Are banks special and if yes, why so?

I. Bank’s crucial role in the payments systems

As financial intermediaries, banks not only serve as a major source of capital for a large number of borrowers, but they also operate and manage the systems for making possible the payments of such funds as well as other payments to and from borrowers.⁹³⁴ Were these systems to suffer interruption or collapse, the consequences would be serious not only for the banking system, but also for the real economy, which relies on capital supply by banks and on a frictionless transfer of payments to meet its financial obligations.

II. Banks are prone to runs and contagion problems

Banks are reputational intermediaries that rely substantially on the confidence of the markets and of their customers for the frictionless performance of their functions and operations.

Moreover, ensuring the confidence of the markets and of their customers is for banks a matter of existence. The high-sensitivity to the volatility in confidence is to be traced back to the problem of information asymmetries that banks are subject to. As already briefly mentioned above, the role as well as the existence of banks can be explained under the assumption of information asymmetries and imperfect markets.⁹³⁵ Although banks as financial intermediaries contribute in reducing informational asymmetries between the providers and the users of capital, banks could face difficulties to transmit credible information to the markets or its customers when such transmission of information would be essential for its existence. Thus information asymmetries arise between the bank on one side and the markets and depositors on the other, which when not adequately and timely addressed could threaten the existence of banks. More specifically, it is suggested that bank’s balance sheets are notoriously opaque and the quality of their assets, mainly loans, is not readily observable or measurable.⁹³⁶ A typical feature of financial contracts is that the exchange of performances between the contractual parties does not take place simultaneously.⁹³⁷ Financial contracts offered by banks have the same feature.

Namely, banks offer near-certainty full-money deposits on the basis of assets with uncertain value⁹³⁸ because the repayment of loans is not guaranteed. The future performance of these contracts is unsure and entails risks that banks need to assess. However even banks themselves

934 Goodhart et al., Financial regulation, p. 11.

935 See Fischel/Rosenfield/Stillman, Virginia Law Review, 1987, 301. See also Goodhart et al., Financial regulation, and Hartmann-Wendels et al., Bankbetriebslehre.

936 Morgan, American Economic Review, 2002, 874, p. 881. See also Mülbert, European Corporate Governance Institute Working Paper Series in Law, 2010, 1, p. 11.

937 Hartmann-Wendels et al., Bankbetriebslehre, p. 98.

938 Goodhart et al., Financial regulation, p. 11.

find this assessment sometimes very difficult.⁹³⁹ This “black-box” nature of banks makes them susceptible to losses in cases of confidence fluctuations.⁹⁴⁰ As a result banks suffer runs, which due to contagion fears could spread to other banks as well. Depositors, rational or irrational, demonstrate in these situations herd behaviour, irrelevant whether the failure of a bank is real or only perceived. The contagion problem is exacerbated further due to the interconnectedness of banks in a financial system through inter-bank loans and the payment system.⁹⁴¹ Thus, it becomes clear that the failure of one bank could wreak havoc in the whole financial system and cause systemic failure, and risks spilling over into other markets as well.

III. The nature of bank contracts

The nature of bank contracts is such that the repayment of the deposits by banks, in the time and amount demanded by the depositor, does not depend from the performance of the bank and the value of its assets.⁹⁴² Apart from the one feature of financial contracts referred to above, namely that the performances of contractual parties do not occur simultaneously, a second feature of financial contracts is that the repayment of loans by the users of capital is influenced by a number of factors the characteristics of which are not wholly known to the providers of capital.⁹⁴³ Hence, the value of bank assets is uncertain. Coupled with problems of information asymmetries already explained earlier, banks will face difficulties to dispose of assets, where the customer-specific information is difficult to evaluate. As a result, even solvent banks from a balance-sheet perspective, could run into difficulties and may be forced to sell assets at a loss.⁹⁴⁴ Fire-sale of bank assets could bring about not only the insolvency of an otherwise solvent bank, but also depress assets prices in general, thus causing major losses not only to financial institutions but also to individuals.⁹⁴⁵

939 Mülbert, European Corporate Governance Institute Working Paper Series in Law, 2010, 1, p. 11.

940 Morgan, American Economic Review, 2002, 874, p. 874.

941 Diamond/Dybvig, Journal of Political Economy, 1983, 401, p. 401.

942 Goodhart et al., Financial regulation, p. 11.

943 Hartmann-Wendels et al., Bankbetriebslehre, p. 99.

944 Goodhart et al., Financial regulation, p. 11.

945 E.g. when bank fire-sales immovable properties used as collateral in mortgage loans, a general fall in asset values will result, and individuals who have borrowed using their immovable property as collateral will suffer losses in the form of higher costs for serving the loans. Such was for example the case in the US during the last financial crisis, where the housing market was suddenly saturated with houses which banks had repossessed from borrowers who could not repay their loans.

IV. Banks are subject to moral hazard problems

It was earlier explained that banks are subject to contagion risks and bank runs, which can cause banks to collapse and in worst cases could also lead to the collapse of the whole financial system.

To prevent this kind of collapses with devastating consequences for the depositors, safety nets⁹⁴⁶ are put in place by the state or by the banks themselves that insure that repayment of deposits.

However, these safety nets are not without costs. They create moral hazards for banks as well as for the depositors. For banks, because their participation in the safety nets is in the form of deposit insurance schemes through fixed premia which does not reflect the risk level of their banking operations. For depositors, the moral hazard comes in the form of lower incentives to monitor the bank. When depositors obtain full insurance for their deposits, they have none or little incentives to monitor the behaviour of the bank, and eventually to take measures to discipline the bank when it behaves opportunistically.

Additional moral hazards are created because of the wrong expectations regarding the health of a bank that is supervised through a public regulatory body. Thus, when a bank is established and adopts the regulatory rules regarding its operations, there is an understanding both on the side of the banks and the bank’s creditors that from that moment on the monitoring of the bank’s activities is done by the regulatory body. One talks of an implicit contract, between the regulatory authority and the provider of the financial services, the bank in our case.⁹⁴⁷ The expectation is thus created that as long as the bank is authorised and supervised by the regulatory authorities, the bank is safe. Therefore, the consumers of the financial services provided by the banks do not need to exert care to monitor the behaviour of the bank. Implicit contracts create moral hazard problems also for banks. Thus, when banks perform their operations by simply adhering to the regulatory requirements established by a regulatory body, the danger exists that banks will adopt a box-ticking rather than a prudent approach to the carrying out of their business. A box-ticking approach would result in a mechanical adherence to the rules and create the impression that as long as the single rules are adhered, the institution is safe. This kind of approach would reduce the incentive of banks for a more proactive attitude towards banking regulation and would create a false sense of security in bank’s solvency. This risk, when coupled with implicit “too-big-to-fail” guarantees, creates even bigger moral hazard problems typically for large and systemically important banks. The expectation that public funds will come at the rescue of failing systemically important banks, because as the term denotes, the fall of such a bank would endanger the stability

946 E.g. deposit insurance schemes.

947 Goodhart et al., Financial regulation, p. 15.

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.