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Banks versus markets.

By Craig Wright | 29 Jun 2017 | Bitcoin & Blockchain Tech

We will attempt to show that banks and financial markets offer both complimentary and competing services depending on a range of factors including the clients that they are serving on the type of finance that they are seeking to provide. Both banks and financial markets exhibit a range of beneficial and detrimental behaviours and outcomes.

Finance has been the centre of many economic concerns and in the 18th and 19th century. Business cycle theory began with the study of credit cycles in the fluctuations in finance. The development of the general equilibrium theory [Walras, 1954] marked the decline and the use of finance as an explanatory variable in economic analysis. The reasons for this resulted from the difficulties in integrating finance into economic theory. In classical economics, the problem arises with the view that monetary theory is less relevant than other aspects of business. In fact, one of the main concerns in classical theory is that money simply acts as a price level determinant and ignores the fact that there is a demand cycle for money itself.

Keynesian theory erred in assuming the aggregation of several financial instruments, including long-term bonds and equities. In this framework, the method used in the financing of a firm had little relevance. Further, the emphasis on money both within Keynesian schools and later with that of the monetarists resulted in the exclusion in the study of the effects other financial instruments had on the firm and an exclusive focus on money and monetary policy.

This simplification ignored the interaction between the various interconnected markets [Robinson, 1937]. And lead to the development of more formalised approaches to the general equilibrium model [Tobin, 1969] with the special case of mean variance models and the differentiation between debt and equity markets. Others such as Modigliani and Miller [1958] followed the general approach of Keynes and argued that financial structuring was irrelevant to the development of companies within the economy.

These approaches came under attack starting with the works of Stiglitz [1696a, 1974d] who demonstrated that bankruptcy and the risk there of impacted the interest rates associated with corporate bonds leaving them to reflect higher interest rate than government debt for the same level of risk. Researchers such as Majluf and Myers [1984] provided evidence as to the effects of moral hazard in adverse selection and how that impacted the financial structure of corporate organisation. Factors such as credit rationing and equity rationing were shown to impact the market value of shares and equity. It was also noted that differences in the impact of obligations derived from debt and equity contracts resulted in agency effects. In these instances, managerial incentives played a strong deciding role as to the allocation of funds.

Capital markets with imperfect information

A role for financial institutions can come about because of the distinctions between capital markets and more general markets for products within the economy. A primary note here is the difference where capital markets cannot be treated as an auction market. Banks do not maximise their expected returns through the allocation of credit to the highest bidder. Just as there can be times of equity rationing [Stiglitz, 1985], banks and other financial institutions engage in credit rationing. Some of this results from the changes in credit availability and how they affect investment and the real interest rate but also lead to firms acting in a risk adverse manner.

External forces can also act through finance to result in changes in risk where the changes in the firms that worth and cash flows are shown to have a noticeable impact.

Consequently, capital is not allocated through an auction market. Banks and other financial institutions act to monitor and control the use of capital that they apportion. It has been argued [Mayer, 1989] that credit rationing results in part from the difficulty in determining the overall quality of the various players competing for credit.

In recent years, especially in the United States, an increased reliance has been placed on the market for raising funds. In particular, the securitisation of mortgages and other debt instruments has opened up opportunities for brokers and other third parties reducing the impact and necessity of banks.

Banks and efficient markets

It is a widely held belief [Beck & Levine, 2002; Sharpe, 1990; Gertner & Sharfstein, 1994, Wurgler, 2000] that markets are more efficient than banks in the allocation of capital. The primary reason for this comes from a view that markets offer lower transaction costs. Transaction costs can be lowered where large well-respected firms with international connections are able to raise capital through the market. Due to factors of scale, banks may become an unnecessary cost when a firm becomes sufficiently large. The governance and compliance factors delivered through the screening operations of banks can be achieved through other sources by a firm when a sufficient scale has been achieved. Risk diversification can be provided through the internal functions of the firm and it is possible to increase security and diversify risk in the manner of an insured bank through the use of government backed securities.

