The banking industry that Milton Friedman seemed to hope for will likely become a reality.
The banking industry that Milton Friedman seemed to hope for will likely become a reality.
B anks do two things that are, at times, inconsistent: They serve as depositary institutions, which provide cash on demand to their customers, and they lend money to homeowners, businesses, and others. These two functions, when combined, are inherently risky. As depositary institutions, banks have no control over the retention of funds. These funds are lent, but almost never on an overnight basis. This problem is called “duration” risk, or a mismatch between the maturity of the source of funds and the maturity of the use of funds. This works until it doesn’t. Usually, what is known as a bank run puts this arrangement to a bad end.
For the past century and a half, depositary institutions, if we include savings and loan institutions and similar deposit institutions, have suffered a crisis almost every decade. Inevitably, there are bailouts and heightened interest in increased government regulation, but nothing seems to bring this process to an end. Sometimes bad credits lead to the crisis; sometimes mismatched maturities lead to a crisis. Sometimes they both do. Usually, severe damage is done to the real economy when financial institutions get into trouble. Between bailouts, real economic damage, and loss of confidence in the capital markets generally, a very high price is paid for having depositary institutions use their deposits as a source to lend funds to their other customers.
Milton Friedman once argued that bank reserve requirements should be 100 percent. I always thought this would probably be the end of banks and so did not give the idea much thought. But now, many years later and many crises later, I see Friedman’s point. As depositary institutions, banks should function as mere custodians of funds and not place depositors’ cash assets at risk. Would this be the end of banking? Not necessarily.
Lending institutions should probably be capitalized like most other businesses. If the auto industry raised all of its capital by lending out overnight deposits, it would not last long as an industry. Why should the lending business be any different? Companies will emerge, and some already have, that are “specialty lenders.” They don’t rely on overnight deposits to fund their lending activities — they rely instead upon common stock and bonds, sold to the public, sometimes packaging these loans, or they depend on large institutions in the hedge-fund and private-equity markets. In any event, the “shadow banking” world does not depend upon an overnight source of funding.
Eventually, banking will go the route suggested in the previous paragraph. As regulators continue to get more and more obtrusive in commercial banking, the banks will lose any competitive advantage that they once had in the lending market and will be gradually replaced, as they have already begun to be, by more-permanent sources of capital that provide loans to the economy. These more permanent sources will not be burdened by the onerous regulatory apparatus of the world’s various bank-regulation regimes. Banks will have no hope of competing with well-funded lending institutions. Sooner or later, the banking industry that Friedman seemed to hope for will likely become a reality, and deposit-institution crises will become things of the past.