A bank is a financial institution which acts as an intermediary between borrowers and savers, and thus enables efficient allocation of financial resource across various sectors of the economy. Banks are the main source of indirect finance in a financial system.
Banks eliminate the problem of adverse selection by bridging the information gap between economic agents and mitigating risk. In the absence of banks, firms which are in need of funds would opt for issuing bonds or securities to borrow directly from the general public. However, this practice presents a major problem. Ordinary people may not be good at judging the quality of the bonds and securities issued by firms, due to lack of information. As a result of this imperfect information, people who buy bonds and securities may inadvertently end up buying bad quality bonds and securities. This problem is known as adverse selection. If adverse selection is particularly prominent, then we may have a scenario where the general public is completely opposed to investing in bonds or securities out of fear of losing money. In such a case, firms will fail to raise capital through the stock market and bond market.
Let us assume that firms have somehow managed to overcome the problem of adverse selection and successfully obtained funds from the general public through the stock market or bond market. Now we are faced with an even bigger challenge. With their newly found capital, firms may engage in risky investment, and, in the worst case, become bankrupt. This means that the general public will be deprived of their hard-earned money due to the negligence of the firms. This is known as the problem of moral hazard. Banks also solve the problem of moral hazard by acting with prudence, based on reliable information. Banks monitor the activities of firms to ensure that they act responsibly. Loans are issued based on thorough assessment of potential risks and creditworthiness of firms. Despite such precaution, if firms still do go bankrupt then banks in most countries offer deposit insurance to their savers. Banks not only provide a source of finance for firms, but also mitigate risks for small investors who may not be able to buy enough securities or bonds to sufficiently diversify their risks. By exploiting economies of scale, banks can effectively reduce the cost per transaction and enable small borrowers to get funds at a relatively low rate. Banks naturally have an incentive to monitor firms and enforce a disciplinary effect on the firm's management. This means that banks, especially powerful banks, are often more effective than legal systems in forcing firms to pay back their debt.
These strengths of banks, however, are largely subject to the state of governance in the banking sector. If banks deviate from the original spirit of banking and instead pursue completely antithetical objectives, then the economic prosperity of a nation can become shackled by the banking system. The word "bank" is derived from the Old Italian word "banca" which roughly means "table" or "counter top". This refers to the tables and counter-tops in 14th century Renaissance Italy where bankers first started doing their business. The "banca" or "counter top" symbolizes the transparency of bankers. It represents the idea that banking as a service is quintessentially based on trust. Yet in recent times, banks in many countries, including the developed ones, seem to be doing more of their business under the table rather than on top of it. This is fuelling a growing distrust of the general public towards the banking sector.
When banks begin to collude with firms, it tends to have deleterious effects on competition, innovation and growth. Banks generate liquidity by borrowing short and lending long. Yet by creating liquidity banks also unwittingly create a system which is vulnerable to crisis. Banks may induce firms to take relatively high proportion of debt, which can make them more financially fragile. In this situation, the government can add fuel to the fire of instability by providing financial support to irresponsible banks. Thus when banks are habitually shielded under the protective umbrella of the government, we get an epidemic form of moral hazard. This completely defeats the purpose of banks, which were supposed to resolve moral hazard in the first place.
The banking sector is important for a country for the sake of providing necessary financing for the real sector of the economy. Any problem in the real sector of the economy is expected to be tackled by the banking sector, and not the other way around. Nevertheless, cross-country empirical evidence shows that the banking sector itself can often turn out to be a problem for an economy. Countries having no problem in the real sector of their economies have sometimes experienced stunted growth due to the problems in their banking sector.
A well-functioning banking system passes funds from savers to borrowers, whilst at the same time mitigating risks and facilitating information disclosure. However in order for a banking system to function properly, it needs to be empowered through freedom to work and backed by good governance. Otherwise, people may get the impression that to take one person's money without that person's knowledge is theft, but to take everyone's money despite their knowledge is banking.
Syed Yusuf Saadat is a Research Associate at the Centre for Policy Dialogue (CPD)