In this way, banks as such can be a specialised intermediary who engage in the role of compliance and governance for smaller firms as well as those firms that are well understood [Franklin, 1993, Hellwig, 1991]. In aggregating funds, the bank can create a comparative advantage through the specialisation of risk control. In their pure role as an examiner and allocator, banks act with an informational advantage judging the quality of management in the supervising of allocated funds [Gehrig, 1998; Gorton & Mullineaux, 1987, Kon & Storey, 2003].

One key advantage that banks have over direct market players comes from the informational advantage attached to a long-term relationship with the client. These long-term relationships can offer advantages in cases where less perfect information is available to the market. There are mutual advantages to both the bank and the firm in this relationship. The bank is in a position where it can accumulate more quality information than the market and the bank also gains through the ability to control and minimise agency problems [Stiglitz & Weiss, 1983]. This comes as a consequence of the incentives placed on management within the firm who act against the threat that their credit might be terminated if they fail to achieve set corporate governance targets.

The aggregation of funds also allows banks to be more flexible. Standardisation of credit lines and contracts offered through banking mechanisms provides the bank with a transactional advantage. A line of credit is one such provision that would be difficult for markets to maintain. Small firms and firms that are not listed lack the means to distribute information widely and accurately. This limits the ability for a market to offer equivalent products to all entrants.

Firms can insure against risk but they cannot insure against the risk that their credit rating will be impacted negatively. If an organisation was able to insure against the risk of their credit rating decreasing and offset the increased interest rates that would result, the organisation would be able to act in an adverse manner.

There are also problems with borrowing more than is needed for the immediate needs of a firm. The difference between lending rates and borrowing rates leave a spread that makes it economically infeasible to maintain more in a line of credit than an organisation needs for its immediate use. Further, the market may deem an organisation that retains a larger cash balance from loans that it needs immediately as a sign of diminished confidence and may hold that the organisation is less likely to achieve its goals.

Whereas, bank finance is more flexible than market finance, banks are limited to an extent through the actions of monetary regulation and authorities. These limits are a direct consequence of the requirements for capital controls that limit the amount of money a bank may be able to loan. For large companies, there is often little cost in moving from bank finance to commercial paper as a source of finance but this option only comes with scale.

Bank finance is generally bundled with close supervision and monitoring. To the market, the choice of raising funds through long-term debt can signal of a lack of credit worthiness. Conversely, a firm can also argue that its financial strength is great enough that it does not need to rely on the additional flexibility offered through banking institutions. Hence, multiple signal equilibria exist [Spence, 1974b]. In this, we see that both the best and worst firms can be seen to resort to market finance over the flexibility of bank finance.

Three factors to be considered when contrasting banks and financial markets include:

1. The transaction cost of using the market,

2. Credit crunch that may result through monetary policy, and

3. The impact of stabilisation policies that have been seen until recently to have limited the impact of cycling fluctuations through credit cycles [Kocherlakota, 2000].

It can be also argued that both banks and markets are inefficient in the allocation of finance. Due to the agency effect, companies do not act in the interest of shareholders and often do not disseminate information such as risk to the market. Consequently, some of the differentiation between market and bank financing can arise through the differences in their inefficiencies. Whereas banks can offer efficiencies in certain markets such as well-known industries, and small firms markets can offer advantages for innovative start-ups in the Schumpeterian sense, as well as large firms where the benefits of diversity and risk allocation a less important. In this manner, the comparison of financial intermediaries and markets may be more of an analysis of their inefficiencies then their effectiveness overall.

Banks provide the capability to closely monitor organisations. In particular, they offer governance to managerially run firms. The consequence of this is that some managerially run firms may opt for market-based finance have a bank based finance as it results in greater managerial discretion. Banks, like markets, may also fail to monitor the clients effectively. Banks also offer specialist risk services that can be far more effective and efficient in the assessing of risks then for lenders in markets generally.

