« The Secret Scripture | Main | Paul Krugman wins the Nobel Prize »
What is a bank?
Via Matt Yglesias, Justin Fox writes:
If you borrow short and lend long, you’re effectively a bank. It’s becoming ever less clear to me what justification there is for nonbank borrow-short-lend-long-institutions other than regulatory arbitrage.
I cannot sign on to this principle. Business-to-business trade credit is huge in the United States (it's not all short term) as is commercial lending, as you might get from General Motors or for that matter Sears or Nordstrom. Pawn shops are more common than you might think. If we regulate these lenders like banks we presumably have to give them comparable privileges, which could mean discount window access, FDIC access, and the use of Fed Wire. Plus they would be subject to other regulations on banks, including restrictions on affiliations with commercial firms. I don't want to do that and in many cases I don't even see what it would mean to do that (how can we stop Sears from affiliating with a commercial firm?). I conclude that we cannot escape some important legal distinction between bank and non-bank lenders. Admittedly any such distinctions can become more problematic with the march of technology and the increasing sophistication of regulatory arbitrage.
Posted by Tyler Cowen on October 12, 2008 at 07:03 PM in Economics | Permalink
Comments
In the case of a pawn shop and Sears, though (not sure about General Motors), isn't the big difference that they're not doing the "borrowing short" part of the "lending long, borrowing short" formula? If the pawn shop ponies up its own owner's cash/equity to supply a loan, then its ongoing business is less fragile than a bank's, because no one, as far as I know, can initiate a run on a pawn broker, any more than they can initiate a run on Sears (not sure on this one, though -- is Sears heavily in debt?). As far as I'm concerned, the lending isn't the big concern -- it's the coupling of lending with short-term liabilities of very similar magnitude.
Posted by: keyholez at Oct 12, 2008 7:38:34 PM
Anyone who borrows stock on margin is a bank?
Posted by: Highgamma at Oct 12, 2008 7:42:30 PM
Sorry. In last comment, please read "borrow" as "buy". So if you buy stock on margin, you should be considered a bank?
Posted by: Highgamma at Oct 12, 2008 7:44:06 PM
I guess having demand deposits as a liability against your issued loans isn't a meaningful enough distinction?
Posted by: Jonas Cord Jr. at Oct 12, 2008 8:17:18 PM
Doesn't business to business credit have the potential to help the companies that are known to be doing well? That seems like a crucial role to be filled when the regular banking industry refuses to make loans.
Posted by: at Oct 12, 2008 8:32:50 PM
I thought the meaning of "bank" was, in modern times and terms: an entity that can lend money, at interest, and can have the debt monetized by a system of money supply administration like the Federal Reserve (or some analogous process, so it isn't just currency thrown out there with a promise to pay back, and no expansion of legal "credit" or money supply.) So, me or a company just lending some cash under a contract to a friend or business, even if the arrangements for repayment are like that offered by a bank - we aren't banks since the Fed doesn't monetize our lent debt - true?
Posted by: Neil Bates at Oct 12, 2008 9:22:28 PM
A run on a pawn shop would occur when everyone came in and paid off their pawn and picked up their tv sets and belt sanders. The pawn shop would have more cash and their back room would be empty.
A pawn shop is not a bank even though it fits that niche for the bottom strata of our society.
Posted by: Nat at Oct 13, 2008 12:30:58 AM
Besides the bizarre confusion of lenders with sellers, aren't you going a little overboard on regulating here? Even assuming a pawn shop is a lender, for example, there's no need for FDIC insurance for a lender that doesn't take deposits. Some regulation doesn't mandate massive regulatoin.
Posted by: L2P at Oct 13, 2008 12:35:48 AM
A run on a pawn shop would occur when everyone came in and paid off their pawn and picked up their tv sets and belt sanders.
There can't be a run that bankrupts because the pawn shop does not loan those items out to other people. In this type of run, the pawn shop would make a ton of money. The problem with banking is that the bank promises the same dollar to more than one entity. When you start leveraging, you end up promising that same dollar to 10, 20 or 30 different entities. It only takes a small percentage increase in defaults, or a smallish bank run to make the bank insolvent.
As for business to business credit, companies buy and sell on credit to each other all the time. It's a bit easier for companies to operate this way, so shipments can go out before an invoice is sent, a check cut and sent back to the vendor. This is far different than the highly leveraged world of modern banking.
