1.1 The Role of Banks in the Economy
1.1.1 The Liquidity Provision Function
Banks play a prominent role in the functioning of the economy. They offer asset side services (e.g., originating and servicing loans), liability side services (e.g., accepting deposits and providing cash) and transformation services (creation of liquidity). Banks are unique institutions since they provide liquidity by accepting a constant maturity mismatch in their balance sheets. They convert deposits and short-term funding to long-term loans. Since liquidity demand stems from depositors as well as from borrowers, banks create liquidity on both sides of the balance sheet. Commercial banks are responsible for liquidity creation within the boundaries set by central banks. They enable financial transactions by processing payment transfers and servicing the payment system. Banks are substantially involved in financing trade by issuing letters of credit, guarantees and providing access to foreign currencies. Besides that, they offer support to companies that conduct international transactions by providing access to local market information via their international network of representative offices, branches and subsidiaries.
Banks also boost liquidity by acting as underwriters in bond issuance, as well as organising and financing syndicated loans for large entrepreneurial projects. Banks not only provide capital and liquidity, but also supply various risk management tools, useful for companies that aim to hedge the risk of their transactions (e.g., derivative contracts). By offering financial instruments and guarantees for transactions banks enhance economic activity. The performance of the banks influences the liquidity and funding provision in an economy and as a consequence financial stability and growth opportunities.
According to the theory of banking, it is the maturity mismatch that creates incentives for banks to supply the necessary liquidity (Diamond & Rajan, 2001). Banks are fragile institutions, since on the asset side of their balance sheets they hold complex, illiquid loans with various maturities, while on the liability side they hold easily withdrawable demand deposits, which are an inexpensive, but risky way to finance loans. To deal with this fragility banks are expected to have unique, specific skills allowing them to manage the above mentioned liquidity constrains. These skills permit banks to shield borrowers from credit limitations due to deposit withdrawals, which could occur at any moment. Since market participants are aware of this bank skill, they are willing to deposit their money in banks, which constitutes a sort of liquidity guarantee for the credit institution. Hence, banks have a comparative advantage in holding loans in their portfolios and offering guarantees of liquidity (Diamond & Rajan, 2001). The guarantees prevent the banks from abusing their skills and imposing excessive charges on their customers. If banks misused their liquidity management skill, for example, by demanding exorbitant fees from borrowers, they would face the risk of a bank run and potential bankruptcy. Hence, the maturity mismatch and the resulting fragility of funding are crucial to avoid such a misuse. This is especially the case for banks that already have large loan positions and use their skills to manage these loans, instead of creating new ones. These banks are particularly dependent on the depositors and may fear runs.
Banks can develop their unique skills due to their simultaneous specialisation in deposit taking and lending (Booth & Booth, 2004). The rationale behind this argument is that both activities, deposit taking and lending, require liquidity provision on demand. If banks focus on both activities simultaneously this generates synergy effects in liquidity holding (Kashyap, Rajan, & Stein, 2002). The specialisation of banks in lending allows them to reduce the costs of loan illiquidity, that is, high lending margins or constrained availability of funding to companies.
Nevertheless, bank fragility may also have negative consequences. In extreme cases it may lead to bank runs, especially in times of economic downturns when banks are confronted with many non-performing loans. To counteract such a scenario it is safer to finance the loans by long-term liabilities, although, long-term funding, especially through equity issuance, is a more expensive way to finance bank activity than deposit funding and may constrain the banksā incentive and ability to lend (Diamond & Rajan, 2001). Hence, in order to secure their liquidity provision function, banks have to adjust their funding structure in a way that trades off the long-term funding costs and the risk of bank runs. The latter could be mitigated through the presence of deposit insurance, which would be an additional unique advantage for banks as liquidity providers (Booth & Booth, 2004). Deposit insurance does not, though, alleviate completely the banksā fragility, since in practice, only a part of deposits is covered by the insurance scheme. Importantly, given that deposit insurance is usually conditional on the banksā performance and capitalisation, it can be viewed as a similar discipline mechanism as demand deposits, allowing banks to fulfil their liquidity provision function.
1.1.2 The Intermediary and Information Provision Function
A further function of banks, pronounced in the theoretical literature, is their role as intermediaries. This function is closely related to the liquidity provision task. Given that single potential lenders (market participants with liquidity surpluses) cannot fully fund the projects of potential borrowers (market participants with liquidity deficiencies), it is essential to gather their funds in an institution that would be willing to take deposits and play the role of intermediary by supplying loans to borrowers (Diamond & Rajan, 2001). The bank also acts as intermediary, since it pays the depositors the charges extracted from the borrowers. Again, this is possible due to the specific skill of the bank consisting of the simultaneous management of deposits and loans.
