A serious question

By Emanuel Derman
September 1, 2011

Capitalism depends on lending and borrowing, and hence on banks. In that sense banks are a utility, like Water Works or Electric Company.

Utilities have to be protected from collapse.

Banks borrow from depositors and have to earn a spread by lending or investing.

How do you set a sensible limit, individually or as a group, on the activities borrowers can lend to or invest in, so as to avoid future economy-shattering disasters?

I don’t think the answer should involve advanced statistics or mathematics.

 

 

8 comments

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Ekk. Maybe you should stick with the quantitative finance and shy away from more conventional economic arguments.

First off, consider an electric company. The economic argument meant to explain why it is okay to have a monopoly for an electric company is that they have a natural monopoly, ie. there is a large initial capital investment, but economies of scale such that only one firm will have the lowest long-run total cost. The economic rationale for regulating a natural monopoly is that otherwise they would charge amounts that would be consistent with monopoly and consumers would be worse off. The reason to regulate is not that they have to be protected from collapse.

If banks are utilities because capitalism depends on them, then why not agriculture. After all, if we didn’t have food, then no one would be living in the capitalist society. Or alternately transportation. Surely without transportation we wouldn’t have capitalism (otherwise we couldn’t get to the market).

You start from an incorrect premise. If you had just asked the question in the second to the last paragraph, someone could try to answer the question without the unnecessary premises proceeding it.

Personally, I think that a free banking system would be far more robust than our current system. In addition, any limit set up in advance is necessarily going to be gamed by the participants. In a world without a free banking system, it might be better for regulators link capital requires and insurance to something like this:
http://pages.stern.nyu.edu/~sternfin/vac harya/public_html/systemic_risk.pdf
And then

Posted by jmh530 | Report as abusive

The Utilities have strict price and tech regulations in order to make sure that they don’t overcharge their clients, for sure, but also to make sure that they will do the right investments to keep the infrastructure up and running (aka, not collapsing).
The food industry and transportation industries, are full of regulations, of all kinds!
As for the banking system: freer than this?!

Posted by RedItalian | Report as abusive

it is difficult to compare banks and utility companies because they deal with different objects. Utility companies deal with something very well known and “stable”, something that can be relatively easy and objectively monitored and managed (gas, electricity, railroad infrastructure, etc.). Banks always deal with risk, with probability to lend/invest in wrong place. Banks make important thing – they create liquidity of capital (by transferring it from one person to another). They do it by means of different agreements between parties of the deal. Agreement is essence of any financial instrument (stock, bond, futures, swap, etc.). You change your money to some paper (electronic record). So all financial instruments were created as a mean of capital transfer. When we limit banks we limit capital transfer. So in my opinion the only possible way to decrease consequences of financial crises is to prevent appearance of “financial bubbles”. How to do it? We have a choice: administrative measures – to restrict some operations, market measures – to decrease profitability of these operations (for example, by increasing margin requirements)

Posted by complexwriter | Report as abusive

Free banking, man. It doesn’t take that much capital to start lending for money. Who says the banks need to be supported? More lenders rise up when some go bust; lending is a very attractive business to be in (in the right legal setting).

Plus, think about Bob Shiller’s story about gold smiths being the original creditors. Does that sound like a public utility to you?

Posted by stat_arb | Report as abusive

There’s no way to say now-and-forevermore what projects are worth lending to. This is why there are markets for equities & debt. Skin in the game and rewards for being right.

Posted by stat_arb | Report as abusive

You know — Prosper.com and other peer-to-peer lending websites failed, but that doesn’t mean that

(a) the idea is bad, or that
(b) those implementations would have failed if there were no Institutionalised banks.

So that’s another alternative to banks-as-regulated-utility.

Posted by stat_arb | Report as abusive

This is an interesting and current question, one that, indeed, can not be answered with statistics and mathematics. I think that the concept of banks as utility goes beyond economics and is about many essential structures of human organization and ethics. What justifies the usefulness, goodness, of something as true for man and social life that it should be organized as utility? And are there any differences in importance of their values, like between law, food, water, education and energy? And how should an utility be structured, regulated and owned? Are utilities contingent and should therefor be adjustable or are they naturally constant and relative to the basic human needs? These are just some of the difficult questions that need to be answer.

The role of banks in modern economical functioning overrules any other form of utility in its impact on organization of man’s basic needs and social cohesion. I think it makes sense to see whether certain bank services can become an utility as their true risk seems always to be externalized on society and nature.

The economical argument of a natural monopoly and risk, as jmh530 implied, is false. It’s only concerned with the economical system value and artificial fragility. There is no consistent relation with true values and natural risks.

I think that a sensible limit on any bank activity must be set on that what limits a bank to only deliver true and consistent, robust, values for both man and nature. If we can know what this values are than it is reasonable to consider them as an utility. No matter how “free” a bank is, as long as it goods are not free there will be a very high risk of collapse followed by unjustified and unequal rescue actions.

Posted by MahdiAbdulrazak | Report as abusive

I don’t know the ultimate solution. But I think crasshopper’s suggestion is right: “Skin in the game and rewards for being right.” AND financial punishment for being WRONG.
Otherwise everything’s a joke.