Banks and security markets.

• Author: Gorton, Gary

What do banks do (that markets cannot do)? In the United States in 1845, the answer would have been that banks made loans and issued mortgages, but their most important role was to provide a medium of exchange by issuing private money.(1) By the late 19th century, U.S. capital markets were more developed, but at the same time large banks resembled German universal banks.(2) Passage of the Glass-Steagall Act in 1934 changed that by restricting banks' activities.(3) In 1996 banks face competition from money market mutual funds for deposit business and from junk bonds, commercial paper, and medium-term notes for bank loans.(4) While smaller firms continue to rely heavily on banks, banks are now engaged in many new activities, such as interest rate and currency swaps.(5) Whatever it is that defines banks as unique institutions, the pattern of bank activities has changed over the last 150 years as banking has interacted with the development of security markets. The challenge is to explain the persistence of banking as security markets increasingly develop.

Banks and Security Markets in the Organization of Capitalist Economies

One problem in understanding what banks do is that the function of securities markets is not well understood. With James Dow, I address the issue of the connection between stock market price "efficiency" and economic efficiency.(6) In this work, we assume that firms are operated by managers who must be compensated in a way that induces them to find desirable investment projects. The managers may make an effort to produce information, but are not always successful in receiving information. When they are not successful, they may be induced by their compensation contracts to rely on inferences drawn from changes in their firms' stock market prices. In such an economy, two types of information must be produced and transmitted in order to achieve the most efficient allocation of resources. First, the stock market must provide forward-looking or prospective information when informed traders produce information about the firm's investment opportunities for managers to act on. Second, the stock market must provide backward-looking or retrospective information when stock prices reflect informed traders' production of information about the outcomes of investment decisions made in previous periods. Managerial compensation based on stock prices then can induce managerial effort.

This model of the stock market seems to be what most economists have in mind when they speak of "market efficiency." Stock prices allocate resources by influencing investment decisions and by providing a way to monitor corporate managers. But, consider the same economy without the stock market but with banks instead. Banks design contracts to hire information-producing loan analysts who write prospective and retrospective reports about investment opportunities and managerial performance. Dow and I show that the banks can implement the same allocation as the efficient equilibrium of the stock market economy. Efficient security prices are neither necessary nor sufficient for economic efficiency.

That the savings-investment process might be equally well organized around banks as around security markets suggests empirically investigating the role of banks in economies where securities markets are less important than in the United States, as in Germany. For much of recent German history the stock market has been small and illiquid. German banks, though, can own stock legally. The question is whether bank block shareholding is, in some sense, a substitute for a liquid stock market. Schmid and I examine the role of banks in Germany, and show that in the 1970s firm performance was better when a bank was a large shareholder. This is consistent with the proposition that when banks obtain a block of stock (via a family selling out, or because of financial distress), they have an incentive to improve firm performance by monitoring because, effectively, the block cannot be sold (since the stock market is traded so thinly).(7) By the 1980s, however, German capital markets had developed further, and this role of banks was no longer present.(8)

Bank Uniqueness

Banks and securities markets may be substitutes but, even in economies with highly developed capital markets, banking persists as an important institution. This suggests that banks perform some tasks that markets cannot accomplish, even when they are highly developed.

On the asset side of the balance sheet...