Fundamentals Fundamentals of Bankingof Banking

ECO 473 - Money & BankingDr. D. Foster

Rothbard on banking typesRothbard on banking types

Asymmetric Information Asymmetric Information & Banking& Banking

Rothbard – Loan BankingRothbard – Loan Banking

Banks as intermediaries for lendingBanks as intermediaries for lending•Funds come from investors (savers).Funds come from investors (savers).

Counts as bank “equity.”Rothbard Bank example…

•MS is unaffected by bank’s actions/activities.MS is unaffected by bank’s actions/activities.The funds will always end up in someone’s pocket!They cannot be inflationary!

•Can expand by selling bonds and CDs.Can expand by selling bonds and CDs.Borrowed funds.

•Ex: venture Kists, invest. bank, finance co. …Ex: venture Kists, invest. bank, finance co. …

Rothbard – Deposit BankingRothbard – Deposit Banking

Banks as warehousesBanks as warehouses•Convenient & safe place to store gold.Convenient & safe place to store gold.

Ownership receipts issued.Receipts are redeemable “on demand.”Receipts start getting traded for one another.Stored gold is a “bailment” not a loan.Historically – goldsmiths.

•Problem – nobody ever has to pick up the gold!Problem – nobody ever has to pick up the gold!Unlike grain, the gold doesn’t get consumed.Goldsmiths can print receipts and start lending!!

Rothbard –Rothbard –Fractional Reserve BankingFractional Reserve Banking

Modern banks serve both functionsModern banks serve both functions•Collect deposits & issue loans.Collect deposits & issue loans.

Courts have ruled deposits as bank debt.Deposits are owned by the bank! If 100% reserves, then no effect on MS.

•With fractional reserves come trouble ...With fractional reserves come trouble ...Create money = inflation.Banks are always “insolvent.” [Not bankrupt.]Contraction of credit = recession/depression.

•Bank notes gave way to Demand Deposits.Bank notes gave way to Demand Deposits.

Direct & Indirect FinanceDirect & Indirect Finance

Most external financing is done through intermediaries.

Banks Reduce Transaction CostsBanks Reduce Transaction Costs

• Banks reduce the cost of acquiring assets.

• Many costs are fixed.

• Bank assets are highly liquid.

• Economies of scale.e.g., using standard loan contracts as legal fees are

averaged over many loans

• Transactions costs are very low for lines of credit.

Adverse SelectionAdverse Selection

• Those most eager to make a deal are the least desirable to the other party.Bad risks want loans.Firms with lots of risk want to sell bonds.

• Risk drives up interest rate & drives out low risk borrowers, if this problem persists.

Moral HazardMoral Hazard

• Post-contractual change in behavior that puts other party at increased risk.Will borrower really be prudent and repay?Will company really be prudent and max. profits?Does insurance reduce vigilance?

• Markets cannot form if this persists.

Principal-Agent ProblemsPrincipal-Agent Problems

• The action of the agent is contrary to the desires of the principal.Workers shirk at their jobs.Managers are also agents - they work for owners-

shareholders.Can bond-holders and stock-holders really monitor

the firm?

• Problems: Enron, Arthur Anderson

How do Banks Deal with Asymmetries?How do Banks Deal with Asymmetries?

• Screen borrowers.Avoids free rider problems with information.

• Requirements for collateral and net worth.Shifts risk to the borrower; avoids adverse selection.Also, mitigates moral hazard.

• Imposing covenants and monitoring.Reduces moral hazard.

• Variable interest rates and credit rationing.Some tolerance for risk.

Should the government get involved with asymmetries?

Investment Banks & AsymmetriesInvestment Banks & Asymmetries

• They provide research on firms.• They underwrite new securities.

• Advantages:They work to show firms are not lemons.Long-run reputation at stake.

• Disadvantages:Are they serving the firm or the buyer?

Fundamentals Fundamentals of Bankingof Banking

ECO 473 - Money & BankingDr. D. Foster

Rothbard on banking typesRothbard on banking types

Asymmetric Information Asymmetric Information & Banking& Banking