The Purpose of Banking

Banking, as we know it, emerged from a surprising place: it was originally a sideline business for medieval goldsmiths. By the nature of their business, goldsmiths needed vaults in which to store their gold. Over time, they realized that they could offer safekeeping services for their customers, too, because a wealthy person might prefer to leave his stash of gold and silver with a goldsmith rather than keep it at home, where thieves might snatch it.

Someone who deposited gold and silver with a goldsmith received a receipt that could be redeemed for those precious metals at any time. And a funny thing happened: people began paying for their purchases not by cashing in their receipts for gold and then paying with the gold, but simply by handing over their precious metal receipts to the seller. Thus, an early form of paper money was born.

Meanwhile, goldsmiths realized something else: even though they were obligated to return a customer’s precious metals on demand, they didn’t actually need to keep all of the treasure on their premises. After all, it was unlikely that all of their customers would want to lay hands on their gold and silver on the same day, especially if customers were using receipts as a means of payment. So a goldsmith could safely put some of his customers’ wealth to work by lending it out to other businesses, keeping only enough on hand to pay off the few customers likely to demand their precious metals on short notice—plus some additional reserves in case of exceptional demand.

Banks make both savers and borrowers happy: savers get ready access to their cash and borrowers get funds to borrow.

And so banking was born. In a more abstract form, depository banks today do the same thing those enterprising goldsmiths learned to do: they accept the savings of individuals, promising to return them on demand, but put most of those funds to work by taking advantage of the fact that not everyone will want access to those funds at the same time. A typical bank account lets you withdraw as much of your funds as you want, anytime you want—but the bank doesn’t actually keep everyone’s cash in its safe or even in a form that can be turned quickly into cash. Instead, the bank lends out most of the funds placed in its care, keeping limited reserves to meet day-to-day withdrawals. And because deposits can be put to use, banks don’t charge you (or charge very little) for the privilege of keeping your savings safe. Depending on the type of account you have, they might even pay you interest on your deposits.

Maturity transformation is the conversion of short-term liabilities into long-term assets.

More generally, what depository banks do is borrow on a short-term basis from depositors (who can demand to be repaid at any time) and lend on a long-term basis to others (who cannot be forced to repay until the end date of their loan). This is what economists call maturity transformation: converting short-term liabilities (deposits in this case) into long-term assets (bank loans that earn interest). Shadow banks, such as Lehman Brothers, also engage in maturity transformation, but they do it in a way that doesn’t involve taking deposits.

A shadow bank is a nondepository financial institution that engages in maturity transformation.

Instead of taking deposits, Lehman borrowed funds in the short-term credit markets and then invested those funds in longer-term speculative projects. Indeed, a shadow bank is any financial institution that does not accept deposits but does engage in maturity transformation—borrowing over the short term and lending or investing over the longer term. And just as bank depositors benefit from the liquidity and higher return that banking provides compared to sitting on their money, lenders to shadow banks like Lehman benefit from liquidity (their loans must be repaid quickly, often overnight) and higher return compared to other ways of investing their funds.

A generation ago, depository banks accounted for most banking. After about 1980, however, there was a steady rise in shadow banking. Shadow banking has grown in popularity because it is not subject to the regulations, such as capital requirements and reserve requirements, that are imposed on depository banking. So, like the unregulated trusts that set off the Panic of 1907, shadow banks can offer their customers a higher rate of return on their funds. As of July 2007, generally considered the start of the financial crisis that climaxed when Lehman fell in September 2008, the U.S. shadow banking sector was about 1.5 times larger, in terms of dollars, than the formal, deposit-taking banking sector.

As we pointed out in Chapter 14, things are not always simple in banking. There we learned why depository banks can be subject to bank runs. As the cases of Lehman and LTCM so spectacularly illustrate, the same vulnerability afflicts shadow banks. Next we explore why.