Money and Banking Term Paper

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Money and Banking

Bankers hold more liquid assets than most business firms. Why?

As is the case for all businesses, one obvious adverse liquidity outcome for banks is the inability to pay liabilities as they fall due. And, liquidity risk is even broader, including the realization of a market loss as a result of the premature or forced sale of assets to raise liquidity and loss of business opportunity or franchise due to a lack of liquidity.

But, banks face even more difficult liquidity challenges than do most businesses. Banks protect customers against liquidity problems by taking in money which can be withdrawn on demand or at short notice, and by providing committed loan facilities to corporate customers and overdraft facilities to personal sector customers. By insuring others against liquidity risk, banks become exposed to it themselves because of the mismatch between the term structure of the assets and liabilities on the balance sheets, generally illiquid loans funded by highly liquid deposits, and on-demand off-balance sheet commitments.

To function and prosper, banks must not maintain a prudent margin of solvency through liquid assets to maintain market and customer confidence. One potential trigger for deposit runs is fear that a bank may be insolvent. Therefore, it is essential that the business and balance sheets of banks to be fundamentally sound, adding even greater pressure for banks to maintain more liquidity than most businesses.

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Bankers insist there are more economies of scale in banking. Academics insist there are none except below medium bank-size levels. Who is correct? Why?

Academics rely on research on banking scale efficiency that shows that the average cost curve is a flat U-shape. This means that large banks getting even larger would be inconsistent with cost minimization. However, a wave of consolidation has swept through the U.S. banking industry, indicating that bankers obviously feel that there are economies of scale in banking.

Bankers may be right given the wave of changes in the banking industry that have impacted production functions and cost curves. For example, the Riegle-Neal Interstate Banking and Branches Efficiency Act, which permits interstate branching effective 1997, may have changed the underlying production function of banking firms. Now that banks do not need to set up separately capitalized banks in different states to deliver their financial products, it could be less costly to expand outputs. Further, rapid advancements in information technology and the sharp drop in the cost of computers and technology may have shifted the average cost curve. And banks have altered to cost of offering certain types of banking products by cultivating alternative delivery channels for certain financial products, for example, through supermarkets, telephone lines, and the Internet.

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