Can we live without banks?

Essay, 2018

9 Pages, Grade: 67%


Banks are defined by Gertler and Karadi (2011) as commercial institutions which act as financial intermediaries in the financial market. Imperfect capital markets where transaction costs and asymmetric information exist are the reasons for the existence of banks, as stated by Scholtens and van Wensveen (2000). According to Allen and Santomero (2001) their aim is reallocating the resources of economic units with surplus funds, when they have more money than they need to spend, to economic deficit units, when they need to spend more money than they have. To do this, they must be in possession of a banking license, as explained by Ajwain (2010). As highlighted by Kashyap et al. (2017) they are using both sides of their balance sheet in doing so. In fact, they are taking deposits from savers and making loans to borrowers. Kashyap et al. (2002) argued that this kind of business is subject to three tasks of transformation. The first transformation is maturity. Typical bank loans given are medium or long-term, while received deposits are usually payable on demand. Secondly, there is risk transformation regarding the capability of intermediaries to diversify risks such as default risks of bank loans or interest risks of bonds bought by the bank. The third task of transformation refers to size issues. Banks pool small savings of savers to make large loans to borrowers. Banks are, as outlined by Sikdar and Kumdar (2017), also providing payment services to their customers. In doing their business, banks concentrate on the mass market with focus on individuals and smaller businesses, as described by Ashton (2002). Byers and Lederer (2001) call these kinds of banks inside the whole banking industry retail banks. This market is characterised by many customers who only make small transactions. These customers are usually only offered standardised products. The fixed costs of a retail bank are very high and the profit margin of a single customer is rather low, as discussed by Webb (2003). It is the multitude of customers that makes a retail bank profitable. The bank earns the margin between savers and borrowers, as reviewed by Diamond (1996) and Pyle (1971). Retail banks have expanded their business in recent decades, from reallocation of the economic resources towards fee-producing activities, as evaluated by Allen and Santomero (2001). In this essay, any reference to a bank is meant to be a retail bank.

As pointed out by Diamond (1984), the existence of banks is an issue because intermediation lengthens the chain of transactions in the provision of financial transactions. Intermediation involves agency costs of having savers provide funds to intermediaries as well as agency costs of intermediaries providing funds to borrowers, as assessed by Ergungor (2004) and Hellwig (2000). Intermediation theory is, as argued by Allen and Santomero (2001), based on imperfect markets due to asymmetric information. According to Hasman et al. (2009) banks are solving market inefficiencies through intermediation between economic units. Without banks, the information barriers to participation would prevent savers and borrowers from reaping the benefits of new markets, and the markets themselves might not survive, as explained by Allen and Santomero (2001). But the authors have the opinion that, if imperfect market frictions are reduced, intermediaries will become less important. Lin (2015) disagrees because in the absence of banks as an information broker, the information essential to the market participants would be less reliable and more expensive to acquire. This would therefore be a driver for more information asymmetry in the market. Furthermore, an agency problem exists between borrowers and lenders, according to the analysis by Gertler and Kiyotaki (2010). The authors explain that this agency problem is reduced through the existence of banks. One can say that as long as there are imperfect markets, there are banks as intermediaries. As soon as markets are perfect, intermediaries are redundant, because they lose their function as soon as savers and investors have all the information available to find each other directly, immediately and without any impediments, as pointed out by Scholtens and van Wensveen (2000).

For example, it can be assumed that a bank only has a demand from savers and another bank only has a demand from borrowers. The banks are economically not viable on their own due to one-sided demand. Gertler and Kiyotaki (2010) contradict this thesis by arguing with the interbank market. The authors describe that if the interbank market works perfectly, then funds flow efficiently from units with surplus funds to deficit units. Through this, the banks create market equilibrium. In my opinion, this cannot be represented in the absence of banks only by individuals.