Posted by: JordanT at Oct 13, 2008 1:16:18 AM
This is a good start on the rationale to regulate everything that can affect anything and have a government ownership stake in those pawn shops that pose systemic risk.
Posted by: Andrew at Oct 13, 2008 4:17:51 AM
This definition of a bank is too easy. To my a opinion, a bank is an institution that lends long and borrows short AND a contract (possibly legally enforced) that promises "careful" treatment of deposits.
In this sense, regulation is part of the contract between the depositor and the bank or a kind of consumer protection.
One should be free to choose other deposit contracts and thus to lend to non-banks.
Posted by: Dirk at Oct 13, 2008 4:19:19 AM
Isn't a bank one of those places where people put their money assuming they always have it immediately at their disposal, but where the guardians of their money go around doing risky stuff with it, and in case they mess up too bad, the tax payer refills the vaults? I've heard this is perfectly legal too, and it's called fractional reserve banking. One of the great triumphs of Western Capitalism; Karl Marx approves of the recurring financial crises this causes.
Posted by: Amerikaansche Brabander at Oct 13, 2008 4:42:42 AM
Tyler's alarmism that financial regulation will extend to all business, no matter how small, is a silly propaganda distraction.
For the purpose of this additional regulation, only players (and actions) big enough to cause systemic failure are important. If you like a domino analogy, some dominoes are not big enough or close enough to topple others.
Posted by: Mike Huben at Oct 13, 2008 5:15:45 AM
I realize the deep economic thinking of Matt Yglesias is so much more important, but when are you going to comment on the magisterial "Anatomy of a Train Wreck" report by economist Stan J. Liebowitz of the U. of Dallas showing that relaxed lending standards implemented to benefit minorities and low-income household caused the mortgage meltdown. I realize you rejected that theory before on general principles, but, isn't it time you thought twice?
Here's Liebowitz's report:
http://www.independent.org/pdf/policy_reports/2008-10-03-trainwreck.pdf
Posted by: Steve Sailer at Oct 13, 2008 7:05:12 AM
Tyler,
FYI...
Anatomy of a Train Wreck: Causes of the Mortgage Meltdown
October 3, 2008
by Stan J. Liebowitz
Why did the mortgage market melt down so badly? Why were there so many defaults when the economy was not particularly weak? Why were the securities based upon these mortgages not considered anywhere as risky as they actually turned out to be?
This report concludes that, in an attempt to increase home ownership, particularly by minorities and the less affluent, virtually every branch of the government undertook an attack on underwriting standards starting in the early 1990s. Regulators, academic specialists, GSEs, and housing activists universally praised the decline in mortgage-underwriting standards as an “innovation” in mortgage lending. This weakening of underwriting standards succeeded in increasing home ownership and also the price of housing, helping to lead to a housing price bubble. The price bubble, along with relaxed lending standards, allowed speculators to purchase homes without putting their own money at risk.
The recent rise in foreclosures is not related empirically to the distinction between subprime and prime loans since both sustained the same percentage increase of foreclosures and at the same time. Nor is it consistent with the “nasty subprime lender” hypothesis currently considered to be the cause of the mortgage meltdown. Instead, the important factor is the distinction between adjustable-rate and fixed-rate mortgages. This evidence is consistent with speculators turning and running when housing prices stopped rising.
Anatomy of a Train Wreck is included in the forthcoming Independent Institute book, Housing America: Building Out of a Crisis, edited by Randall G. Holcombe and Benjamin Powell.
Stan J. Liebowitz is Research Fellow at The Independent Institute, Ashbel Smith Professor of Economics and Director of the Center for the Analysis of Property Rights and Innovation at the University of Texas at Dallas, and co-author with Stephen Margolis of Winners, Losers, and Microsoft: Competition and Antitrust in High Technology, published by the Independent Institute.
http://www.independent.org/publications/policy_reports/detail.asp?type=full&id=30
Posted by: Steve Sailer at Oct 13, 2008 7:09:57 AM
Krugman wins Nobel. I was hoping for Thaler or Shiller, but at least it will be fun watching the outrage.
Posted by: Nimm at Oct 13, 2008 7:12:25 AM
They should have given the Nobel to Stan J. Liebowitz. He's been hollering for many years about the government's drive for "relaxed lending standards" to improve minority and low income home ownership.
Posted by: Steve Sailer at Oct 13, 2008 7:28:10 AM
when banks taht borrow short and lend long hedge that risk the market makers on the other side take the same borrow short and lend long position. are we going to make all market makers become banks? you'll be left with almost no market makers
Posted by: at Oct 13, 2008 8:36:59 AM
A bank is an entity chartered by the government to borrow money without collateral.
