Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

What are banks for?

Much has been written since the Global Financial Crisis about how modern banking system has become less and less about financing productive investments and more and more about shuffling pieces of paper in speculative trading. Last month, Jordà, Schularick and Taylor wrote an NBER Working Paper “The Great Mortgaging: Housing Finance, Crises, and Business Cycles” describing an even more fundamental change in banking during the 20th century. They construct a database of bank credit in advanced economies from 1870 to 2011 and document “an explosion of mortgage lending to households in the last quarter of the 20th century”. They conclude that:

To a large extent the core business model of banks in advanced economies today resembles that of real estate funds: banks are borrowing (short) from the public and capital markets to invest (long) into assets linked to real estate.

Of course, it can be argued that mortgage lending is an economically useful activity to the extent that it allows people early in their career to buy houses. But it is also possible that much of this lending only boosts house prices and does not improve the affordability of houses to any significant extent.

The more important question is why banks have become less important in lending to businesses. One possible answer that in this traditional function, they have been disintermediated by capital markets. On the mortgages side, however, perhaps, banks are dominant only because they with their Too-Big-To-Fail (TBTF) subsidies can afford to take the tail risks that capital markets refuse to take.

I think the Jordà, Schularick and Taylor paper raises the fundamental question of whether advanced economies need banks at all. If regulators impose the kind of massive capital requirements that Admati and her coauthors have been advocating, and banks were forced to contract, capital markets might well step in to fill the void in the advanced economies. The situation might well be different in emerging economies.

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