The securitisation of finance has led to a more widespread reliance on market based systems. As banks handoff the mortgages they issue into marketable packages, more opportunities for brokers who write the mortgages arise. These brokers are incentivised differently than banks who maintain loans for extended periods of time and often do not have reliance on a requirement to monitor those receiving finance.

As information becomes more widely available we have seen a shift away from banks towards an increase in the use of market-based finance [Franklin & Gale, 1997]. A move away from the monitoring capacities of banks into specialised lending activities is one of the many changes in capital markets that have consequentlydeveloped. These changes are argued to have increased the level of moral hazard associated with finance [Hoff & Stigliz, 1990]. A further consequence has been a decline in governance associated with the allocation of funds and a limit to the level of specialisation that existed in the banking sector. Markets allow for greater risk diversification than small local banks, but the actions of the borrower are less likely to be controlled and monitored. The difficulty is that although markets do provide opportunities for diversification, the level of knowledge and information required to achieve that is limited.

Information provision

The secondary market for securities has improved markedly. These markets provide a means such that previously issued securities may be re-traded and allow for the later trading of finance products. This process adds liquidity and helps to ensure that the true value of the security is reflected in the market.

Stock markets act as a simple benchmark in the understanding of capital markets. The assumption made on this model is that share prices reflect the expected profitability of companies related to the equity on offer.

The cost in raising new finance (at least in US markets) suffers extremely high transactional costs relative to the level of the financial transactions [Summers & Summers, 1989]. This is a result of the inflated costs of operating the markets when contrasted to the amounts raised.

The main factors that enhance the use of the market within the framework of the Allen and Gale model of diversity of opinions and system of financing

We see from Allen and Gale [1993, 1997] that there is no reason to conclude that any one method of finance could be optimal across all situations. The authors present several different parameters that result in the optimisation of financial solutions. As a result, a single type of financing solution provided across the entire economy is not likely to be efficient. In the example of Germany, a strong bias leans towards intermediated finance. This is compared to other countries such as the United States. In this market, the market is demonstrated to have a more dominant role.

Some of the differences might stem from restrictive regulations that stymie the development of markets or the fixed cost that come with the development of markets. These differences lead to multiple equilibria.

The model presented can be further developed. In particular, financial markets and banking intermediaries exist side-by-side to different degrees within all countries. The model could be validated or approved through an analysis of the types of technologies and the extent of financing through each system in each country. The primary aspects of the model rely on an assumption that firms financed within the market will be predominately of a diverse opinion where there is a low assessment cost. Conversely, the model implies that tanks will finance firms and well-known industries that utilise technologies that are expensive to individually assess.

Financial intermediaries such as banks are shown to function poorly where there is limited information and adversity of opinion. This divergence in views is systemic in the development of new industries. As innovative technologies and processes disrupt the status quo, the traditional ways of assessing performance themselves become obsolete. Simply, markets are superior at providing for the financing of highly risky endeavours whilst banks provide more stability in times of calm.

Conclusion

We conclude from the work of Allen and Gale [1997] that market-based systems are more suited for the financing of disruptive and innovative industries which contrasts directly the role of bank-based finance which is more effective in the financing of more established industries where analytic models exist and can be applied.

Banks and market actors substitutes for one another, but they are not complete substitutes. The primary focus of the presented model is weighted towards a Schumpeterian [Schumpeter, 1911] system based on dynamical change and disruptive technologies. Disruptive technologies can be shown to promote the development of wealth via the creation of new products on the provides strong support for this role and industry [McKinnon, 1973].

With the overlap, we can see that banks and financial markets are to some extent complimentary as well as competing. No market is perfect, and consequently financial intermediaries can be seen to arise as a market response that limits the effects of information asymmetry in respect to investment. One thing that we can expect is to see the development of disruptive technologies and changes within the banking sector itself as markets apply pressure to these industries. In this, we can expect to see change in both the means deployed by markets and banking as disruptive technologies undermine existing models.

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