Posted by: Joel at Oct 13, 2008 11:37:19 AM
First, I really like Joel's definition of what a bank is. In exchange for granting of this special privilege (and the accompanying regulatory requirements to ensure good conduct) the bank provides liquidity, savings vehicles and a "default" payment system (alternative payment systems exist, but this payment system helps promote the government's fiat currency).
The only point I wanted to make was that all legitimate institutions are already regulated. As individuals we are subject to the laws of the state, so even if we are operating an unregistered sole proprietorship we are regulated. Any other organization of reasonable size is incorporated (and so exists as a pseudo individual).
I can agree with you that government ownership is not the answer. Why should the government purchase senior stock or debt when it has every right to simply tax for fine institutions for their bad behavior? The reason we know the current situation is not be handled properly is because it is being handled on Wall Street's terms and not on the government's.
Talk about moral hazard. Who wants the government voting its shares? And as a tax payer, why wouldn't I insist on the government having voting shares if it absolutely has to have shares? Ownership is not the answer. Just ask Japan.
Posted by: Sam Wilson at Oct 13, 2008 12:02:21 PM
Banks do more than just lend long and borrow short.
Banks create money.
Do pawn shops create money?
Posted by: spencer at Oct 13, 2008 5:05:15 PM
I'm going to demolish everything you said and prove Yglesias right. I hope to see your rebuttal or agreement. :-)
"Business-to-business trade credit is huge in the United States (it's not all short term)"
However, that sort of lending is usually *not* borrow-short-lend-long. Traditionally, businesses fund such credit with cash reserves which are either from capital, retained earnings from prior years, or long-term borrowing. If they start funding such credit with expected earnings from the future, they're playing a very risky game.
"as is commercial lending, as you might get from General Motors or for that matter Sears or Nordstrom."
Again, this is usually not borrow-short-lend-long.... and in the cases where it is -- as with General Motors' GMAC -- you end up with what is effectively a bank, namely GMAC.
"Pawn shops are more common than you might think."
And again, they don't borrow-short-lend-long, unless they're financing their lending on the commercial paper markets!
The point is that there is not necessarily any "borrowing short to lend long" in any of these businesses. *None of them are subject to bank runs* unless they finance themselves in very particular ways. If they *do*, then they are subject to bank runs, and as such need to be regulated like banks.
Basically you missed the entire point of what Yglesias was saying. If you borrow short and lend long, then you are subject to bank runs where you can be unable to pay back your creditors despite being solvent, due to a panic. Institutions subject to bank runs need to be regulated like banks.
You can lend long as much as you like as long as you aren't subject to bank runs. If you fund that lending with cash you actually own, with stockholder investment, or with long-term (maturity-matched or exceeded) borrowing, you aren't subject to runs.
Likewise, if a "bank" was fully maturity-matched -- if it issued 20-year commercial loans backed by 20-year certificates of deposit, and demand deposits were only used to back overnight or shorter loans -- it wouldn't be subject to bank runs, and therefore would *not need banking regulations*.
So indeed, if you think clearly about Yglesias's (and my) point, you'll see some "non-bank" institutions should be considered banks for regulation (because they're subject to runs) -- and some "banks" shouldn't be (because they're not)!
Posted by: neroden at Oct 14, 2008 9:55:12 AM
To put this in another way:
The reason banks need to be regulated *at all* (beyond the normal anti-fraud regulations applicable to all industry) is bank runs.
Bank regulation is based around preventing bank runs, and when they happen, preventing them from having further long-term bad effects.
Since the purpose of bank regulation is to prevent bank runs, any entity which is subject to bank runs needs to be regulated like a bank.
The entities which are subject to bank runs are those which mismatch their borrowing and lending maturities by borrowing short-term and lending that money out long-term.
Therefore all such entities (and no others) should be subject to banking regulation.
Simple, isn't it?
Posted by: Nathanael Nerode at Oct 14, 2008 10:04:05 AM
After reading this article I thought that it had some good and bad points. The bank whether it lends for short term or long term is still a bank. A pawn shop does not need to be regulated. If that happens it’s not going to be a pawn shop, even if it sells windows access or other major components. People shouldn’t worry about stuff like that; it’s not our major problem. The problem is the banks running out of money not pawn shops selling discounted price.
Posted by: john j at Oct 15, 2008 2:02:11 PM
