Banks should be rewarded for transparency
Eric Knight | Saturday, 21 June 2008
The banking industry has gone through a remarkable transformation, much of it driven by the way the industry is regulated. Banking regulations may unwittingly have contributed to the current financial crisis and an understanding of how and why this occurred is essential to finding appropriate remedies.
Banks profit by charging a higher rate of interest on the loans they make than they pay on customer accounts. They also earn fee income by providing services and earn trading or investment income by risking their own capital. Collectively, customers need immediate access to only a fraction of what is in their accounts at any time so banks need only keep a small proportion of their assets in immediately available funds. In case of emergency, banks turn to the central bank for funding and in exchange they agree to be regulated.
Based on this model, most of a bank's earnings should be interest on loans and fee income. We find, instead, that many banks carry vast amounts of liquid assets on their balance sheets and earn more from investing this liquidity than they do from their core business. While it is prudent in times of crisis to have surplus liquidity, some banks now carry $1,000bn (euro645bn,
Banks profit by charging a higher rate of interest on the loans they make than they pay on customer accounts. They also earn fee income by providing services and earn trading or investment income by risking their own capital. Collectively, customers need immediate access to only a fraction of what is in their accounts at any time so banks need only keep a small proportion of their assets in immediately available funds. In case of emergency, banks turn to the central bank for funding and in exchange they agree to be regulated.
Based on this model, most of a bank's earnings should be interest on loans and fee income. We find, instead, that many banks carry vast amounts of liquid assets on their balance sheets and earn more from investing this liquidity than they do from their core business. While it is prudent in times of crisis to have surplus liquidity, some banks now carry $1,000bn (euro645bn,