FRBSF Economic Letter
2001-37; December 21, 2001
Financial Modernization and Banking Theories
Financial innovation has greatly changed the business of banking. Instead
of just accepting deposits and making loans the old-fashioned way, banks
nowadays are increasingly active in lending without putting loans on their
balance sheets, through either securitization of their asset portfolio
or outright loan sales. Banks also are shifting from interest-based revenues
towards fee-based activities, including lines of credit and many types
of credit guarantees. The 1999 Gramm-Leach-Bliley Financial Modernization
Act further legalizes the integration among commercial banks, securities
firms, and insurance companies under the financial holding company (FHC)
organizational structure, allowing banks to diversify into other nonbank
activities. So far (as of 12/7/01), 591 financial organizations have elected
to become FHCs, though only a few firms are active in the full spectrum
of financial services.
While it is difficult to predict how the financial services sector in
general, and the banking industry in particular, will evolve over time,
financial regulators and policymakers are keenly interested in the course
of financial modernization. As we look to the future of the financial
services industry, it may be useful to revisit the roots of banking. Banking
theories provide us with insights into why banks exist in the economy.
If these theories are correct, banks exist because they perform certain
special functions that no other financial services firms can replicate.
Thus, no matter what course financial modernization takes in the future,
we can count on certain defining characteristics in banking to be preserved.
This Economic Letter looks at financial modernization through the
lens of existing banking theories. First, I review some well-known banking
theories in the finance literature. Then, I discuss the implications of
these theories for financial innovation and financial integration.
What's different about banks?
Economists have been asking the question "what's different about
banks" for ages. In his famous article, Corrigan (1982) argued that
banks are special because: (1) they provide transaction services and administer
the nation's payments system; (2) they provide backup liquidity to the
economy; and (3) they are transmitters of monetary policy. Due to their
special function in the economy, the government set up a safety net to
protect the banking system, in the forms of deposit insurance and access
to the Fed's discount window borrowing. Based on this argument, what makes
banks special spans both the asset side and the liability side of the
bank's balance sheet: banks make loans in the course of providing liquidity,
and they accept demand deposits in providing transaction services. Since
only commercial banks have the unrestricted power to make commercial loans
and accept demand deposits, it is their banking power that defines banks'
specialness. Thus, banks are special not because of the government safety
net, but, rather, the safety net is in place because banks perform special
functions in the economy.
One can go deeper into the specialness of banks and ask a more fundamental
question: Why do banks make loans and provide deposit services? For decades,
banking researchers have studied the question of why banks exist and have
made considerable progress in developing banking theories to explain banks'
central role in the economy. Although many of us may take the existence
of banks for granted, in a "perfect" world, where savers can
channel their surplus funds to borrowers without friction, financial intermediaries
like banks are not needed. As a corollary, banks' existence must be motivated
by certain economic frictions, so that banks, as financial intermediaries,
can provide some "value added" from transferring funds from
savers to borrowers and providing liquidity.
An important value added provided by banks, according to several theories,
is dealing with the information problems in lending and the incentive
problems caused by the moral hazard behavior of borrowers. Because a lender
must evaluate a borrower's creditworthiness, banks' investments in information
technology allow them to achieve scale economies in information production,
making them more efficient information producers than individual investors.
Delegating the loan monitoring function to banks avoids the redundancy
of monitoring by numerous individual depositors. Banks are credible monitors
because their returns are more predictable due to the diversification
effect of making a large number of loans (Diamond 1984). With credibility,
banks can gather deposits at relatively low cost.
While information production represents a key function performed by banks,
banks by no means have monopoly access to information production technology.
Other nonbank lenders, such as finance companies, also engage in information
production and loan monitoring. Moreover, nonbank lenders could enjoy
certain advantages over banks because they are not subject to banking
regulations. However, empirical evidence suggests that there is something
"special" about bank loans. Specifically, research has found
that bank loan approvals represent positive economic signals that can
lift the borrowing firms' stock prices, while loan approval by nonbank
lenders does not have the same economic effect (for example, see James
Since loan making by itself does not seem to make banks special, banking
theorists also have focused on the role of liquidity provision in conjunction
with loan making to explain the unique economic function performed by
banks. Calomiris and Kahn (1991), Flannery (1994), and Diamond and Rajan
(2001) showed that the fragile capital structure in banks and, hence,
their vulnerability to deposit runs serve important economic functions.
