6.2.

Banks

Bank history, definition and activities

Definition: I thought I should start out by, defining a bank.

The word bank, by the way means, counter or table top, where bankers used to
do their business. That's the English word that emerged in the 15th century.
But the banks of course precede that with other names.

What is it that is the characteristic activity of banks?

Spread: I would say the most, maybe the most characteristic thing, is that
banks earn spread income. That is, they borrow at lower interest rate and lend
it out at a higher interest rate and they make the difference. Your deposit rate
is lower than the rate at which they charge for the loans they make. So that's
the spread income or margin.
So that might be considered the core idea of a bank that you borrow at a lower
rate than you lend. But I'm not sure that summarizes it either. There are other
aspects of banks that we'll talk about.
Note issue: Another aspect of banks traditionally has been note issue. That is
they print paper money and then it circulates and goes. You have some of
these in your pocket. Their currency. If you stop a person on the street a
couple hundred years ago, and said, what is the essence of a bank? I suspect
the first thing they would say is, Oh, they print money, and that's the paper
money that we use.
But you don't think of it this way. That's be, probably not, because most of that
function all over the world has been shifted to the government banks, the
central banks in the various countries. And so, you don't think of private banks
as issuing bank notes. But they used to, and it used to be prominent. The
private bank issuing of notes, today in the world, I believe is concentrated
primarily in two countries. One of them is the United Kingdom and the other
one is Hong Kong.
There's other aspects of a bank I want to emphasize.

Provide Liquidity: One is liquidity. And this is essential element of banking as

well. And I'll come back to that when we talk about theory in a minute. But
banks offer liquidity by borrowing short and lending long. This is different from
spread income in saying the interest rate I slower on the borrowing of the bank
than the lending of the bank.
There's another discrepancy.
The maturity is longer on the lending of the bank than the borrowing of the
bank. So banks are providers of liquidity. That means a business wants to
borrow money, or let's say a home owner wants to borrow money to buy a
home, right?
Let's take that example because that's more familiar. You're going to lock up
the money for maybe 30 years; you don't want to pay the loan back tomorrow.
What if the lender says, I need the money, give it back? You can't give it
back, or you don't want to give it back. So what a bank does is it takes deposits
and allows people to cash them in whenever they want. It lends the money out
long on 30 year or so loans. So it generates liquidity.
The borrower has what he or she wants, which is a 30 year loan. The lender has
what they want. They have a loan account they can get at any time. But the
problem with this so this is an important function of banks, but the problem
with it is that there's a problem of crises, because if everybody asked to pull
their money out at once, they can't do it.
The banks in normal circumstances generate liquidity. But they create a system
that's vulnerable.
History: And so the banking industry has been plagued by frequent crises
throughout history. Renaissance time and when they actually had a banking
institution. And that's where the oldest bank in the world today exists. It's
Banca Monte dei Paschi in Sienna. And that means the bank of the mountain of
sheep.
The same, it's the same analogy, I guess.I don't know if they called their
interest lambs, but, and so that bank was set up in, 1472, and that's the oldest
surviving bank in the world.
I went there. You could go there if you visit Sienna and they have a little
museum on the first floor near the lobby. And it's actually the third largest
banking Italy. Very old institution. It's interesting that the this bank, which
was founded in 1472, was founded a philanthropic institution to lend money to
the poor. And wealthy donors in Italy gave money to set up this bank. It goes
beyond that now, it's not just lending to the poor.

