The crucial role of commercial banks

Read my article to be published in Banque & Stratégie of april 2021

Commercial banks are companies that, like others, produce an offer that must meet a demand, by mobilising human resources and capital. Their effectiveness can be seen through their ability to achieve sufficient results to ensure their continuity and growth. But banks have the particularity of being subject to very heavy regulation, which well exceeds that relating to any other sector. They manage – and so must protect – savings and, individually, they are a link in systemic risk. This risk must be averted so as to safeguard the financial system, the very lifeblood of the economy.

Banks are central to financing the economy. We can clearly see in emerging countries that the quest for growth goes through the development of banks and the adoption of banking among the population, because savings placed in “piggy banks” cannot be mobilised to finance economic growth.

In developed countries, even though recent decades have seen a sharp increase in the relative contribution of financial markets to the overall financing of the economy, banks have a crucial role, for several reasons it is worth reiterating. First of all, they play a strong brokerage role in the economy, which consists of aligning, through their balance sheets, the financing needs of certain parties and the financing capacities of others. Financial markets have the ability to mobilise savings to finance the economy, but they do so on a small proportion of economic agents, both on the savers’ side and that of the economic agents to be financed. There is very strong asymmetry of information between the issuer and the purchaser of securities. Gaining access to the financial markets is therefore difficult. The vast majority of financial markets are reserved for companies that are large enough to meet the requirements of visibility, financial communication and recurrence of emissions, without any reference to individuals and professionals, who of course cannot finance themselves on the markets. At the same time, savers do not all have sufficient time, information or the skills necessary to understand the risks inherent in the financial markets, even though they would go through investment funds, for example.

Unlike financial markets, which are opportunity markets, commercial banks have a long-term relationship with their individual, professional and corporate clients, which they finance and whose investments and flows they also manage. This comprehensive, long-term relationship gives them capacity for fine analysis that reduces information asymmetry “industrially”. We should add that by carrying loans and deposits on their balance sheets, banks do not directly bring together the borrower and the saver. They thus greatly facilitate a much higher number of financing operations than if they had to wait for the wishes of borrowers and lenders to coincide with each other. And they do this in terms of the desired levels of credit risk, loan and investment duration and other types of interest rate.

Banks thus in particular take on a credit risk, with depositors taking this risk only on the bank itself. This remarkable function undertaken by banks is key to financing the economy, while the market leaves this risk to investors. If commercial banks play a vital role, it is also because they bear the maturity transformation risk on their own income statements. Savers want short-term and liquid investments, while borrowers are most often willing to borrow over the medium to long term, whether households for their properties or companies for their investments. For their part, financial markets meet this maturity transformation need through secondary markets, but the risks considered are then left to the economic agents themselves. By investing in the medium to long term amounts that may be necessary in the short term, savers are faced with a liquidity risk, and the crisis of 2007-2009 was a forceful reminder of its existence. They must also take on an interest rate risk, i.e. a risk of capital gains or losses on the investments made, in the event that rates fall or rise. Investment funds mutualise the risk for the benefit of savers, but do not in the least remove it from them. Conversely, banks cover the liquidity risk, as well as interest rate risk.

All in all, therefore, commercial banks are risk hubs that carry credit, liquidity and interest rate risks on their own income statements. The role of the bank is to take the risks that economic agents are either unaware of or do not want to take. It also ensures professional, regulated and supervised management, having the equity calculated to be able to absorb them. In this way, they play a unique, crucial and indispensable role in the economy.

Finally, through credit that generates deposits of the same amount, banks create money, under the regulation provided by central banks. They can therefore, as an aggregate, lend money even before it has been saved. In this way, they can set up additional means of payment, in anticipation of the creation of future wealth. For their part, the financial markets do not create money; they make pre-existing capital circulate.

In addition, the financial markets are very useful because, on the one hand, they make it possible to finance, particularly through equity markets, that which cannot reasonably be financed by bank credit, and, on the other, they complement financing from banks, with significant amounts. They cannot provide all the necessary financing due to their limited amount of capital by design and compliance with the essential regulatory solvency ratios. Finally, the markets facilitate the circulation of financial risk, thanks in particular to derivatives.

It is therefore necessary to find the pertinent relative reciprocal contributions to financing the economy between the financial markets and commercial banks, both indispensable. The development of financial markets in the 1980s increased funding opportunities and necessarily made banks more efficient and more competitive. However, given their specific characteristics – in particular their self-referential behaviour, faced with the difficulty of knowing the fundamental value of the prices of financial assets, with the future being difficult to probabilise – the financial markets behave in a more volatile and imitative manner than banks. The right proportion between markets and banks – well regulated – is thus in itself crucial to financial stability, a good economy and the well-being of everyone.

Professor of Economics and Bank Management, Financial Macroeconomics and Monetary Policy at HEC – Chief Executive Officer of BRED

Read it on Olivier Klein’s blog