Banks as critical factors for the stability of the financial system

of the financial system, creates negative incentives for opportunistic behaviour by banks.⁹⁴⁸ Larger banks, believing in their own invulnerability will expand their risky activities whereas medium-size banks will increase their risky activities and their balance sheets in order to join the club of ‘specially treated banks’. The principle of limited liability serves only to exacerbate this problem. The result could be a more fragile financial system prone to systemic crises.

In a definition of systemic risk by the Group of Ten Report, the adverse real economic effects from systemic risks⁹⁵³ were considered as arising from disruptions to the payments systems, to credit flows, and from the destruction of asset values. ⁹⁵⁴ All these three adverse effects are strongly related to the well-performance and stability of banks, the occurrence of which could bring about serious repercussions for the stability of the financial system.

II. Financial system stability as a public good

Although discussions about collective or public goods do not usually refer to the financial sector,⁹⁵⁵ arguments about the positive and negative externalities of the stability or instability of financial institutions on the public interest form the basis for a special regulation of these institutions. Problems that are characteristic of financial institutions, such information asymmetries and moral hazard pose serious dangers to banks because they way how these problems are handled has repercussions for the rest of the system.⁹⁵⁶ According to a simple case scenario, the insolvency of a bank could cause the insolvency of other banks due to domino and confidence effects. Bank runs and bank panic considerations, as well as breach of confidence between market players could result in a breakdown of financial intermediation, the direct effects of which would be felt also in the real economy in the form of less capital for investment and job creation.⁹⁵⁷ The current financial crisis that started to materialise in the early 2008 is a point in case as it showed how financial instability exacerbated due to confidence concerns spilled over into the real economy because of the credit crunch that resulted when banks stopped lending not only to each other but also to the corporate as well as other type of borrowers. In this respect, financial stability as a collective good is not a particular good or service that is sold and bought, but is rather a system, where banks are a particular part of it.

1. Defining public goods

As an extreme form of positive externality, a public good has two distinctive characteristics: (1) non-excludable in supply; and (2) non-rival in consumption.⁹⁵⁸ The first characteristic, non-excludable in supply implies that the producer of the good cannot exclude anyone from

953 Understand financial system instability.

954 Group of Ten, Report on consolidation in the financial sector, 2001, p.126.

955 They do usually refer to e.g. national defence, maintenance of social law and order, redistribution of resources to achieve social justice, etc. See Schinasi, Financial stability, p. 51.

956 Patra, Economic and Political Weekly, 2003, 2271, p. 2273.

957 Crockett, Journal of Banking and Finance, 2002, 977, p. 979.

958 Schinasi, Financial stability, p. 50.

benefiting from the consumption of the good.⁹⁵⁹ This is so because the producer cannot control who is benefiting, as such control would be either impossible or prohibitively costly. The second characteristic, non-rival in consumption means that the consumption of the good by one person does not affect the benefits in consuming the same good by others. Thus, the same good is provided to an additional consumer at zero costs.⁹⁶⁰ With these considerations in mind, financial stability is a public good. When the financial system is stable, the supply of benefits from stability is non-rival in that it is irrelevant how many persons profit from its consumption. The stability of the system does not depend on how many persons make use of it, but rather whether the elements that make up the system function appropriately. Moreover, no one can be excluded from accessing the benefits resulting from financial stability. As a public good, financial stability impacts not only the financial system but also the real economy. Therefore, no one can be excluded from enjoying the benefits of a stable and efficient economy.⁹⁶¹

Further, not only the provision but also the maintenance of financial stability is a public good. It was mentioned earlier that financial systems are prone to confidence and domino effects. The costs, both public and private, from an instable or collapsed financial system are higher than the costs for ensuring its stability. Therefore it is in the interest of everybody that stability is maintained. However, a distinctive characteristic of public goods is free riding. Everyone agrees that financial stability is a public good, but due to high private costs included in providing systemic stability, everyone expects that someone else will take care of that. Hence, everyone wants to enjoy it, but no one wants to pay for it. The actions that individuals take, reflect their own personal interests, although these actions have direct or indirect repercussions on the whole system. However, even when financial stability is provided by one particular individual, due to free riding, all individuals will reap the benefits from it without diminishing the value of it.

2. Banks as providers of public goods

Finance is about uncertainty and risk, because it is based upon a not-so-stable foundation, such as human trust. The stability of the financial system is therefore strongly dependent on the confidence of the participants in the well performance of the system. One of the most important participants of the financial system, banks, is itself subject to confidence effects. Serving as an intermediary between capital savers and capital users, they rely on the trust of their depositors

959 Ibid., p. 50.

960 Ibid., p. 50 961 Ibid., p. 58.

to enable them to perform their functions adequately, ensuring in this way a stable banking system, and consequently a stable financial system.

Further, banks rely also on the promise of its borrowers to meet their repayment obligations when they fall due. However, a promise is never a sure thing, and it can be broken. A broken promise means risks for banks. Therefore, banks have developed ways to identify, quantify and transform such risks in order to efficiently spread them so that they will not endanger their existence. Although, these mechanisms for identifying, quantifying and transforming these risks are not and cannot be perfect, they play an important role in mitigating the information asymmetries between capital savers and capital users, and thus enable the use of free capital for economic beneficial projects. When banks are able to identify, quantify and transform risks adequately they contribute to the stability of the system; they become a source of financial stability. If financial stability is a public good, then banks are providers of public goods.

The reverse is true when banks fail to perform adequately those functions. Failure to adequately identify and price risk, as well as failure to carefully monitor the performance of capital users in meeting their repayment obligations can have negative repercussions not only for the bank alone, but as it was argued above, also for the whole financial system and beyond. Thus, banks could become also a source of instability. Therefore, one could say that the performance of banks with respect to the stability of the financial system could be a “maker or breaker” for the system. It is for this reason that banks, as significant participants of the financial system, are delegated the important role of ensuring financial stability.

§ 7 Banks’ incentives as financial intermediaries to monitor borrowers

In the previous chapter it was explained that banks are financial intermediaries who typically serve as middlemen between the capital savers and the capital users. Through debts contracts which, they issue to investors when they borrow capital (in the form of bank deposits) and the debt contracts they are issued by a diversified category of borrowers that they fund through bank loans, banks perform a number of transformation functions.⁹⁶² These transformation functions allow for an efficient resource allocation in the economy. Further it was also mentioned that banks dedicate their existence to information asymmetries and market imperfectness. More specifically, financial intermediation by banks is justified on the basis that banks are in a position to reduce information asymmetries between investors and borrowers, and are able to produce information needed for entering a debt contract as well as for monitoring it at a lower cost than it would be the case if the investor contracted directly with the borrower. This is also the core of the financial intermediation theory as developed by Diamond⁹⁶³. Diamond suggests that financial intermediaries, such as banks, have an advantage in performing monitoring at a lower cost because of their ability to collect borrower-related information in a cost-effective way.⁹⁶⁴ Banks become in this way “delegated monitors” on behalf of the investors. The purpose of this chapter is to investigate more specifically the reasons why banks may make better monitors. The results of the investigation will be used later when looking at the role of banks as gatekeepers in general, and as gatekeepers in the financial system in particular.