Deposit runs represent a powerful disciplining device that limits banks'
incentives for risk-taking and misallocation of resources. This provides
some degree of quality assurance in banks' loan portfolios. Because nonbank
lenders that cannot issue demand deposits do not have the "benefits"
of a fragile capital structure, they are less credible in their loan portfolio
quality commitment. This may explain why a loan approval by nonbank lenders
does not carry the same "good news" weight as does a loan approval
Implications for financial modernization
If the roots of banking are in loan making and liquidity provision, how
will financial innovations and financial integration shape banking's future?
Regarding financial innovations, the most noticeable trend in the loan
making process is the movement towards securitization and fee-based activities.
Securitization means packaging bank loans into securities for resale,
which permits banks to move those loans off their balance sheets. According
to theory, good securitization candidates are less information-intensive
assets, such as mortgages and credit card receivables, but not the more
information-intensive assets, which include most business loans. Thus,
this self-selection of loans for securitization leaves the bank's balance
sheet with a high concentration of information-intensive loans. This may
make the bank less flexible in dealing with liquidity shocks. Because
the fragile capital structure calls for banks to invest in relatively
low-risk assets that can be liquidated to meet depositors' withdrawal
demand, this implies that there is a limit to how extensively securitized
assets can be shifted outside of the banking system.
The same is true for fee-based activities, where banks do not make loans
but provide credit lines, credit enhancements, or credit guarantees. Banks
can provide these fee-based services because of their credibility, which
stems from their commitment to low-risk assets as dictated by their fragile
capital structure. Although banks can leverage their reputation capital,
they can do so only up to a limit. To stay credible, banks need a core
of low-risk assets on their books that are funded by demand deposits,
and the scale of these core activities must be proportional to the overall
Regarding financial integration, the driver seems to be linking activities
in which banks can share expertise and operating systems, as well as the
potential for providing one-stop-shopping for financial services to individual
customers. Consider first securities underwriting. Both securities underwriting
and loan making involve pricing financial assets. In loan making, a bank
underwrites a loan and then funds it by putting it on its book. In securities
underwriting, a bank underwrites a security but quickly turns around and
resells it to the public. Securities underwriting involves information
production, an expertise that banks already have in making loans. Further,
information produced during credit underwriting is potentially reusable
for securities underwriting. Thus, banks already have the know-how and
infrastructure to engage in securities activities and would seem likely
to realize a degree of scope economies by engaging in these activities.
On the other hand, securities firms that diversify into commercial banking
also must engage in deposit-taking and payments service activities, which
are integral to banking but have very little overlap with their existing
dealing and underwriting activities. Except for securities brokerage firms,
which already have established retail networks that can be readily used
for gathering deposits, the required investment in retail deposit taking
can be quite substantial. This may be one factor explaining why, so far,
we observe relatively more financial integration originating from the
banking side, especially those with a strong retail franchise, than from
the securities side.
Next consider insurance. Its commonality with banking appears to be limited,
because the two businesses are fundamentally different. Still, both share
expertise in credit management and loan monitoring, whether it is a bank's
loan portfolio or an insurance company's investment portfolio. In addition,
both insurance products and banking services are retail activities targeted
towards individual consumers. Thus, the ability to engage in cross-marketing
seems to be an important force behind the integration of insurance and
For both securities and insurance activities, the direction of integration
is complicated by the government safety net and the regulation and supervision
under which banks operate due to their special role in the economy. Banks,
which already bear the cost of banking regulation and supervision, may
not face appreciably more regulatory burden as the result of becoming
an FHC and diversifying into nonbank activities. In contrast, nonbanks
entering commercial banking must subject the entire organization to umbrella
supervision by a banking regulator. The regulatory burden of being an
FHC may deter nonbanks from integrating with banks. This also may explain
why a number of nonbank financial institutions have decided to enter banking
through the so-called nonbank-bank or thrift options, rather than through
integrating with a full-fledged commercial bank.
An objective way of looking into the future of the financial services
industry is to appeal to banking theories. As the intermediary channeling
funds from savers to borrowers, banks engage in information production
when making loans and commit themselves not to take excessive risks by
having a fragile capital structure consisting of demand deposits. Thus,
regardless of how financial modernization progresses, these core activities
that define banks are expected to be preserved, suggesting that there
may be a limit to the transformation of banks' balance sheets through
financial innovations. Furthermore, to the extent that certain characteristics
are unique to banks, such as gathering demand deposits in the course of
providing payments services, banks may have some comparative advantage
in financial integration over securities firms or insurance companies.
This may be further accentuated by the disparity in supervision and regulation
between banking organizations and nonbank financial firms.