The Bankwatch

Tracking the consumer evolution of financial services

The essence of banking | Howard Davies – LSE

Sir Howard Davies, director of the London School of Economics sums up banking perfectly.

New banking rules; tread carefully

Banks engage in maturity transformation, turning sight deposits [which can be immediately withdrawn without penalty] into long-term loans. This confidence trick depends on just that – confidence. Depositors must believe their money is safe, even if they are dimly aware that if they all wanted to take it out the cash would not be there.

The impossibility of creating this illusion is managed through the interbank money market.  Everything is fine so long as people continue to place their hard earned cash, and not ask for it all back at the same time:  banking 101.

He goes on to note the basics of why this illusion works:

  1. depositor protection offerred by the Government
  2. Government regulation on the level of capital Banks must hold
  3. Central bank ‘lender of last resort’ whereby the Central Bank will loan banks money against certain collateral, ie, the loans that Banks have made.

He goes on to call into question the degree to which those rules can be strengthened, making the point that there is nothing for nothing.  Increased capital requirments for example mean higher borrowing costs for retail customers.  Higher deposit protection means retail consumers will favour bank deposits over other investments, such as equities.  Finally, increased access to lender of last resort is a snowball effect that just increases banks’ reliance on central government;  can that be a good thing?  Why not nationalise banks?

Thought provoking piece.

Written by Colin Henderson

October 5, 2008 at 17:39

Posted in Banking Strategy, Business Models

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