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The University of Chicago Business Law Review

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Abstract

Banks, which are businesses that simultaneously make loans and take deposits that are available to customers on demand, are inherently unstable. The instability exists because the mismatch in the (long-term) maturity of banks’ assets and the (short-term) maturity of their liabilities makes them susceptible to runs and panics that destabilize the broader economy and require bailouts on a regular basis. As such, banks essentially hold society hostage. They must be continuously propped up by the government to prevent them from collapsing and bringing the rest of the economy down with them.

There is a strong need for the transaction-account services provided by banks, and there is a strong need for the loans provided by banks. Why it is necessary to combine lending and deposit taking,withinasingle firm, rather than have them supplied by separate firms, such as commercial lending companies and money market mutual funds, is an issue that has received surprisingly little attention. The main argument in favor of banks is that economies of scope can be achieved by combining lending and deposit taking. For example, by offering checking accounts to borrowers, banks obtain private information about these borrowers that is not available to rival, nonbank lenders. This private information from depositors is thought to make banks unusually efficient lenders.

In this Article I first argue that improvements in technology and information retrieval and sharing have reduced or eliminated the traditional efficiency justification for combining deposit taking and lending. At the same time, other improvements in technology have made banks even more fragile by making it easier for depositors to trigger runs by withdrawing their funds electronically.

Previous scholars have argued for “narrow banks” that would unbundle the provision of lending and deposit taking. Here I observe that these scholars do not consider the rationales offered by financial economists to explain why these activities are combined. They ignore the sparse but important literature in economics and finance that models how combining lending and deposit taking generates efficiencies in the form of synergies. Thus, these scholars focus on the costs of combining lending and deposit taking without considering the benefits.

While the scholars who argue for narrow banks ignore the beneficial efficiencies associated with combining lending and deposit taking, the financial economists who argue that combining lending and deposit taking is efficient ignore the harmful costs associated with combining these two functions. In particular, combining lending and deposit taking makes banks unstable, requiring the creation and maintenance of a thicket of regulation to deal with that instability, which still fails to prevent periodic runs and panics. This Article concludes that when the costs associated with combining lending and deposit taking are properly considered, the arguments that traditional banking is efficient appear highly doubtful.

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