NOTE: This is an work-in-progress collective blog post collecting ideas and notes on some inter-related topics:

  • Statistics about financial firms balance sheets (both at individual and sector level)
  • The theory and the practice of the functions performed by the financial sector in general
  • The cost of financial intermediation
  • The benefits and risks of financial intermediation

Banks’ function – beyond fiction.

The debate about the actual function of banks has been famously brought forward in several speeches by Adair Turner, former Chairman of the UK Financial Services Authority. While he colorfully describes the standard economic textbook description of banks’ function as “largely fictional” he emphasizes the role of financial interconnectedness in combination with leverage. See his speech on this topic at the INET conference in Toronto in 2013 and here is a full transcript. Three points from that speech remain particularly relevant today and matter for this post:

  1. Endogenous money. Banks do not merely lend pre-existing money but create money. This is what is called endogenous money (see: a Bank of England paper describing its mechanics; a recent DOLFINS paper on endogenous money in networks by Duuc, Napoletano, Barucca and Battiston 2018).
  2. Intra-financial activity. The largest portion of financial actors assets (often about 50% for large banks) is not invested as usually assumed in real sector activities but in intrafinancial activities. This investments give rise to a complex web if intra-financial contracts. The function and the implications of this financial interconnectedness is investigated by a growing stream of works, notably within the DOLFINS project.
  3. Real-estate versus business. The second largest portion of banks assets is again not ending up in real sector activities (not in productive businesses at least), but in loans to households. This is visible from many of our studies based in ECB data (see e.g. the posts on (climate) stress-testing). Presumably the majority of these loans goes into financing the purchase of real-estate. (In this regard, see a comprehensive study by Jorda et al. 2016, free ssrn version).

 

An optimal size of the financial sector?

From a speech by Benoît Cœuré, Member of the Executive Board of the ECB “… there is a link between the size of the financial sector and its complexity. It is likely that the complexity and interconnectedness of financial institutions increases (presumably in a non-linear way) with the size of the overall financial system, making it more difficult for regulators to understand what is going on within its bounds.”