What Do Banks Do?

March 1, 2013

Banks operate by holding a diversified portfolio of debt and a diversified set of depositors. This mix allows the bank to meet immediate demands for funds on a daily basis. The equity-to-asset ratio determines how much equity or stock a bank issues based on the debt it holds. Calls for the government to raise the equity-to-asset ratio will make households worse off, says Arnold King, a member of the Financial Markets Working Group at the Mercatus Center.

  • Holding debt is preferable to holding equity, because 98 percent of the time the debt will be paid back with interest.
  • Banks issue two types of claims on the debt claims they hold: one claim is equity in the bank and the other claim is deposits.
  • Households typically hold bank deposits that can be withdrawn at any time.

To understand an equity-to-asset ratio, suppose a bank has a 10 percent ratio. If a new business issues $100,000 in debt that is held by the bank, then the bank will issue $10,000 in equity and hold $90,000 in deposits to cover the loan.

  • All financial claims are ultimately held by households.
  • If equity-to-asset ratios were raised to 30 percent, the result would be that households own more bank equity and thus have fewer deposits available.
  • In the example, if the equity-to-asset ratio was 30 percent, the banks would issue $30,000 in equity, which would be owned by households, and only $70,000 in deposits would be on hand.

Households would be worse off because increased holdings of bank equity are not as liquid as were their bank deposits. In addition, households would need to be concerned about "insiders" within bank management, who control financial strategy, making gains at the expense of households who are less active in equity management.

  • If more equity is issued by banks when households prefer deposits, new firms may begin to issue financial claims that work like deposits.
  • This "shadow banking" would make the overall financial sector less efficient and riskier.
  • The effects of more regulation and rearranging the financial system may be more complicated than proponents of raising the equity-to-debt ratio realize.

Source: Arnold Kling, "What Do Banks Do?" The American, February 26, 2013.

 

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