Banks

4 Pages 991 Words

Banks have proved themselves to be the most hazardous economic institutions known to man. Breakdowns in banking lie at the center of most financial crises. And banks are unusually effective at spreading financial distress, once it starts, from one place to another. It is tempting to conclude that banks should simply be abolished. Unfortunately, that is unlikely to be possible. Banks seem to be necessary.
To see why, consider the job that any financial system has to do. It has to bring willing lenders and willing borrowers together. One way or another, this involves processing information. Two kinds of problem arise. First, the lender needs to know whether a would-be borrower is a good risk. To complicate matters, the keener the borrower—and the higher the interest rate he is willing to pay on the loan—the more likely he is to be a bad risk. This is called adverse selection: the most eager borrowers will be the least desirable, making lenders less willing to lend. The possibility of adverse selection inhibits productive lending and borrowing.
The other problem that financial systems encounter in processing information is moral hazard. Once a borrower has his loan, he may try to cheat. In investing the money, the most he can lose is the amount of the loan. But he may calculate that the greater the risk he takes with the money, the higher his chances of doing very well. Because his losses are capped, he is encouraged to take a bigger risk with his investment than he otherwise would.
Moral hazard becomes acute if the borrower expects to lose the value of his investment anyway. In that case he has nothing further to lose by taking a much bigger risk in the hope of turning his fortunes around. If this “gamble on redemption” works, he keeps all the proceeds after the loan is repaid, but the lender gets no extra return. If the gamble fails, the borrower is no worse off than if he had acted prudently. Moral hazard also takes more obvi...