22 Jul 2014  Working Papers

Banks as Patient Fixed-Income Investors

Executive Summary — What is the business of banking? Do banks primarily create value on the liability side of the balance sheet as suggested in theories of banking emphasizing liquidity creation? Does the essence of banking reside on the asset side, as in theories emphasizing banks' ability to monitor borrowers? Or does the special nature of banks derive from some synergy between their assets and liabilities? This paper argues that the specialness of traditional banks comes from combining stable money creation on the liability side with assets that have relatively safe long-run cash flows but possibly volatile market values and limited liquidity. To make this business model work, banks rely on deposit insurance, and bear the associated costs of capital regulation. Some preliminary evidence supports the authors' argument. For traditional banks there is a critical synergy between the asset and liability sides of the balance sheet. Key concepts include:

  • One central role of intermediaries—and of banks in particular—is to act as a bridge between households who want to put their money in a safe place they do not need to watch, and securities markets where even assets with relatively low fundamental risk can have volatile market prices.
  • The structure of financial intermediation may be shaped in important ways by the sorts of non-fundamental movements in asset prices-due to fire sales, slow-moving capital, and other frictions-that have been so extensively documented in asset-pricing scholarship.

 

Author Abstract

We examine the business model of traditional commercial banks in the context of their coexistence with shadow banks. While both types of intermediaries create safe "money-like" claims, they go about this in different ways. Traditional banks create safe claims by relying on deposit insurance, supported by costly equity capital. This structure allows bank depositors to remain "sleepy": they do not have to pay attention to transient fluctuations in the mark-to-market value of bank assets. In contrast, shadow banks create safe claims by giving their investors an early exit option that allows them to seize collateral and liquidate it at the first sign of trouble. Thus traditional banks have a stable source of funding, while shadow banks are subject to runs and fire-sale losses. These different funding models in turn influence the kinds of assets that traditional banks and shadow banks hold in equilibrium: traditional banks have a comparative advantage at holding fixed-income assets that have only modest fundamental risk but are relatively illiquid and have substantial transitory price volatility.

Paper Information