Moreover, financial transactions in the real world are based on transaction costs, as demonstrated by Hasman et al. (2009). These are caused by the conduction of financial market operations in imperfect markets. The author further describes that transaction costs are reduced by financial intermediaries represented by banks. Lin (2015) points out that in the absence of banks reallocating capital between economic units they would likely have to expend more transaction costs in trying to acquire the requisite capital for the desired objectives from a multitude of capital sources. The author emphasises that the general positive purpose of banks is to produce more efficient financial transactions. Banks are supposed to make it simpler and cheaper for individuals seeking financing to work with an intermediary than to do it on their own. Nowadays, financial markets are very complex and it takes a lot of time and exertion to find the right contractor for each specific purpose, which leads to high search costs, according to Palazzo (2017). Banks can serve as important and efficient intermediaries for market participants by being conduits for liquidity and exchange in the marketplace, as found by Lin (2015). In this way, they reduce search costs for all market participants. Furthermore, the author points out that, in a world without banks playing the role of market makers, units in the market may have to expend significantly more reserves trying to find the appropriate counterparty. The investigation effort concerning the true quality of opportunities contains verification costs, as stated by De Alencar and Nakane (2004). The authors recount that it is nearly impossible for a private market participant to evaluate the true condition of a borrower without interposition of a bank. De Haas (2006) identified that after entering into a financial contract, the saver typically bears monitoring costs. These arise from the fact that once the loan is paid under the agreed conditions, the borrower could decide to take higher risks than previously appointed. Banks, as analysed by Swamy and Tulasimala (2011), fill information gaps between savers and borrowers, as agents and as delegated monitors. This is because they have a relative informational advantage over both units. They scrutinise and watch over investors on behalf of savers, as highlighted by Ergungor (2004). In my opinion, an individual cannot ensure such monitoring as the banks; this would involve excessive costs, which would make the business no longer profitable for the savers. The last part of transaction costs are enforcement costs. If monitoring is successful and shows that the borrower does not behave like agreed or at worst defaults, consequences have to follow to recover the loan capital, according to Ahlquist and Prakash (2010). Possibilities are extrajudicial steps or legal action. In the authors view, both can be very costly and consume more than the expected return of the loan. In my opinion, a saver would decide to use the bank deposit rather than the direct transaction, if the deposit return is higher than original return less transaction costs. This value creation is caused by the concepts economies of scale, as discussed by Daniel et al. (1973). This concept describes the benefits of producing something in a large number and profiting from the decreasing fixed costs per produced unit.

The reallocation of resources reduces the transaction costs and increases information transparency for all market participants. That thought could be expanded by the fact that intermediators are costly by nature and therefore disadvantageous. The transaction cost approach is hence useful, but it does not completely explain the presence of banks, in my view.

Also, banks also add value to the economy through handling deposits and loans with different maturities, as found by Diamond and Dybvig (1983). The authors developed a model which shows how banks are adding value through investing in long-term illiquid assets, while at the same time, it is ensured that depositors can withdraw their money at any time they want. They hold long-term assets and fund these assets with short-term liabilities, as pointed out by Gertler and Karadi (2011). In the case of an investment, a saver must always find, in the absence of banks, a borrower who has the same credit period; otherwise it would be too expensive, in my opinion. However, these same interactions can also be a source of fragility for banks. Kashyap et al. (2017) highlight that transforming illiquid long-term assets into liquid short-term claims is desirable, but exposes banks to the possibility of a run which can be disastrous for the bank, its borrowers, and its savers. Scholtens and van Wensveen (2000) denote risk management as the key area of intermediary activity. The risk arises, as explained by Kashyap et al. (2017), because borrowers use the bank funding to invest in something which future value is uncertain and this is private information for the borrower. Therefore, banks can play an important role in making sure that markets receive and reflect accurate information to reduce the risk, according to Lin (2015). In a world without banks serving as risk managers, many financial transactions would be costlier and riskier, as further characterised by the author. Allen and Santomero (2001) agree that it is too expensive for the economic units to manage risk directly. Benes and Kumhof (2012) support this by saying that this would increase the monitoring cost and would be economically unfavourable. Banks are operating with different values of deposits and loans as well, as considered by Allen and Santomero (2001). In doing this, they play a key role in pooling all the savings for economic growth purposes, as argued by Swamy and Tulasimala (2011). In the absence of banks, I assume that it would be very hard to find the matching counterpart with the same size of the expected financial transaction and this would therefore be a driving force for search costs. In practice, the described functions of banks appear in a miscellaneous form. Modern banks coordinate the sizes of loans and deposits, they match the maturities, and finally they reduce the loan risk through diversification, according to Kindleberger (1993). As highlighted by Swamy and Tulasimala (2011), financial intermediation is a value-creating economic process.


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Can we live without banks?
University of Strathclyde
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ISBN (Book)
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Banks, Fintech
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Moritz Meyer (Author), 2018, Can we live without banks?, Munich, GRIN Verlag,


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