Central Banking Essay 5 Revised
Toma Cubrilo Essay 5 Revised
1. Banks are special
Banks play a special role in the economy. They take deposits from firms and individuals and lend these deposits out to investors of all kinds. In short, they act as intermediaries and are responsible for channeling savings to investors. But are they really the only institutions capable of doing that? Would it not be possible for people to set up a collective investment fund and then invest these funds in the same way banks invest them? According to Goodhart, the answer is clearly no. The difference lies in the type of assets banks and funds invest in. Investment funds can only invest in marketable assets, while banks invest primarily in nonmarketable assets. Ideally, every borrower would like to issue his debt on the market. But markets are not as natural of a phenomenon as one might think they are; financial markets need to be set up, prospectuses must be issued and investment information must be made publicly available. John Chant (1987) elegantly writes: “marketable securities are (securities) for which the borrower supplies the bulk of information required by investors, whereas with nonmarketable securities the lender gathers more of the information.” The repercussion of this minor difference is that banks will extend loans on a fixed nominal value basis in order to reduce their information costs and, analogously, depositors will seek fixed nominal deposits from the bank because it is too expensive to acquire relevant information about the financial health of the bank.
2. Bank runs are inevitable The fundamental nature of the relationship between banks and depositors is what made Goodhart conclude, that “the combination of the nominal convertibility guarantee, together with the uncertainty about the true value of bank assets, also leads to the possibility of runs on individual banks and systemic crises.” Indeed, if deposit holders suspect their bank of having financial difficulties, they will quickly run
1. Banks are special
Banks play a special role in the economy. They take deposits from firms and individuals and lend these deposits out to investors of all kinds. In short, they act as intermediaries and are responsible for channeling savings to investors. But are they really the only institutions capable of doing that? Would it not be possible for people to set up a collective investment fund and then invest these funds in the same way banks invest them? According to Goodhart, the answer is clearly no. The difference lies in the type of assets banks and funds invest in. Investment funds can only invest in marketable assets, while banks invest primarily in nonmarketable assets. Ideally, every borrower would like to issue his debt on the market. But markets are not as natural of a phenomenon as one might think they are; financial markets need to be set up, prospectuses must be issued and investment information must be made publicly available. John Chant (1987) elegantly writes: “marketable securities are (securities) for which the borrower supplies the bulk of information required by investors, whereas with nonmarketable securities the lender gathers more of the information.” The repercussion of this minor difference is that banks will extend loans on a fixed nominal value basis in order to reduce their information costs and, analogously, depositors will seek fixed nominal deposits from the bank because it is too expensive to acquire relevant information about the financial health of the bank.
2. Bank runs are inevitable The fundamental nature of the relationship between banks and depositors is what made Goodhart conclude, that “the combination of the nominal convertibility guarantee, together with the uncertainty about the true value of bank assets, also leads to the possibility of runs on individual banks and systemic crises.” Indeed, if deposit holders suspect their bank of having financial difficulties, they will quickly run