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Banks

Banks

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,

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