www.sciencedirect.com/science/article/pii/S1057521915001477The link above is to a paper which is addresses the question of what banks do and what it means. It is the clearest explanation I have seen and it discusses different theories of the role of banks, and what they mean. The author claims and empirical approach, that is, he goes and looks at what really happens. This is in contrast to what we usually see: the construction of models based on untested assumptions. As an aside, he points out that economics has made no progress in more than a century, and to me that reinforces its status as a "social science" rather than the "hard science" it prefers to present itself as.
The paper discusses three different theories of the role of banks. That sounds daunting, but it is very easy to understand, with none of the usual equations or obfuscatory language. So it is accessible for we lay people. One may or may not accept what he says, but at least it is clear what we are talking about. That is progress in itself
Some of what he says is obvious once pointed out: but unsurprisingly, I missed some of the more obvious implications even though I had all the information.
As an example, in discussing the mainstream theory of banks as mere financial intermediaries ( as proposed by Krugman, amongst many others) he answers a question which has been lurking in my mind, and which I have struggled to conceptualise. Recently there has been much talk of "bail ins", eg in the context of Cyprus, and as a proposal for future action to resolve bank failure. For me, and for many others that seems wrong, but the gut feeling did not translate into the debate as conducted by the experts, and I could not really see why. It is obvious that most of us put money in the bank, for them to look after it for us. We expect it to be safe, and available for use when we need it. The financial crash showed that was not the reality, and in fact the guarantee of bank deposits is not given by banks, but by governments. And there is widespread talk of reducing or eliminating that guarantee on unclear notions that it is somehow unfair. As seen from the perspective of bankers, and governments, largely.
That is because those bodies take the view that you and me are lending our money to the bank when we put it there. So we are creditors of the bank and if they go bust we should lose our money. But you and I don't enter that contract at all. We do not get a profit from our deposits ( though arguably we could if interest rates were higher) and we do not expect to. We do not intend to risk our money when we put it in the bank: rather the opposite. The situation from our perspective is much more like giving our money to a lawyer. A lawyer is required to keep his client's money separate from his own. If he does not, he is breaking the law. If a lawyer goes bust the client's money is not affected because it is kept in a separate account and does not belong to him. It cannot be used to pay his creditors. It does not appear on his balance sheet, and it is not part of his business.
Though most of us think of our money in the bank in that way, the reality is completely different. The bank does not keep that money separate. It IS their money, from the point of view of the bank, and of the government. Were you consciously aware of that difference? I had a vague notion this was true but had not thought it through. The implications are rather important.
The paper is long and it covers a lot of ground. But it is an easy read. And it is very instructive. It is particularly chilling in its discussion of the regulation of banks and why the much vaunted new arrangements under Basel will not work. I urge you to read it.
