Do we still need commercial banks?

• Author: Rajan, Raghuram G.

According to many observers, the commercial bank - the institution that accepts deposits payable on demand and originates loans - has outlived its usefulness and is in a state of terminal decline. Commercial banks' share of total financial institution assets in the United States has fallen dramatically, from more than 70 percent around the turn of the century to just around 30 percent today.(1) Bank share of corporate debt in the United States has declined from 19.6 percent in 1979 to 14.5 percent in 1994.(2) Competition on both sides of the banks' balance sheet has increased. On the banks' asset side, the growth of the commercial paper and junk bond markets has given large firms an alternative to borrowing from the bank. On the liability side, new technologies and deregulation have given customers choices. Instead of being forced to deposit at the local bank branch or make payments through a bank checking account, customers are able to use mutual funds that offer much the same services.

At the same time that banks appear to be losing business to financial markets and other institutions, they are also imposing huge costs on society. The savings and loan crisis in the United States cost taxpayers several hundred billion dollars by even the most conservative estimate. Estimates of the cost of cleaning up the Japanese banking crisis now exceed $500 billion, and few will hazard a guess as to the costs of the East Asian banking crisis. In the face of the apparent decline in the role of banks and the large costs they can still impose on taxpayers, it is legitimate to ask whether we still need commercial banks.

Further Questions

In order to answer this, we have to ask two further questions. First, what functions do banks perform? Second, is the institutional form that carried out these functions no longer useful?

Before I go further, let me be more specific about the institutional form under investigation. The U.S. Banking Act of 1971 defines the "commercial bank" as an institution that offers demand deposits and originates loans. Therefore, a money market mutual fund is not a bank (it does not originate loans) and a finance company is also not a bank (it does not offer demandable deposits). To start with, I adopt this product-based description as my working definition of a commercial bank.

What Banks Do: Liquidity Provision

Banks essentially perform two functions. First, they provide liquidity. Every time customers withdraw money from an automated teller machine or write a check, they rely on the bank's liquidity provision function. Because this is the immediate point of contact most of us have with banks, early influential papers in banking quite naturally focused on the role of banks in meeting the liquidity needs of depositors.(3) Still, there is very little difference between a demand deposit that an investor holds and a line of credit extended to a firm. Both products require the bank to pay the client money on demand. Therefore it seems natural to conclude that the bank provides liquidity on both sides of the balance sheet - to both depositors and borrowers.

Why might a bank want to do this? A bank can achieve scale economies by using the same underlying reserve of liquid assets and the same institutional arrangements (access to the central bank's discount window and to other banks) to meet the unexpected demands of both borrowers and depositors. Also, the demands may offset each other (borrowers draw down lines of credit at different times from depositors), economizing on the need to hold low-return reserves.(4) Anil Kashyap, Jeremy Stein, and I find evidence suggesting complementarities between demand deposits and lines of credit for banks in the United States - the more a bank does of one, the more it does of the other. Moreover, our work suggests that synergies between the products arise because a bank can economize on holdings of liquid assets when the two products are jointly offered.

In summary, banks appear to provide liquidity in many ways, not just through demand deposits, and the banks' ability to take advantage of diversification is what gives them an advantage in servicing these various demands.

What Banks Do: Fund Complex Positions

The second major function banks perform is to fund complex, illiquid positions.(5) Historically, this has taken the form of making term loans to borrowers who are "difficult" credits. By virtue of their past relationships with client firms, banks know more about...