24 Oct 2018

“We Need More Trust”

SAFE Policy Lecture: Anjan V. Thakor talks about the purpose of banks and their impact on stable financial markets

Why do banks exist, and what are their functions for modern societies? At a SAFE Policy Lecture on 18 October, Anjan V. Thakor from Olin Business School, Washington University in St. Louis, spoke about the role banks play for society and about the implications for financial stability and banking regulation.

For Thakor, banks are an “essential part of society” with a higher purpose. For him, this higher purpose is a reflection of higher intent. “It is the most meaningful thing - beyond economic transactions and outcomes - that an organization has to give”, Thakor said. Often the importance of banks is underestimated: “We focus a lot on financial markets, but we can´t have well-functioning financial markets without banks”, Thakor said. This importance leads to a great responsibility for banks. According to him, the financial industry and especially banks have earned a bad reputation in the last years. This is mostly because of the experience of the financial crisis, Thakor said. He pointed out that today, 35 percent of Americans would favor socialism. “I find this scary”, Thakor said.

He identified three core functions of banks: First, he stressed the importance of funding liquidity creation, allowing economy to invest more. He pointed out that banks create funding liquidity only when they use deposits to make loans, not merely when they take in deposits. “That is why banks must perform both deposit-taking and account-keeping on the one side and lending functions on the other”, Thakor explained. Second, banks provide safekeeping for valuables and develop trust, and third, as they process different information, they reduce contracting and verification costs.

These functions of banks are connected to banking risks and financial crises. “Every crisis is different. But all crises have two things in common: some kind of asset price bubble and too much leverage”, Thakor said. He pointed out that many problems are due to a lack of capital. Banks with a higher capital ratio would lend more and create more liquidity; they would lead to more economic growth and are more likely to survive a financial crisis. Moreover, they would take less risk and screen more diligently, and subsequently, would create less systemic risk.

A false reading from the financial crisis

What does that mean for banking regulation? For Thakor, regulatory protection is “a double-edged sword”. In his view,  regulatory protection may enhance bank services in the beginning, but in the long run banks will be riskier and leveraged as the regulations distorts their behavior and a new financial crisis would become more likely. According to Thakor, banking are narrowed by regulating reserve and liquidity requirements because it prevents banks to create liquidity by making loans and therefore, limits creating deposits. He pointed out that liquidity requirements were a false reading of financial crisis.

To be prepared for a crisis, Thakor suggested to have higher capital requirements for depository institutions and shadow banks and to make these requirements countercyclical. In addition, liquidity requirements should be reduced. The regulatory structure should be more integrated, across national boundaries. Thakor argued for restrictions on consumer leverage and made the case for improving consumer financial literacy. He also stressed that banks need to focus on bank governance, culture and their higher purpose. “Banks need to explain to the tax payer and society why they exist and what their purpose is”, he said. A more safety-oriented bank culture could increase trust in the stability of the financial system.

During a crisis, he would favor stricter consequences for executives of failing banks. Further, he argued against intrusive regulation but for dividend restrictions and capital support that dilutes current shareholders.

In his view, this may increase trust and therefore, help to meet recent developments like more big and complex banks, the growth of fintech and the disillusionment with capitalism due to banking crises and bailouts. “We need higher purpose, higher capital and stronger culture in banking – we need more trust”, Thakor concluded.