The other thing is in the 1600s they gave it deposit insurance, believe it or not,
the Duke of Sienna said he would guarantee all deposits. So deposit insurance
appears to have been invented in Italy, as well. But a lot of people emphasize
when they talk about the history of banking I was reading in preparing for
this history of economic histories to see what they would say about banking
and Professor Clive Day, a professor here at Yale wrote a book called Theory,
History of Commerce in 1907.
You can pick up his book, if you want to, on Google Books. It's past its
copyright. And I had great fun reading it. He's long gone Professor at Yale, but
his history begins in England with the so called Goldsmith Bankers. What
happened was in England in the six-, maybe 1500s, or 1600s, somewhere
around that, Goldsmiths who made gold jewelry had safes when they, good
places to store gold. And so people would go to the Goldsmith and maybe they
were having jewelry made, but then they'd say, could you keep some of my
gold in your vault?
And so the Goldsmith banker would say Alright, I'll do that, and I'll give you a
note saying I'll promise to pay you this amount of gold that's in my vault. So
sometime when you're out shopping, the Goldsmith banker's note would be in
your pocket still, and you'd want to buy something. So you'd say, Well, I've
got this, but you talked to the merchant and you'd say I've got this gold
that's in the Goldsmith I've got his note here. So the merchant would say,
Alright, I'll take that, but you've got to endorse it over to me. Write a note on
the note saying that this thing is being transferred to me. And so I can go to
the Goldsmith and get it out. And that's how paper money got started in
England, it started to circulate with many endorsements on it. And then finally,
the Goldsmith said, Let's forget about endorsing it through one person. Let's
just say to the bearer. And so that paper money started developing kind of
spontaneously.
And then the Goldsmiths noticed, you know, they've got all this gold in their
vault. They can lend it out. Why not? Because nobody ever comes and asks for
it. Now that these paper notes are circulating, nobody asks for it, so I'll start
lending it out. And they didn't have to pay any interest on the notes because
people would hold them anyway just because they valued the safekeeping. I
guess they were paying interest in the sense that they were providing the
safekeeping.

Commercial Banks
So that's how banking got started in England but it was really, preceded in Italy.
The most important type of bank is called a commercial bank. And these are

banks that take deposits. You can put your money in the bank and then, it will
pay you interest.
And it will also make loans of various kinds but most characteristically,
business loans. Commercial banks were the most even more prominent 100
or 200 years ago because they didn't do mortgages and consumer loans then.
It was all business loans, initially, so this is kind of the historic important kind of
bank.
And in 2010 the total assets, of US commercial banks, uh, of US located
commercial banks was 14.6 trillion. But actually, a lot of that was foreign
commercial banks operating in the United States, of that 14.6 trillion only, 10.1
was US charted banks. The bankers operate all over the world. So we have
banks like H I've mentioned Hong Kong and Shanghai Bank Corporation
(HSBC), or the various Swiss banks that have big operations or Deutsche Bank
big operations in the United States, so they account for almost a third of our
commercial banks.
But then there are other kinds of banks and they are smaller in terms of this
is assets of the banks. It's not their market cap, market cap would be much
lower, because remember, off setting these assets or liabilities, they owe to the
depositors.

Saving Banks
So but there's other kinds of banks. There are savings banks and in the US the
savings banks had only 1.2 trillion. These savings banks were generally they
tend to be old institutions that have grown very large over time. The result of a
savings bank movement in the 19th century which was a philanthropic
movement to set up banks for lower income people, because commercial
banks traditionally wouldn't take deposits from small, you'd have to have a
minimum size.
They didn't care about; they didn't deal with ordinary people. So they created
savings banks to encourage thrift and saving. Actually, it follows on a UK
movement, a savings bank movement in the UK, and they're still with us but
they're not as not so big.

