Living Economics

Banks and Non-Bank Finance
Banks may be able to expand money supply through fractional-reserve loans, but more and more loans and other financing are channeled through the non-bank finance sector.

In poor countries, most people do not have bank accounts. They keep their money under their mattresses, so to speak. If they have more money than is required for daily transactions, they buy precious metals in the form of jewelry to ward off price inflation. Most businesses fund their start-ups with loans from relatives. And there are loan sharks who tide over short-term emergency needs.

Banks appear as the economy gets richer and more stable. The more trusting souls deposit their surplus cash into bank accounts for safe keeping and to earn interest. Banks make money by expanding credit by keeping only fractional reserves to back up their loans. There is still no stock exchange to invest in business start-ups or bond market for the government or business to borrow money from private investors. In other words, to the extent that banks invest in business start-ups or lend to businesses and the government, they also perform the functions of what are called capital and debt markets today.

As economies get richer, capital and debt markets emerge as separate financial institutions independent of banks. In the stock market, businesses can sell stock ownerships directly to investors. In the bond market, businesses and governments can borrow directly from private investors by issuing debt securities. And before business start-ups are ready to sell stocks in the stock market, private investors can invest in them through the venture capital markets (Bond vs Stocks).

The existence of non-bank finance markets means that savers have a greater choice of financial assets to invest in other than checking or savings deposits with banks. In the US, non-bank finance markets (specifically the bond markets) have grown so big that they have over-shadowed banks. In the summer of 2007, assets funded through non-bank finance markets were larger than those held by America’s banks. Only one-third of US home mortgages were on banks’ balance sheets.

But there is a symbiotic relationship between banks and bond markets. For example, it is banks that originate the mortgages which bond markets package into asset-backed debt securities for investors. In effect, bond markets facilitate the recycling of investors’ money back into banks for more mortgage origination, among other loans. Without bond markets for mortgage-backed debt securities, banks would have to hold their mortgage loans on their balance sheet and can no longer make new loans when their excess reserves are exhausted until the loans are repaid.

The role of non-banks in finance markets are far from being benign. Unrestrained by capital reserves requirements, they often engage in highly leveraged debt financing and unregulated credit default swaps that are highly sensitive to systemic shocks. Their high-yield/high-risk activities ultimately led to an asset bubble and the subsequent credit crunch of 2007 which more than wiped out the previous illusory paper gain (See Bubble Economics).

Although non-banks have become big players in the financial markets, banks were not innocent bystanders in the Great Credit Crunch. In addition to originating subprime mortgage loans, they also engaged in risky derivative trading through off-balance-sheet entities. Many small banks failed and big banks escaped bankruptcies only because of taxpayer bailout as they are considered too big to fail.

Banks, however, remain the only institutions that can expand the money supply through the fractional reserve system. And they were the only institutions where deposits were federally insured until the big bailout during the 2007 credit crunch when the value of almost all non-bank deposits was guaranteed. Until and unless the value of deposits in non-bank institutions (such as money market mutual funds) is not guaranteed, the only advantage of banks (secure deposits) over other financial institutions will forever be gone. And the rationale for depositors' accepting lower interest rates in exchange for safety will no longer be supportable.

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