Banks also fulfil their intermediary function by acting as delegated monitoring institutions over the borrowers on behalf of the depositors. This is an efficient arrangement, since in its absence each lender would have to monitor borrowers separately. This would lead to duplicated efforts in the banking system or a renouncement of monitoring, conducive to a free-rider problem (Diamond, 1984). The delegated monitoring also relates to another function of banks, which is information provision. Banks produce information on the credit risk of borrowers, which is viewed as a credential by depositors (Boyd & Prescott, 1985). They do not disseminate the information, but they communicate it by making payments to depositors. Doing this, they reduce substantially the information asymmetry and incentive problems between depositors and borrowers (Diamond, 1984).
Banks have incentives to carry out their delegated monitoring and information provision function since these tasks entail substantial benefits in the form of fees. Banks are motivated to hold lending portfolios, instead of originating new loans and just monitoring borrowers (Beatty & Liao, 2014). This motivation may be exacerbated by the existence of delegation costs related to carrying out the mentioned functions. These costs can be, though, alleviated if the bank has diversified funding and sets a convenient pattern of returns to depositors and from borrowers. The bank can use the extracted charges from deposit and lending activities to finance monitoring and to minimise its cost (Diamond, 1984). In addition, the diversification of funding and lending allows banks to distinguish between the respective depositors and satisfy the need for information provision on an individual basis. This may be requested by single depositors to avoid disclosure of the monitored information to competitor banks.
The importance of the intermediary function of banks has been underscored by Boyd and Prescott (1985). They show that in an environment where the information about borrowersā credit risk is only privately available, financial intermediaries arise endogenously. The market participants (agents) in this environment do not have the full information about the borrowersā credit risk, which gives rise to adverse selection problems. Also, agents are not identically endowed with market information. The function of the intermediaries, which are coalitions of agents, is to support the privately available information. This is possible due to the lending and borrowing function of these intermediaries. Since they usually borrow and lend to large groups, intermediaries are substantially diversified on both sides of the balance sheet. This diversification decreases largely the cost of monitoring (Diamond, 1984). The need for intermediary coalitions is conditional on whether there is adverse selection before contracting and whether information production is possible after contracting. Otherwise the same functions could be fulfilled by a simpler construct, namely the securities markets (Boyd & Prescott, 1985).
Given the delegated monitoring task, banks enable the issue of better lending and investments contracts (Diamond, 1984). They also facilitate safer investments, which are less affected by information asymmetry (Freixas & Santomero, 2002).
1.1.3 Non- Typical Banking Activities
Besides fulfilling their liquidity provision and intermediary function banks have extended their scope to non-typical banking tasks over the past decades. This tendency was triggered by various factors, mainly the competition of shadow banking institutions, deregulation in banking, technological progress and financial innovation.
Shadow banking institutions, for instance investment funds, money market funds or special purpose vehicles, provide services which are in direct competition with banks, although they are less regulated. Weaker regulation entails lower costs of shadow banking activity and a competitive disadvantage for banks causing the latter to put pressure on deregulation and engage in regulatory arbitrage by shifting their activities to the non-regulated sector. As a consequence, the banking systems worldwide have undergone substantial liberalisation and deregulation. Credit institutions were allowed to take on more and more risk and to mix non-typical and typical banking activities (Altunbas, Manganelli, & Marques-Ibanez, 2011). The liberalisation also enabled the trading of credit risk between banks and financial markets via securitisation; that is, selling loans converted to tradable securities at the secondary market. The wave of consolidation in the financial sector via mergers and acquisitions led to the creation of large conglomerates with great market power which again eased exerting further influence on regulations. As a consequence, banks undertake various non-typical activities, for instance securities trading, brokerage, real estate activities or insurance activities.
Besides deregulation, a substantial factor of the banksā expansion to new fields of activity was technological progress, which enabled an increasing number of banks to access and use market information on a current basis and fulfil the function of market makers (SÅawiÅski, 2006). Monitoring, processing and pricing of financial data improved substantially over a short period of time and reduced the cost of issuing derivatives and structured products by banks. The large increase of derivative instrument trading worldwide and the expansion of direct funding available via the financial markets further boosted financial innovation. Subsequently, banksā business models changed from āoriginate to holdā to āoriginate to distributeā (Altunbas et al., 2011; Blundell-Wignall, Atkinson, & Roulet, 2014). This means that banks switched to making loans with the intention to sell them on the financial market to a third party, instead of keeping them in their portfolio until maturity. The alteration of banksā business models was reflected in an increased share of non-interest income in proportion to their total revenues (Boot & Thakor, 2010).
The growing complexity and availability of derivative instruments and the increasing liquidity of financial markets were substantial factors contributing to the shift of banking activity from deposit taking and lending towards non-traditional activities. An essential alteration of banksā business models led to changes in bank size, recourse to non-interest income revenues, corporate governance and funding practices. Deregulation and financial innovation have thus changed the banksā traditional functions that relied on liquidity and credit provision, as well as maturity transformation (Altunbas, Gambacorta, & Marques-Ibanez, 2009).
A theoretical explanation for banksā expansion into non-typical activities is given by Diamondās model (Diamond, 1984). The delegated monitoring function implies that the bank has to hold illiquid assets (loans) due to its task of exerting control over borrowers. The bank cannot sell the loans. If it did, it would have to transfer the monitoring to a thi...