ABSTRACT
The traditional ‘productionist’ view of the role of banking is that of mobilizing and directing savings into loans for financing investments into productive assets. In the process banks are managing the risk associated with a timing difference between loans made (relatively long-lived assets) and liabilities incurred in the form of deposits held on behalf of households (relatively volatile).
Understanding the many roles that banks play in the financial system is one of the fundamental issues in theoretical economics and finance. The efficiency of the process through which savings are channeled into productive activities is crucial for growth and general welfare. Banks are one part of this process.
(Allen and Carletti, 2008: 1) The focus of the economics literature has been on two key aspects of banking. One aspect is the duration risk associated with the discrepancy between asset and liability risk and how timing mismatches can lead to a possible financial contagion. The other aspect concerns the classification of banking systems as either ‘bank based’ (e.g. in continental Europe and Asia) or ‘market based’ (e.g. in the UK and USA), and how differences in system characteristics help to explain variations in growth and economic development. Our argument is that banks are best viewed as operating within a particular banking business model (BBM) where market and non-market stakeholder relations have an impact on bank reported financials. From the mid-1970s on, US (and later European) banks have managed to disconnect their financing (from savings) through securitization, which facilitates the selling on of loans to other investors that raise their funds in the bond market. This process of securitization helped to disconnect the growth in banks’ assets (loans) from GDP and household savings, thereby inflating banks’ assets ahead of GDP and liquidity. Liquidity and possible loan charge-off risk are ameliorated by the need to maintain 8–10 per cent of equity funds in a bank’s balance sheet to satisfy capital adequacy tests set out by the so-called Basle I–III regulatory agreements. The purpose of capital adequacy is to act as a financial buffer in circumstances where high risk assets (loans) become irrecoverable and have to be written off against earnings and thus also shareholder equity.