Critical Issues in the

Politics of Global Finance

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WEEK 3
TH E P R O B L EM WI TH B A N KS
 Introduction
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1. As you know, I have been researching and writing about

the institutions in the securities markets for many years.
2. For me, these capital markets were the focus of finance
and banks were very much secondary considerations.
3. The problem with banks stems from the obsolescence of
banks and their struggle to avoid this, plus inherent
challenges in banking that have existed since the start of
banking.
4. My comments focus on what you might call traditional
commercial banks, rather than the shadow banking
system, although clearly the two are merging.
 Outline
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1. Introduction
2. Tutor Comments
3. Seminar Questions
4. Exercise
5. Main Points and Next Time
 Tutor Comments 1
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1. The first thing to understand about banks as we know them is that

they engage in fractional reserve banking. Banks keep a small
portion of deposits on hand in cash and lend out the rest.
2. Banks are motivated to engage in fractional reserve banking because
deposits are actually liabilities on their balance sheets and they
must create revenue through lending.
3. But this situation generates a contradiction between short-term
deposits and longer-term debts. A run on the bank can clear out the
small amount of cash on hand quickly. The challenge of balancing
the short and long term aspects of a bank balance sheet is called
maturity transformation.
4. Notice that a feature of post-2007 financial stability policy has been
to increase the proportion of funds banks keep in reserve. This may
help with the maturity transformation problem. It will, however,
reduce the earnings of banks, other things being equal.
5. Whether reserves are helpful in the context of a future great freeze
is an interesting question.
 Tutor Comments 2
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1. In addition to this inherent problem, banks have been subject to

pressure from alternative sources for borrowing, typically via the
capital markets. Deposits too have gone elsewhere to a degree, to
money market accounts in the US for example.
2. This process started in the US, then to Europe, and then on to Asia,
gathering pace after the Asian financial crisis.
3. At the core of this process is the observation that bank
intermediation (of maturity transformation) is expensive. You
have to pay for the bank infrastructure and the cost of bad loans.
This raises the cost of capital, making capital markets more
attractive.
4. The big, creditworthy borrowers typically exit bank borrowing for
good, appreciably worsening bank balance sheets. The sign of a
declining corporate in the US is the need to borrow money from
banks. GM did this toward the end of its pre-bankruptcy existence.
 Tutor Comments 3
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1. In conjunction with regulatory change, such as the

Gramm-Leach-Bliley Act of 1999, which repealed the
Banking Act of 1933 separation of investment and
commercial banking, the disintermediation process I
have described, in the context of low interest rates and a
search for yield, has radically changed banks.
2. While we still call Citibank a bank, in many ways
institutions like this are searching for income in almost
any way other than via traditional commercial lending
to corporations (corporate finance).
3. This is the case because there is comparatively little
money to be made in corporate finance and many risks
to the bank balance sheets from default.
 Tutor Comments 4
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1. Disintermediation has transformed banks from being

stable, stolid institutions into players in the casino. Their
identity has been transformed as they have sought a new
business model. We still call them banks, but they are
unlike the banks of the past.
2. It is the hunt for a profitable business model that has led
banks to pursue aggressive financial innovation. It is this
search that is behind the derivatives trading associated
with the subprime crisis and the volatility of banking.
3. Banks may be obsolete as we have known them, but they
have zealously pursued their interests nevertheless as
they want to survive.
 Seminar Questions
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1. What are the main challenges in

banking?
2. How have banks changed in recent
years?
3. Do banks have a future?
 Exercise
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1. You have been asked to prepare a paper for

the finance minister on why banks seem to
be such a problem for government.
2. You need to identify the core challenges
experienced by banks in their environment.
3. Also make one or two points on the
motivations of governments in dealing with
banks. Can anything be done about these
institutions?
 Main Points and Next Time
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Next time we consider the challenge

of credit rating agencies.