Credit Unions
And there are also credit unions. That's another social movement, and they're
only 0.9 trillion, or about 900 billion in assets. Credit unions are basically clubs
of people that belong together in some group. So you can, if you have a

company, you can set up a credit union for the employees of your
company.there they make, both savings banks and credit unions make a lot
of mortgage loans. That's kind of their characteristic business.
I wanted to mention the theory of banks was laid out in the Diamond-Dybvig
Model. In The Journal of Political Economy 1988.
They were both colleagues of ours at Yale. They've moved on. So I know them
both. Doug Diamond and Phil Dybvig. But what they described is a mod
I'm not going to give you the model, just to tell you about it. The theoretical
model of banks as providers of liquidity. That liquidity is an economic good that
you can somehow get for nothing. It comes out of, well, it's just like portfolio
diversification we don't need to expend any resources to get diversification.
We just have to manage our portfolios right. Similar, you set up a bank and lo
and behold, liquity appears and it makes it possible for people to live their
lives better.
I mentioned how you can live in a house for 30 years or you can move
whenever you want. But the problem with it is that their multiple equilibri.
Their model has a good equilibrium and bad equilibrium and it depends on our
expectation that people think that the banking system is sound and it's going
to work well. It works splendidly but the problem is all it takes is for people to
suddenly change their expectations and then it falls apart, because you have a
run, you have a bank run. So what Diamond and Dybvig did is to provide an
economic rationale for deposit insurance. It's a system insuring deposits
against the default of the bank. Helps people, helps prevent bad outcomes.
Keeps us in the right equilibrium.

Investment Bank and Adverse Selection

But there are other issues that banks do, problems they solve. One of them is
an Adverse Selection Problem that plagues securities. I didn't mention the
alternative to banks, for raising money if you're a business, is that you could
issue bonds or commercial paper. You can borrow money directly from the
public without an intermediary. Okay?
Adverse Selection: I'm a company they do this...I'm a company. I need money
to, say, build a new factory.I go not to a commercial bank; I go to an investment
bank. And they help me issue some paper to the public and we sell it off in
some market. The problem with issuing that directly to the public is that the
public can't judge the quality of the company easily, right? Most people are
not who are investors (Most people) are not good at estimating the value of the

security of a company. So they need some kind of experts. If the Adverse

Selection would happen, see the experts, the people who know, would buy all
the good stuff and it would leave beyond, people would start to think I'm not
going to buy these securities, because why are they being offered to me? I
don't know anything; I'm a sucker, that's the idea...Not a sucker, I just don't
know, I may be smart, but I just don't know what the quality of this company is.
So, I'm, if I just go in there blindly and pick up whatever seems to be out there,
I'm going to suffer an adverse selection. I'm going to get the worst stuff
because I'm not looking. I can't look. They're going to dump the bad paper on
me. The banks solve that by being in the community, knowing who is
borrowing, and guaranand having a reputation so that instead of you
suffering this adverse selection problem, the bank has people who know what's
going on.
Moral Hazard: So the thing about banks is they have local loan officers, who
serve in a particular community, and they know all about that community and
they solve the adverse selection problem. The moral hazard problem that
banks solve The moral hazard is that a company may borrow money and
then take a big flyer and do some wild investment.
Let's, let's think this for example. Suppose we own a small company and it's
not doing well. We, I have this great idea. Let's borrow, you know ten million
dollars and let's go to the race track and let's put it all on the least likely horse
to win, alright? And, you know, but our chance of winning is only one of ten,
one of ten. But if we win, I got $100 million. Okay, if we lose, then hey, we just
go bankrupt. We say sorry. Of course, you really couldn't do it at the race
track. I mean, you'd be sued if you did that. But you see what I'm saying. I
would, I could see I wouldn't do that but I could see wanting to do that.
Right?
Your company's going out of business anyway; you know you don't have any
prospects. But we, if we can borrow $10 million, go and bet it on the
racetrack, and one in ten will be super rich. We'll have 90 million, right, pay off
the debtors everything's fine. They won't complain if you win, they'll complain
if you lose but then you say sorry, you know, we're out ofbusiness so, it's
limited liability. So, what banks do is they help solve this problem by constant
monitoring and they make commercial loans, they're effectively long term. But
in practice in officially short term, they keep renewing them. And they can cut
you off when they think you're doing something that reflects moral hazard.
So the constant monitoring that banks provide solves the moral hazard
problem just as their information collection solves the adverse selection
problem.