they are also likely to con-

clude that they are ‘too big to fail’, which is an incentive to take more

risk. Both are a form of moral hazard.

To combat moral hazard, regulators try to be ambiguous about how

big is too big, and to restrict the amount of insurance they provide. In re-

cent years, none of these measures has prevented ill-advised lending by

banks around the world. Failures include the excessive loans of Ameri-

can banks to Latin America in the 1980s; and banking crises in Japan,

Scandinavia and East Asia.

In many countries, governments have responded to emergencies

by nationalizing the worst banks, often pledging to inject capital, take

on their dud loans, and re-privatize them. This is fine in theory, but in

practice it often distorts the market for the remaining privately owned

banks by keeping too many banks in business and by allowing national-

ized banks with the benefit of a government guarantee to borrow more


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